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Abstract
By embedding RFID tags onto their products, both manufacturers and retailers try to control for shrinkage (e.g. due to
theft). Current inventory control systems do not take into account the disappearing inventory due to this shrinkage. As a
response, corrective actions are made by performing costly audits in which actual inventory is counted. The research
presented in this paper adapts the inventory policy by including both the shrinkage fraction and the impact of RFID
technology. Accordingly, by comparing the situation with RFID and the one without RFID in terms of costs, an exact
analytical expression can be derived for the break-even prices of an RFID tag. It turns out that these break-even prices are
highly related with the value of the items that are lost, the shrinkage fraction and the remaining shrinkage after
implementing RFID. A simple rough-cut approximation to determine the maximum amount of money a manager should
be willing to invest in RFID technology is presented and evaluated.
r 2007 Elsevier B.V. All rights reserved.
0925-5273/$ - see front matter r 2007 Elsevier B.V. All rights reserved.
doi:10.1016/j.ijpe.2007.05.005
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522 A.G. de Kok et al. / Int. J. Production Economics 112 (2008) 521–531
system inventory which is higher than the Along the same line, Kang and Gershwin (2005)
actual inventory. found that the best performing store in their sample
(ii) Misplacement of products: goods are not in the study only had 70–75% of its inventory record
correct place and are thus not available for matching physical inventory during its annual
customers. Consequently, inventory is correct inventory audit. The overall average over all stores
but partially not available, introducing an was 51%. Raman et al. (2001a, b) reported that, at
inventory deviation. the stores of one retailer, two-thirds of the stock
(iii) Transaction errors: this is related to wrong keeping units (SKUs) had inaccurate inventory
scanning of products at the check-out counters records upon physical audits. Such inaccuracies
in retail outlets or switches of products in the could have the potential of reducing profit by 10%
suppliers warehouse. due to higher inventory cost and lost sales. Other
studies report that the main cause of inventory
The standard way of identifying and remedying discrepancy is due to shrinkage: Fleisch and Tell-
for the above inventory deviations is doing costly kamp (2005) reported that shrinkage accounted for
audits. As such, both physical errors (e.g. misplaced 2–4% of sales in the US retail industry in 2001.
items) as system inventory errors (e.g. due to Alexander et al. (2002) at IBM reported that the
shrinkage or transaction errors) are corrected for. amount of inventory shrinkage rates are around
Complete and accurate information on the inven- 1.75% of 2001 sales in the US, Europe and
tory status in the supply chain is thus crucial. In this Australasia. ECR Europe (2003) found that, in
paper, we mainly focus on the inventory inaccuracy Europe, the shrinkage rates were 1.75% for retailers
caused by shrinkage. and 0.56% for manufacturers.
Our application assumes that, depending upon In general, literature on an analytical assessment of
the achieved read accuracy, RFID enhances the the RFID technology is fairly limited. Atali et al.
accuracy of the information currently obtained (2005) and Lee and Ozer (2005) mainly focus on the
through bar code scanning which is more vulnerable inventory function and the effect of taking into
to human error. Consequently, we assume that account the inventory discrepancy. It is, however,
RFID results in a better control of shrinkage. stated that a cost–benefit trade-off for RIFD tags is
Shrinkage can then either be completely vanished still an open issue not tackled by their research. In
(i.e. 100% reliable RFID), or some fraction of the another paper, Kok and Shang (2005), assume in
shrinkage observed in the situation before RFID their model that inventory errors are i.i.d. with a
was used, is left (RFID is less than 100% reliable, mean of zero. In this setting, they model the
e.g. due to read errors). The latter case seems to be transaction and misplacement errors but not the
more realistic: Lee and Ozer (2005) report that shrinkage errors. They state that the commonly
between 10% and 66% of the original shrinkage practiced audit policies can only be effective if the
observed is reduced after implementing RFID right inspection cycle is chosen. They, however, did
technologies. not optimize on this inspection cycle length for the
When having this shrinkage information, one, audits in their study. Rekik et al. (2005) model
however, should take this information into account the consequences of misplacement of inventory on the
when determining the stock levels. Traditional retail shelf by comparing three alternatives. In
inventory management literature assumes that the first alternative, the retailer is unaware of the
inventory managers know exactly what they are misplacement and places his orders as if inventory
storing and that this information is 100% reliable. information is perfect. In the second case, the retailer
In reality, due to e.g. shrinkage inventory records is aware of the errors in his inventory status
are only rough estimates of the actual inventory on information, and adjusts his ordering policy accord-
the retail shelves or in the manufacturer’s ware- ingly. In the final scenario, perfect inventory status
house. A contribution of this paper is that we information based on RFID technology is assumed.
