Inventory Management

&
Risk Pooling
Introduction
General Motors in 1984:
Logistic network consisted of 20,000 supplier plants, 133
parts plants, 31 assembly plants, and 11,000 dealers.
Freight transportation costs were about $4.1 billion, of
which 60 percent for material shipments.
GM inventory was valued at $7.4 billion, of which 70
percent was WIP and the rest was finished vehicles.
Response:-
Inventory Management in Supply Chain
Goals of Inventory Management
By effectively managing inventory:
GM has reduced parts inventory and transportation costs
by 26% annually
Xerox eliminated $700 million inventory from its supply
chain
Wal-Mart became the largest retail company utilizing
efficient inventory management
Reduce Cost, Improve Service
Inventory Levels
Financial
Investment
Operational
Need
Inventory
Where do we hold inventory?
Suppliers and manufacturers
warehouses and distribution centers
retailers
Types of Inventory: General classification
WIP
raw materials
finished goods
Functions of Inventory
To meet anticipated demand
To smooth production requirements
To decouple operations
To protect against stock-outs
To take advantage of order cycles
To help hedge against price increases
To take advantage of quantity discounts
Factors Affecting Inventory Policy
Demand Characteristics: known in advance or random
Lead Time
Number of Different Products Stored in the Warehouse
Economies of scale offered by suppliers & transport
companies
Length of Planning Horizon
Service level desired
1000 2000 3000 4000 5000 6000
0
50
100
150
200
250
300
350
Ordering (Acquisition)Costs
H
o
l
d
i
n
g

o
r

C
a
r
r
y
i
n
g

C
o
s
t
s
T
o
t
a
l

C
o
s
t
s
Economic Order Quantity
Economic Order Quantity Model
Assuming demand certainty
Trade-offs between setup costs and inventory holding costs,
but ignores issues such as demand uncertainty and forecasting.
Single Period Model
Without Initial Inventory
Case: Swimsuit Production
A company designs, produces, and sells summer fashion
items such as swimsuits.
The company has to commit itself six months before summer
to specific production quantities for all its products
predicting demand for each product.
The trade-offs are clear: overestimating customer demand
will result in unsold inventory while underestimating
customer demand will lead to inventory stockouts and
loss of potential customers.
Demand forecast
forecast averages about 13,100
The marketing department uses historical data from the last
five years, current economic conditions, and other factors to
construct a probabilistic forecast of the demand.
11% 11%
28%
22%
18%
10%
0%
5%
10%
15%
20%
25%
30%
8000 10000 12000 14000 16000 18000
Unit sales
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
Profit = Revenue - Variable Cost - Fixed Cost + Salvage
Swimsuit Two 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 Questions ?
Find order quantity that maximizes
weighted average profit?
Will this quantity be less than, equal to, or
greater than average demand?
How much to Make?
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
$0
$100,000
$200,000
$300,000
$400,000
8000 12000 16000 20000
Order Quantity
P
r
o
f
i
t
If Quantity ordered is 12000
Profit = (0.78)*12000*125+ 8000*125+ 10000*125-80*12000-100000+4000*0.11*20+2000*0.11*20
= 1170000+247500 960000 -100000 + 13200= 3070700
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
9000 and 16000 units lead to about the same average
profit, so which do we prefer?
Swimsuit Expected Profit
Expected Profit
$0
$100,000
$200,000
$300,000
$400,000
8000 12000 16000 20000
Order Quantity
P
r
o
f
i
t
Case: Swimsuit Production
But Need to understandrisk associated with certain
decisions.
A frequency histogram provides information about
potential profit for the two given production
quantities, 9,000 units and 16,000 units. The
possible risk and possible reward increases as we
increase the production size.
Probability of Outcomes
0 0 0 0 0
0 . 8 9
0 0 0
0 . 11 0 . 11
0 0
0 . 2 8
0
0 . 2 2
0
0 . 2 8
0 . 11
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
-
3
0
0
0
0
0
-
2
0
0
0
0
0
-
1
0
0
0
0
00
1
0
0
0
0
0
2
0
0
0
0
0
3
0
0
0
0
0
4
0
0
0
0
0
5
0
0
0
0
0
6
0
0
0
0
0
Profi t
P
r
o
b
a
b
i
l
i
t
y
Q=9000
Q=16000
Key Points from this Case
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
Single Period Model With
Initial Inventory
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 the company do? What should
they do if there are 10,000 remaining?
Initial Inventory and Profit
0
100000
200000
300000
400000
500000
5
0
0
0
6
0
0
0
7
0
0
0
8
0
0
0
9
0
0
0
1
0
0
0
0
1
1
0
0
0
1
2
0
0
0
1
3
0
0
0
1
4
0
0
0
1
5
0
0
0
1
6
0
0
0
Production Quantity
P
r
o
f
i
t
The case motivates a powerful (s,S) inventory policy (or a min max
policy): s is the reorder point and S is the order-up-to-level
Multi-Order Opportunities
under Uncertainties
Inventory Policies
Continuous review policy
in which inventory is reviewed every day and a
decision is made about whether and how much to
order.
Periodic review policy
in which the inventory level is reviewed at regular
intervals and an appropriate quantity is ordered
after each review.
Variable Demand with a Fixed ROP
Reorder
point, R
Q
LT
Time
LT
I
n
v
e
n
t
o
r
y

