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Inventory Management and Risk Pooling

Chap 03

Copyright 2001

Outline of the Presentation


Introduction to Inventory Management

The Effect of Demand Uncertainty


(s,S) Policy Risk Pooling

Centralized vs. Decentralized Systems Practical Issues in Inventory Management

Logistics Network
Sources: plants vendors ports Regional Warehouses: stocking points

Field Warehouses: stocking points

Customers, demand centers sinks

Supply

Inventory & warehousing costs


Production/ purchase costs Transportation costs Inventory & warehousing costs Transportation costs

Case: JAM Electronics


JAM produces about 2,500 different products in the Far East. Central warehouse in Korea 70% service level for JAM USA
difficulty forecasting customer demand long lead time in supply chain to USA large number of SKUs handled by JAM USA low priority given the US subsidiary by headquarter in Seoul

Inventory (1/2)
Where do we hold inventory?
Suppliers and manufacturers warehouses and distribution centers retailers

Types of Inventory
WIP raw materials finished goods

Inventory (2/2)
Why do we hold inventory?
Uncertainty in customer demand
short life cycle implies that historical data may not be available many competing products in the marketplace

Uncertainty in quantity and quality of the supply, supplier costs, and delivery times Economies of scale offered by transportation companies

Goals: Reduce Cost, Improve Service


By effectively managing inventory:
Xerox eliminated $700 million inventory from its supply chain Wal-Mart became the largest retail company utilizing efficient inventory management GM has reduced parts inventory and transportation costs by 26% annually

Goals: Reduce Cost, Improve Service


By not managing inventory successfully
In 1994, IBM continues to struggle with shortages in their ThinkPad line (WSJ, Oct 7, 1994) In 1993, Liz Claiborne said its unexpected earning decline is the consequence of higher than anticipated excess inventory (WSJ, July 15, 1993) In 1993, Dell Computers predicts a loss; Stock plunges. Dell acknowledged that the company was sharply off in its forecast of demand, resulting in inventory write downs (WSJ, August 1993)

Understanding Inventory
The inventory policy is affected by:
Demand Characteristics: known in advance or random Lead Time Number of Different Products Stored in the Warehouse Length of Planning Horizon Objectives
Service level Minimize costs

Cost Structure
Cost Structure
order costs:
cost of product transportation costs

holding costs:
tax insurance obsolescence opportunity cost

EOQ: A Simple Model*


Book Store Mug Sales
Demand is constant, at 20 units a week Fixed order cost of $12.00, no lead time Holding cost of 25% of inventory value annually Mugs cost $1.00, sell for $5.00

Question
How many, when to order?

EOQ: A View of Inventory*


Note: No Stockouts Order when no inventory Order Size determines policy Inventory
Order Size Avg. Inven Time

EOQ: Calculating Total Cost*


Purchase Cost Constant Holding Cost: (Avg. Inven) * (Holding Cost) Ordering (Setup Cost): Number of Orders * Order Cost Goal: Find the Order Quantity that Minimizes These Costs:

EOQ:Total Cost*
160 140 120 100

Total Cost
Holding Cost

Cost

80 60 40 20 0 0 500

Order Cost

1000

1500

Order Quantity

EOQ: Optimal Order Quantity*


Optimal Quantity = (2*Demand*Setup Cost)/holding cost So for our problem, the optimal quantity is 316

EOQ: Important Observations*


Tradeoff between set-up costs and holding costs when determining order quantity. In fact, we order so that these costs are equal per unit time Total Cost is not particularly sensitive to the optimal order quantity
b for b*EOQ Cost Increase 50% 25% 80% 90% 100% 110% 120% 150% 200% 0 0.4% 1.6% 8.0% 25%

2.5% 0.5%

The Effect of Demand Uncertainty (1/2)


Most companies treat the world as if it were predictable:
Production and inventory planning are based on forecasts of demand made far in advance of the selling season Companies are aware of demand uncertainty when they create a forecast, but they design their planning process as if the forecast truly represents reality

The Effect of Demand Uncertainty (1/2)


Recent technological advances have increased the level of demand uncertainty:
Short product life cycles Increasing product variety
The three principles of all forecasting techniques: Forecasting is always wrong The longer the forecast horizon the worst is the forecast Aggregate forecasts are more accurate

Case: Swimsuit Production


Fashion items have short life cycles, high variety of competitors Swimsuit products
New designs are completed One production opportunity Based on past sales, knowledge of the industry, and economic conditions, the marketing department has a probabilistic forecast The forecast averages about 13,000, but there is a chance that demand will be greater or less than this.