determine an inventory policy taking into account The problem is modeled using a conventional news-
shrinkage. boy formulation with some modifications to adjust
Today, a substantial amount of empirical re- for the scenarios described above. A numerical
search on inventory discrepancy is available. De- analysis demonstrates the limited benefits of RFID.
Horatius and Raman (2004) found that 65% of the Our paper positions itself close to these literature
inventory records at one retailer were inaccurate. contributions. More specifically, it focuses on the
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A.G. de Kok et al. / Int. J. Production Economics 112 (2008) 521–531 523
cost–benefit trade-off between inventory costs and imation is presented to calculate the break-even
the costs of RFID with regards to shrinkage (as prices.
such extending the analysis in Atali et al., 2005).
Next to this, the length of the inspection cycle is This paper is organized as follows: in the next
explicitly taken into account in the analysis. This section the model is developed and exact expres-
was a parameter that needs to be optimized as sions for the break-even prices are derived, then
indicated by the research of Kok and Shang (2005) computational results are presented for a complete
(they considered in their paper the inspection cycle experimental design; the last section concludes the
length as given). Compared to Rekik et al. (2005) paper.
model, we use a more appropriate inventory model
(i.e. a periodic review based stock policy) rather
than the single period newsboy model of which the 2. Model development
use is mainly limited to e.g. fashion products.
The overall objective of this paper is to determine Before starting with the analysis, we summarize in
the additional cost per time unit caused by Table 1 the variables used in the analysis.
shrinkage. One might then consider RFID equip- We assume a periodic review based stock policy:
ment and tag investments that in principle allow to every R periods, the inventory is reviewed and
prevent shrinkage and to come to (almost) perfect raised to an order-up-to level S (see also e.g. Silver
observation (i.e. benefits), yet at the expense of et al., 1998 for more information on the stock policy
additional investments in equipment and tags (i.e. used). Demand in subsequent periods is i.i.d.; let
costs). The insights in this paper are not limited to E½D denote the expected demand per period and
RFID only but are also useful for any technology assume that a fraction of demand per period, P
cost–benefit analysis with inventory implications.
This paper makes the following contributions: Table 1
List of variables used in the analysis
Current inventory based stock policies are Variable Description
augmented taking into account inventory shrink-
age. As such, we quantify the potential gains of C Observation cycle length
using any technology (e.g. RFID) leading to 1=p Expected observation cycle length
1=pnoRFID Expected observation cycle length without RFID
better knowledge on the actual inventory status. 1=pRFID Expected observation cycle length with RFID
The approach is flexible as it also considers E½D Expected demand per period
residual shrinkage after implementing RFID. As P Disappearance fraction
such, it takes into account potential problems ls The rate of disappearances
(e.g. read errors) occurring after RFID imple- X jk Physical inventory at the end of the jth replenishment
cycle associated with observation cycle of length k, just
mentation. before the next order is delivered
The analysis presented gives a detailed cost–be- Bjk Amount of the demand backordered during the jth
nefit analysis focusing on the most relevant replenishment cycle associated with observation cycle
factors (e.g. the cost of the technology, the of length k
inspection cycle length, etc.). This results in exact X Value of the physical inventory at the end of an
arbitrary period, just before an order is delivered
analytical expressions for the break-even RFID B Value of the amount of demand backordered during
prices. an arbitrary period
The effect of the length of the inspection cycle is D1 ðs; t Demand during the interval ðs; t
explicitly taken into account, quantified and D2 ðs; t Disappearances during the interval ðs; t
optimized. It is shown that the inspection cycle R Length of the review period
Lj Lead time for the jth order in an observation cycle
has an important effect on the behavior of the S Order-up-to level
break-even prices. Nr Number of periods per year
Finally, it is shown that the value of the item, the v Price per unit of the product sold
fraction of demand that is disappeared and the d Auditing costs
remaining shrinkage after RFID implementation r Annual interest rate
a Fraction of P that cannot be prevented from
have the largest impact on the break-even prices disappearing
for the RFID tags (when the inspection cycle y Tag costs
length is optimized). A simple rough-cut approx-
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disappears due to shrinkage, misplacement, etc. The Likewise, the actual net inventory just before the
disappeared stock is lost. We assume that demand arrival of the next order (placed at time jR and due
not met from the shelf is backordered and assume at time jR þ Ljþ1 ), denoted by N bj;k is equal to:
that the process of disappearances is pure Poisson
with rate ls ¼ PE ½D. Hence total consumption per N bj;k ¼ S D2 ð0; jR þ Ljþ1 D1 ððj 1ÞR; jR þ Ljþ1 .