l
e
v
e
l
0
Result of
uncertainty
Reorder Point with a Safety Stock
Reorder
point, R
Q
LT
Time
LT
I
n
v
e
n
t
o
r
y

l
e
v
e
l
0
Safety Stock
The amount of safety stock needed is based on the degree of uncertainty
in the lead time demand and desired customer service level
Determinants of the Reorder Point
The rate of demand
The lead time
Demand and/or lead time variability
Stockout risk (safety stock)
Continuous Review Policy
AVG = Average daily demand faced
STD = Standard deviation of daily demand faced
L = Replenishment lead time
h = Cost of holding one unit of the product per unit time
= service level (the probability of stocking out is 1 )
h p
p
+
=
p =shortage cost
Continuous Review Policy
The inventory position at any point in time is the actual
inventory at the warehouse plus items ordered by the
distributor that have not yet arrived minus items that are
backordered.
The reorder level, R consists of two components: the
average inventory during lead time, which is the product of
average daily demand and the lead time; and the safety stock,
which is the amount of inventory that the distributor needs
to keep at the warehouse and in the pipeline to protect
against deviations from average demand during lead time.
Continuous Review Policy
Variable demand & fixed lead time
Average demand during lead time is exactly
Safety stock is
where z is a constant, referred to as the safety factor.
This constant is associated with the service level.
The reorder level is
Economic lot size is
L STD z
AVG L
L STD z AVG L +
h
AVG K
Q

=
2
Continuous Review Policy
Variable demand & fixed lead time
The expected level of inventory before receiving the order
is (lowest level i.e. Safety Stock)
The expected level of inventory immediately after receiving
the order is (highest level)
The average inventory level is the average of these two
values
L STD z Q +
L STD z
Q
+
2
L STD z
In many situation, the lead time to the warehouse must be
assumed to be normally distributed with average lead time
denoted by AVGL and standard deviation denoted by STDL.
In this case, the reorder point is calculated as
whereAVG * AVGL represents average demand during lead
time, &
is the standard deviation of demand during lead time. The
amount of safety stock that has to be kept is equal to
2 2 2
STDL AVG STD AVGL z AVGL AVG + + =
2 2 2
STDL AVG STD AVGL z +
2 2 2
STDL AVG STD AVGL +
Continuous Review Policy
Variable demand & lead time
Periodic Review Policy
Inventory level is reviewed periodically at regular intervals
and an appropriate quantity so as to arrive at base stock
level is ordered after each review .
Since inventory levels are reviewed at a periodic interval, the fixed cost
of placing an order is a sunk cost and hence can be ignored.
This level of the inventory position should be enough to protect
the warehouse against shortages until the next order arrives.
The next order should cover demand during a period of r + L
days, with r being the length of review period and L being the
lead time.
Periodic Review Policy
Thus, the base-stock level should include two
components: average demand during an interval of r + L
days, which is equal to
and the safety stock, which is calculated as
where z is a safety factor.
AVG L r + ) (
L r STD z +
Periodic Review Policy (with SS)
Periodic Review Policy
Maximum inventory level is achieved immediately after
receiving an order, while the minimum level of inventory
is achieved just before receiving an order.
It is easy to see that the expected level of inventory after
receiving an order is
while the expected level of inventory before an order
arrives is just the safety stock
Hence, the average inventory level is the average of these
two values
L r STD z AVG r + +
L r STD z +
L r STD z
AVG r
+ +