Swimsuit Demand Scenarios


Demand Scenarios
30% 25% 20% 15% 10% 5% 0%

Probability

80 00 10 00 0

12 00 0

14 00 0

16 00 0

Sales

18 00 0

Swimsuit Costs
Production cost per unit (C): $80 Selling price per unit (S): $125 Salvage value per unit (V): $20 Fixed production cost (F): $100,000 Q is production quantity, D: demand Revenue - Variable Cost - Fixed Cost + Salvage

Profit =

Swimsuit Scenarios
Scenario One:
Suppose you make 12,000 jackets and demand ends up being 13,000 jackets.
Profit = 125(12,000) - 80(12,000) - 100,000 = $440,000

Scenario Two:
Suppose you make 12,000 jackets and demand ends up being 11,000 jackets.
Profit = 125(11,000) - 80(12,000) - 100,000 + 20(1000) = $ 335,000

Swimsuit Best Solution


Find order quantity that maximizes weighted average profit. Question: Will this quantity be less than, equal to, or greater than average demand?

What to Make?
Average demand is 13,100 Look at marginal cost Vs. marginal profit
if extra jacket sold, profit is 125-80 = 45 if not sold, cost is 80-20 = 60

So we will make less than average

Swimsuit Expected Profit


Expected Profit
$400,000 $300,000

Profit

$200,000 $100,000 $0 8000

12000

16000

20000

Order Quantity

Swimsuit Expected Profit


Expected Profit
$400,000 $300,000

Profit

$200,000 $100,000 $0 8000

12000

16000

20000

Order Quantity

Swimsuit Expected Profit


Expected Profit
$400,000 $300,000

Profit

$200,000 $100,000 $0 8000

12000

16000

20000

Order Quantity

Swimsuit : Important Observations


Tradeoff between ordering enough to meet demand and ordering too much Several quantities have the same average profit Average profit does not tell the whole story Question: 9000 and 16000 units lead to about the same average profit, so which do we prefer?

Probability of Outcomes
100%

Probability

80% 60% 40% 20% 0% Q=9000 Q=16000

-3 00 00 0 -1 00 00 0 10 00 00 30 00 00 50 00 00
Cost

Key Points from this Model


The optimal order quantity is not necessarily equal to average forecast demand The optimal quantity depends on the relationship between marginal profit and marginal cost As order quantity increases, average profit first increases and then decreases As production quantity increases, risk increases. In other words, the probability of large gains and of large losses increases

Initial Inventory
Suppose that one of the jacket designs is a model produced last year. Some inventory is left from last year Assume the same demand pattern as before If only old inventory is sold, no setup cost Question: If there are 7000 units remaining, what should SnowTime do? What should they do if there are 10,000 remaining?

Initial Inventory and Profit

500000
Profit

400000 300000 200000 100000 0


00 00 00 00 0 0 0 00 14 15 00 50 50 65 80 95 11 12 50 0

Production Quantity

Initial Inventory and Profit

500000
Profit

400000 300000 200000 100000 0


00 00 00 00 0 0 0 00 14 15 00 50 50 65 80 95 11 12 50 0

Production Quantity

Initial Inventory and Profit

500000
Profit

400000 300000 200000 100000 0


00 00 00 00 0 0 0 00 14 15 00 50 50 65 80 95 11 12 50 0

Production Quantity

Initial Inventory and Profit


500000 400000
Profit

300000 200000 100000 0


5000 6000 7000 8000 9000 10000 11000 12000 13000 14000 15000 16000

Production Quantity

(s, S) Policies
For some starting inventory levels, it is better to not start production If we start, we always produce to the same level Thus, we use an (s,S) policy. If the inventory level is below s, we produce up to S. s is the reorder point, and S is the order-up-to level The difference between the two levels is driven by the fixed costs associated with ordering, transportation, or manufacturing

A Multi-Period Inventory Model


Often, there are multiple reorder opportunities Consider a central distribution facility which orders from a manufacturer and delivers to retailers. The distributor periodically places orders to replenish its inventory

Case Study: Electronic Component Distributor


Electronic Component Distributor Parent company HQ in Japan with worldwide manufacturing All products manufactured by parent company One central warehouse in U.S.

Case Study:The Supply Chain

Demand Variability: Example 1


Product Demand
250 200 Demand 150 (000's) 100 50 0 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Month 150 75 100 50 225 150

125 61 48 53

104 45

Demand Variability: Example 1


Histogram for Value of Orders Placed in a Week
25

Frequency

20 15 10 5 0

$2 5, 00 0

$5 0, 00 0

$7 5, 00 0

00 0

00 0

00 0

00 0 $1 75 ,

$1 00 ,

$1 25 ,

$1 50 ,

Value of Orders Placed in a Week

$2 00 ,

00 0

Reminder:

The Normal Distribution


Standard Deviation = 5

Standard Deviation = 10

Average = 30
0 10 20 30 40 50 60

The distributor holds inventory to:


Satisfy demand during lead time
Protect against demand uncertainty Balance fixed costs and holding costs

The Multi-Period Inventory Model


Normally distributed random demand Fixed order cost plus a cost proportional to amount ordered. Inventory cost is charged per item per unit time If an order arrives and there is no inventory, the order is lost The distributor has a required service level. Intuitively, what will a good policy look like?