time unit equals ð1 þ PÞE ½D.
At each review moment, the observation of the Using the above expressions for the net inventory
inventory takes place. We assume that inventories and the fact that X jk ¼ MaxðN bj;k ; 0Þ and Bjk ¼
are counted then for a random sample of SKUs. ðMaxðN bj;k ; 0Þ MaxðN aj1;k ; 0ÞÞ, we find the fol-
The probability that a particular SKU is in this lowing equations:
sample is set equal to p. Consequently, with this
EðX jk Þ ¼ E½ðS D2 ð0; jR þ Ljþ1
probability p the disappearance of items is identified
correctly and with probability ð1 pÞ the inventory D1 ððj 1ÞR; jR þ Ljþ1 Þþ ,
is based on the inventory at the last review moment EðBjk Þ ¼ E½ðD2 ð0; jR þ Ljþ1
minus observed demand plus replenishment arriving þ D1 ððj 1ÞR; jR þ Ljþ1 SÞþ
between the last review moment and the current
E½ðD2 ð0; ðj 1ÞR þ Lj
one.
Define C as the length of an observation cycle, i.e. þ D1 ððj 1ÞR; ðj 1ÞR þ Lj SÞþ .
the number of periods between two review moments Define the following auxiliary variables to sim-
at which the inventory is observed correctly. Then it plify the notation:
follows that:
Z j1 ¼ D2 ð0; jR þ Ljþ1 þ D1 ððj 1ÞR; jR þ Ljþ1 ,
PðC ¼ kÞ ¼ pð1 pÞk1 ; k ¼ 1; 2; . . . . (1)
Z j2 ¼ D2 ð0; ðj 1ÞR þ Lj þ D1 ððj 1ÞR; ðj 1ÞR þ Lj
Consequently, the expected observation cycle
) E½X jk ¼ E½ðS Z j1 Þþ
length E ½C is then equal to:
) E½Bjk ¼ E½ðZ j1 SÞþ E½ðZj2 SÞþ .
1
E½C ¼ . (2)
p Then it follows that:
From renewal reward theory (Tijms, 2003), we
X
1 X
k
find the following identities: E½X ¼ p pð1 pÞk1 E½X jk
P1 k1 Pk k¼1 j¼1
k¼1 pð1 pÞ j¼1 E½X jk
E½X ¼ , ð3Þ X
1 X
k
E½C ¼p pð1 pÞk1 E½ðS Z j1 Þþ
P1 k1 P k
k¼1 pð1 pÞ j¼1 E½Bjk
k¼1 j¼1
E½B ¼ . ð4Þ 1 X
X 1
E½C
¼p pð1 pÞk1 E½ðS Zj1 Þþ
Suppose that at time 0 the inventory is perfectly j¼1 k¼j
observed, i.e. an observation cycle starts. Suppose X
1 X
1
that this cycle has length k. Let us consider the jth ¼p E½ðS Z j1 Þþ pð1 pÞj1 ð1 pÞk
review moment in this cycle 1pjpk, with the first j¼1 k¼0
moment the actual inventory position is equal to ¼ pð1 pÞj1 E½ðS Z j1 Þþ . ð5Þ
j¼1
S D2 ð0; ðj 1ÞR, while the inventory control
function assumes that the inventory position equals Similarly, the following expression for E½B can
S. The order generated at time ðj 1ÞR is received at be obtained:
time ðj 1ÞR þ Lj , with Lj the leadtime of the jth
order in the observation cycle. Thus the actual net X
1
E½B ¼ pð1 pÞj1 ðE½ðZj1 SÞþ
inventory at moment ðj 1ÞR þ Lj , immediately j¼1
after arrival of this order, denoted by N aj1;k , equals:
E½ðZ j2 SÞþ Þ. ð6Þ
N aj1;k ¼ S D2 ð0; ðj 1ÞR þ Lj
We remark here that the expressions for E½ðZ j1
D1 ððj 1ÞR; ðj 1ÞR þ Lj . SÞþ and E½ðZj2 SÞþ can routinely be calculated if
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Z j1 and Z j2 are assumed to be mixed-Erlang As one can see, the costs depend on the value of a:
distributed (see e.g. Tijms, 2003). if a ¼ 0, then RFID is 100% reliable so that audit
Let P2 be the long-run fraction of the demand costs can be dropped. If aa0, then audits are still
filled directly from the stock on-hand, then it necessary to periodically correct the inventory
follows that: records. This might be due to e.g. read errors with
the RFID equipment, etc. Note that the specific
E½B physical inventory depends on the use of RFID
P2 ¼ 1 . (7)
E½DR ðE½X RFID ) or not ðE½X noRFID Þ and on a. The
Let N r denote the number of periods per year. Let inventory level ðE½X RFID Þ needed to guarantee the