2
RISK POOLING
Risk Pooling
Consider these two systems:
Market Two
Supplier
Warehouse One
Warehouse Two
Market One
Market Two
Supplier
Warehouse
Market One
Questions:
Q1: For the same service level, which system will require more inventory?
Q2: For the same total inventory level, which system will have better service?
What is Risk Pooling?
The idea behind risk pooling is to redesign the supply chain,
the production process, or the product to either reduce the
uncertainty the firm faces or to hedge uncertainty so that
the firm is in a better position to mitigate the consequence
of uncertainty.
Location pooling
Product pooling
Lead Time pooling
Capacity pooling
Lead Time Pooling
Store 1
S
u
p
p
l
i
e
r
Store 100
8-week lead time
Lead Time Pooling
Store 1
S
u
p
p
l
i
e
r
Store 100
8-week lead time
Retail DC
1-week lead time
Capacity Pooling
3 Links no flexibility
Capacity Pooling
9 Links Total Flexibility
Advantages / Disadvantages
Advantages Disadvantages
Location Pooling
reduce demand variability
creates distance between inventory and
customers
reduce expected inventory investment
needed to achieve a target
service level
Product Pooling
reduction in demand variability potentially degrades product functionality
better performance in terms of
matching supply and demand
Lead Time Pooling
decrease lead time extra costs of operating distribution center
keep inventory closer to customer additional transportation costs
reduce inventory investment
Capacity Pooling
accommodate demand uncertainty large costs to have flexibility
Summary Risk Pooling
Risk-pooling strategies are most effective when demands
are negatively correlated because then the uncertainty
with total demand is much less than the uncertainty
with any individual item/location
Risk-pooling strategies do not help reduce pipeline
inventory
Risk-pooling strategies can be used to reduce inventory
while maintaining the same service or they can be used
to increase service while holding the same inventory
Example
Decentralized system:
total SS = 47.88
total avg. invent. =179
Safety Stock
SS =z STD
L
Reorder Point R =AVGL + SS
Order Quantity
Q =sqrt(2*C0*AVG/h)
Order-up-to-level R +Q
Average Inventory SS +Q/2
AVG STD SS R Q
Order-
up-to Level
Average
Inventory
Warehouse 1 39.3 13.2 25.08 65 132 197 91
Warehouse 2 38.6 12.0 22.8 62 131 193 88
Centralized
Warehouse
77.9 20.7 39.35 118 186 304 132
Service Level:97% k=1.88
Lead Time= 1 week
Q/2+SS
Risk Pooling Effect of Correlation
The benefits of risk pooling depend on the
behavior of demand from one market relative
to the demand from another market.
Warehouse
Market 1
Market 2
D
1
+D
2
: (,
2
)
Calculating demand variability
of centralized system
Warehouse 1
Warehouse 2
Market 1
Market 2
D
1
: (
1
,
1
2
)
D
2
: (
2
,
2
2
)

2
=
1
2
+
2
2
+ 2
1

2
,
where -1 1

2
=
1
2
+
2
2
+ 2
1

2
,
where -1 1
: correlation coefficient of D
1
, D
2

1
+
2

1
+
2
Conclusions:
1. Stdevof aggregated demand is
less than the sum of stdevof individual
demands
2. If demands are independent or
negatively correlated, the std of
aggregated demand is much less
Conclusions:
1. Stdevof aggregated demand is
less than the sum of stdevof individual
demands
2. If demands are independent or
negatively correlated, the std of
aggregated demand is much less
1. If D
1
, D
2
positively correlated, > 0
2. If D
1
, D
2
are independent, = 0
3. If D
1
, D
2
negatively correlated, < 0
=
1
+
2
= ??

1
+
2
1 0 -1
2
2
2
1
+
P.C. N.C. Ind.
As (safety) stock is based on standard deviation
Square Root Law: Square Root Law: stock for combined demands
usually less than the combined stocks
Risk Pooling
Effect of Coefficient of Variation
The higher the C.V. of demand observed in one
market, the greater the benefit from risk pooling
COV= Standard deviation/Avg. demand
Decentralized Centralized
Facility/Labor cost
Outbound transportation cost
(from warehouses to retailers)
Responsiveness to customers
(lead time)
Inbound transportation cost
(from factories to warehouses)
Safety Stock
Centralized vs. Decentralized
Overhead
Costs
Service Level
Echelon Inventory System
Supplier
Warehouse
Retailers
Warehouse
echelon
inventory
Warehouse
echelon lead
time
Managing Inventory in the Supply
Chain
How should the reorder point associated with the warehouse
echelon inventory position be calculated? The reorder point
is
where L
e
= echelon lead time, defined as the lead time between the
retailers and the warehouse plus the lead time between the
warehouse and its supplier
AVG = average demand across all retailers (i.e., the
average of the aggregate demand)
STD = standard deviation of (aggregate) demand across
all retailers
e e
L STD z AVG L s + =
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