A View of (s, S) Policy


S
Inventory Position

Inventory Level

Lead Time

s 0 Time

The (s,S) Policy


(s, S) Policy: Whenever the inventory position drops below a certain level, s, we order to raise the inventory position to level S. The reorder point is a function of:
Lead Time Average demand Demand variability Service level

Notation
AVG = average daily demand STD = standard deviation of daily demand LT = lead time in days h = holding cost of one unit for one day SL = service level (for example, 95%). Also, the Inventory Position at any time is the actual inventory plus items already ordered, but not yet delivered.

Analysis
The reorder point has two components:
To account for average demand during lead time: LTAVG To account for deviations from average (we call this safety stock) z STD LT where z is chosen from statistical tables to ensure that the probability of stockouts during leadtime is 100%-SL.

Example
The distributor has historically observed weekly demand of: AVG = 44.6 STD = 32.1 lead time is 2 weeks, desired service level SL = 97% Average demand during lead time is: 44.6 2 = 89.2 Safety Stock is: 1.88 32.1 2 = 85.3 Reorder point is thus 175, or about 3.9 weeks of supply at warehouse and in the pipeline

Model Two:

Fixed Costs*
In addition to previous costs, a fixed cost K is paid every time an order is placed. We have seen that this motivates an (s,S) policy, where reorder point and order quantity are different. The reorder point will be the same as the previous model, in order to meet meet the service requirement: s = LTAVG + z AVG L What about the order up to level?

Model Two:

The Order-Up-To Level*


We have used the EOQ model to balance fixed, variable costs: Q=(2 K AVG)/h If there was no variability in demand, we would order Q when inventory level was at LT AVG. Why? There is variability, so we need safety stock z AVG * LT The total order-up-to level is: S=max{Q, LT AVG}+ z AVG * LT

Model Two: Example*


Consider the previous example, but with the following additional info: fixed cost of $4500 when an order is placed $250 product cost holding cost 18% of product Weekly holding cost: h = (.18 250) / 52 = 0.87 Order quantity Q=(2 4500 44.6) / 0.87 = 679 Order-up-to level: s + Q = 85 + 679 = 765

Risk Pooling
Consider these two systems:
Warehouse One Market One

Supplier
Warehouse Two LT = 1 week Market One Market Two

Supplier

Warehouse Market Two

1500 products, 10000 accounts

Risk Pooling
For the same service level, which system will require more inventory? Why? For the same total inventory level, which system will have better service? Why? What are the factors that affect these answers?

Risk Pooling Example


Compare the two systems:
two products maintain 97% service level $60 order cost $0.27 weekly holding cost $1.05 transportation cost per unit in decentralized system, $1.10 in centralized system 1 week lead time

Risk Pooling Example


Week Prod A, Market 1 Prod A, Market 2 Prod B, Market 1 Product B, Market 2 1 33 46 0 2 2 45 35 2 4 3 37 41 3 0 4 38 40 0 0 5 55 26 0 3 6 30 48 1 1 7 18 18 3 0 8 58 55 0 0

Risk Pooling Example


Warehouse Product AVG Market 1 Market 2 Market 1 Market 2 A A B B 39.3 38.6 STD CV 13.2 12.0 .34 .31 s 65 62 S 158 154 26 27 Avg. % Inven. Dec. 91 88 15 15

1.125 1.36 1.25 1.58

1.21 4 1.26 5

Centralized A Centralized B

77.9 20.7 .27 2.375 1.9 .81

118 226 6 37

132 20

26% 33%

Risk Pooling: Important Observations


Centralizing inventory control reduces both safety stock and average inventory level for the same service level. This works best for
High coefficient of variation, which reduces required safety stock. Negatively correlated demand. Why?

What other kinds of risk pooling will we see?

Risk Pooling: Types of Risk Pooling*


Risk Pooling Across Markets Risk Pooling Across Products Risk Pooling Across Time Daily order up to quantity is:
LTAVG + z AVG LT

Orders

10

11

12

13

14

15

Demands

To Centralize or not to Centralize


What is the effect on:
Safety stock? Service level? Overhead? Lead time? Transportation Costs?

Centralized Systems*
Supplier

Warehouse

Retailers

Centralized Decision

Centralized Distribution Systems*


Question: How much inventory should management keep at each location? A good strategy: 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 the service level at each of the retailers will be equal.

Inventory Management: Best Practice


Periodic inventory review policy (59%) Tight management of usage rates, lead times and safety stock (46%) ABC approach (37%) Reduced safety stock levels (34%) Shift more inventory, or inventory ownership, to suppliers (31%) Quantitative approaches (33%)

Inventory Turnover Ratio


Industry
Dairy Products Electronic Component Electronic Computers Books: publishing Household audio & video equipment Household electrical appliances Industrial chemical

Upper Quartile 34.4 9.8 9.4 9.8 6.2 8.0 10.3

Median 19.3 5.7 5.3 2.4 3.4 5.0 6.6

Lower Quartile 9.2 3.7 3.5 1.3 2.3 3.8 4.4

Memo