us assume that the price of the product sold equals v service level will be higher (compared to the a ¼ 0
and the annual interest rate equals r. So the case). On top of this inventory increase, we will face
inventory holding costs are v r (euro per unit extra costs due to shrinkage at a rate of aP.
per year) times the average number of units in the The total relevant annual costs under RFID are
pipeline or on-hand. The cost of auditing the then equal to:
inventory equals d. Let E½L be the expected
TRCRFID ¼ vrð1 þ aPÞE½DE½L þ vrE½X RFID
leadtime of an order, then the total relevant annual
costs, TRCnoRFID , are equal to: þ vaPE½DN r þ yE½DN r
þ dpRFID N r jðaa0Þ . ð9Þ
TRCnoRFID ¼ vrð1 þ PÞE½DE½L þ vrE½X noRFID
þ vPE½DN r þ dpnoRFID N r . ð8Þ If a ¼ 0 (i.e. assuming 100% reduction of
shrinkage), Eq. (9) reduces to:
These costs are the sum of all the relevant cost
components involved: TRCRFID ¼ vrE½DE½L þ vrE½X RFID þ yE½DN r .
(10)
(i) Inventory costs, being the costs for the pipeline Comparing Eqs. (8) and (9), we find that the no-
stock, vrð1 þ PÞE½DE½L and for the average RFID situation is more costly than the RFID
inventory on-hand, vrE½X noRFID . situation (in the case that the observation cycle
(ii) Shrinkage costs: vPE½DN r . length is the same in both situations) if and only if:
(iii) Audit costs: dpnoRFID N r .
TRCnoRFID 4TRCRFID
Similarly, we can construct the total relevant 3
annual costs under RFID (denoted as, TRCRFID ). vrð1 þ PÞE½DE½L þ vrE½X noRFID
Assume that RFID has the potential to eliminate
shrinkage but might leave some fraction a of P þ vPE½DN r þ dpnoRFID N r ð11Þ
ð0pap1Þ that cannot be protected from shrinkage. 4
In other words, the shrinkage left after implement- vrð1 þ aPÞE½DE½L þ vrE½X RFID þ vaPE½DN r
ing RFID will be between 0 (a ¼ 0, i.e. 100% þ yE½DN r þ dpRFID N r jðaa0Þ . ð12Þ
reduction) and P (a ¼ 1, i.e. no reduction of
shrinkage through RFID). Using the a factor we Or equivalently:
can thus control for the expected shrinkage when
using RFID. The total relevant costs using RFID vrð1 aÞPE½DE½L þ vrðE½X noRFID E½X RFID Þ
with y the cost of the RFID tag is composed of the þ vð1 aÞPE½DN r yE½DN r
following cost components:
þ ðdpnoRFID N r dpRFID N r jðaa0Þ Þ40. ð13Þ
(i) Inventory costs, being the combination of costs Again if a ¼ 0, then the term dpRFID N r jðaa0Þ
for the pipeline inventory vrð1 þ aPÞE½DE½L equals zero and can be dropped; in the other case
and for the average inventory on-hand, where the fraction aa0, some residual shrinkage is
vrE½X RFID . left from P after RFID implementation and we
(ii) Shrinkage costs: vaPE½DN r . again have to take into account the audit costs
(iii) Tag costs: yE½DN r . under RFID. Expressing this inequality as a
(iv) Audit costs: dpRFID N r jðaa0Þ . constraint on y, we find that RFID is profitable if
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526 A.G. de Kok et al. / Int. J. Production Economics 112 (2008) 521–531
the following condition holds: value of an item v is chosen such that there are
vrð1 aÞPE½L vrðE½X E½X RFID Þ cheap items (e.g. 1 euro, which is typically the
vð1 aÞP þ þ average price in grocery retailing, see e.g. Donselaar
Nr N r E½D
! et al., 2004) and expensive items (in this paper set to
dpnoRFID dpRFID 20 euro) in our experimental design. The other
þ 4y. ð14Þ
E½D E½D ðaa0Þ values in the table are inspired on Atali et al.
(2005) and Lee and Ozer (2005) and chosen such
If a ¼ 0, then the term dpRFID N r jðaa0Þ equals zero that the experimental design is complete and
and can be dropped. Note that the pRFID is not balanced. Combining all these values for the specific
necessarily the same as the pnoRFID . In Section 3 we parameters, resulted in an extensive data set
will look more closely on the optimal p for each of including 62; 208 observations, (in which each
the two situations. If RFID is 100% reliable then observation refers to a specific parameter setting,
the above equation reduces to: its resulting costs and the break-even price obtained
vrPE½L vrðE½X E½X RFID Þ to reach the pre-defined P2 ).
vP þ þ The analysis is performed in a number of
Nr N r E½D
dpnoRFID consecutive steps: first, we analyze the complete
þ 4y. ð15Þ data set and identify the main drivers of the break-
E½D
even prices (Section 3.2). Secondly, we reduce the
In the next section, the exact analytical expression data set by optimizing over the observation period,
for the break-even prices in Eq. (14) will be i.e. we select the best setting for each parameter
evaluated for a large number of settings. combination which is minimized for the observation
cycle length on the total relevant cots. This reduced
3. Experimental results data set is then analyzed in detail (Section 3.3).
Finally, we present and evaluate a simple approx-
3.1. Experimental design and methodology imation for the break-even prices based on the
analysis (Section 3.4).
To analyze the effect of the different parameters
on the expected break-even prices, we perform a 3.2. Overall analysis
closed experimental design (see e.g. Law and
Kelton, 2000). The demand in the analysis is based The average break-even prices for each of the
on fitting a mixed Erlang distribution (see e.g. parameters and its specific value are presented in
Tijms, 2003); the number of periods per year N r , is Table 3. Each column represents a different value
set equal to 250. The observation cycle lengths 1=p for a, i.e. in the case where a ¼ 0:50, 50% of the
in Table 2 correspond to checking once a week original theft fraction P remains unresolved after
(1=p ¼ 5), once in four weeks (1=p ¼ 20), once in 12 implementing RFID.
weeks (1=p ¼ 60) and once a year (1=p ¼ 250). The An analysis of the range of all the parameters
shows that the break-even prices vary significantly
Table 2 with the theft fraction, P and the value of the item,
Experimental design v. For the other parameters in the analysis the effect
is less pronounced. Next to this, a also has an
Parameter used Values
important impact on the break-even prices: compar-
P Theft fraction f0:01; 0:02; 0:05; 0:2g ing horizontally one can observe in all cases a
v Value of an item f1; 20g significant effect of changing a.
r Annual interest rate f0:1; 0:2g Finally, note that for the observation cycle length
EðDÞ Expected demand f0:2; 1; 5g
CVðDÞ Coefficient of variation demand f0:1; 0:5; 1g
1=p a significant effect can be observed (for all a
L Lead time f1; 5; 20g values). Especially for a ¼ 0, we observe a U-shape
P2 Target fill rate f0:90; 0:95; 0:99g effect. This is due to the interaction effect of the
d Audit costs f0:25; 0:75; 1:50g inventory costs and the audit costs averaged over all
1=p Observation cycle length {week, 4 weeks, 12 observations. For the other a values this effect is
weeks, year}
a Fraction of theft that cannot be f0; 0:25; 0:50; 0:75g
distorted by the extra addition of audit costs due to
solved by using RFID the imperfect observation (e.g. due to the read rate).
The observation cycle length does have a big impact
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Table 5
Break-even prices (in euro) for each parameter (optimized
scenarios)
vrð1 aÞPE½L vrðE½X E½X RFID Þ P2 0.90 0.7789 0.5732 0.3808 0.1900
vð1 aÞP þ þ 0.95 0.7876 0.5778 0.3835 0.1912
Nr N r E½D
! 0.99 0.8046 0.5864 0.3883 0.1933
dp dp d 0.25 0.7691 0.5692 0.3783 0.1888
þ 4y. ð16Þ
E½D E½Dðaa0Þ 0.75 0.7902 0.5791 0.3840 0.1913
1.50 0.8119 0.5891 0.3902 0.1943
In this equation, p and p are the optimized
observation cycles for the no-RFID resp. the RFID
(aa0) situation in terms of the minimized total
relevant costs for the no-RFID versus the RFID α
case. Do note that depending upon the cost 0.5 0.25 0
0.75
structure, we might get two different optimal
observation cycles. Depending upon the specific 4
parameter settings it might be optimal to do more or
Breakeven
3
less audits in the RFID case where aa0 compared
to the no-RFID situation. 2
The main effects as originally observed in Table 3
1
stay the same, only the importance of the relevant
parameters (i.e. the theft fraction, P, the value of 0
the item, v and the remaining theft fraction a) 3
compared to the other parameters, has increased 2
1
πν 0
even further. In the subsequent analysis, we will
focus more on the specific relationship between P, v Fig. 2. Optimal break-even prices for all combinations a and Pv.
and a. Fig. 2 shows the optimal break-even prices
for all possible combinations of a and Pv.
From Fig. 2 it is clear that there is a significant Similar, for low Pv one might come to the same
influence from both a and Pv on the break-even conclusion. However, as the numbers are extremely
prices. For high Pv (left hand in the figure), break- small in this region, we also present the table with
even prices reduce almost linear as a function of a. some relevant key numbers. Table 6 shows the
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A.G. de Kok et al. / Int. J. Production Economics 112 (2008) 521–531 529
break-even prices spread over the different demand Referring to Eq. (16), we distinguish between three
rates for the optimized observation cycle length. sources of gains when utilizing RFID: (1) gains in
Looking at the ‘‘Overall’’ row in Table 6, we see inventory investment; (2) gains in audit costs; and
that for Pv ¼ 0:01 (i.e. low) that the relationship (3) gains in shrinkage costs. The effect of imple-
with a is not linear, while for Pv ¼ 4:00 it is closer menting RFID on each of these three cost
to linear. In other words, if after implementation the components is presented in Table 7. Again as before
read rate would not lead to 100% correct informa- the a ¼ 0 is when RFID results in 100% reliable
tion, the effect on the break-even price for the cheap observation. Here the gains are largest in inventory
items is more severe than for the more expensive investment, audit costs (100%) and shrinkage costs
items. The table also shows that the higher the (100%). If aa0 then the gains reduce. The
expected demand, the lower the break-even prices shrinkage costs are, of course, a direct function of
will be as the auditing costs are spread out over a: i.e. if 0.25 of the original theft fraction P is left,
more items. Moreover, the break-even prices tend to then shrinkage costs are reduced with 75%. Even if
converge to the value of ð1 aÞPv as a function of aa0, there are still significant gains to be realized
demand. The overall average for Pv ¼ 0:01 is equal for the audit costs. It might be worthwhile to invest
to 0.0199 euro and for Pv ¼ 4:00, the average equals more in inventory but only audit this inventory once
4.1856 euro (for the a ¼ 0:00 case; the averages for a year, hence realizing an overall saving from a total
the other cases can also be found in the table). relevant cost perspective. Finally, it has to be noted
As a final analysis, we evaluate the gains of that inventory can be substantially reduced for all
implementing RFID as a function of a and Pv. cases of a (the range is going from 5.83% up to
47.04%). These savings are in line with the ones
reported by Lee and Ozer (2005).
Table 6
Break-even prices (in euro) for the optimized parameter settings 3.4. An approximation for the break-even prices
Table 7
Gains for the different components of implementing RFID
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