Inventory Management, Supply Contracts

and Risk Pooling

1
Inventory Management, Supply Contracts
and Risk Pooling

Learning Objectives:
 Introduction to Inventory Management.
 The Effect of Demand Uncertainty:
 Economic Order Quantity
 Reorder Points
 Service levels
 (s,S) Policy
 Periodic Review Policy
 Supply Contracts
 Risk Pooling
 Centralized vs. Decentralized Systems.
 Practical Issues in Inventory Management.

2
 Types of Inventory & the Flow of Materials

S S

Supplier Supplier
B Supplier Supplier
A C D

Work in Process

S
S
Finished Goods
ss

Warehouse X Warehouse Z
Warehouse Y

Customer Demand Customer Demand Customer Demand

3
 Role of Inventory in Supply Chain

Where do we hold inventory?

 Suppliers and manufacturers
 Warehouses and distribution centers
 Retailers

Types of Inventory
 WIP
 Raw materials
 Finished goods
 Distribution Inventories
 Maintenance, Repair, and Operational Suppliers (MROs)
 Transit Inventories

4
 Role of Inventory in Supply Chain

Why do we hold inventory?

 Unexpected changes in demand:

 Short life cycles for a number of products.
 Presence of many competing products.
 Presence of significant uncertainty in the quantity and
quality of supply and supplier costs.
 Reducing uncertainty due to delivery lead time.
 Serving decoupling of operations.
 Allowing flexibility in production scheduling.
 Reducing purchase ordering and material handling costs.
 Taking advantage of quantity discounts by bulk purchases
and transportation costs.
 Satisfying MRO Needs.
 Hedging the future price increases.

5
 Role of Inventory in Supply Chain

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.
 In 1984, GM’s distribution network consisted of:
 20,000 Supplier plants.
 133 Parts plants.
 31 Assembly plants.
 11, 000 dealers.
 Freight transportation costs were about US44.1 billion with 60% for
material shipments.
 Inventory valued at US$7.4 billion: 70% of this is WIP and the rest is
finished vehicles.

6
 Role of Inventory in Supply Chain

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).

7
 Objectives of Inventory Management

 Maximize customer service,

 Maximize operational efficiency of the plant,

and

 Minimize investment in inventories.

8
 Understanding Inventory

The inventory policy is affected by:

 Demand Characteristics
 Replenishment Lead Time
 Number of Products
 Objectives
 Service level

 Minimize costs

9
 Inventory Cost Structure
Cost Structure:
 Order costs
 Setup and teardown costs.
 Production control costs.
 Purchase order costs.
 Lost capacity cost.
 Holding Costs
 Insurance & Security
 Warehouse rental, heat & lights
 Maintenance and Handling
 State and Property Taxes
 Opportunity Costs
 Losses due to Pilferage, Spoilage, Damage, or
Obsolescence

10
 Economic Lot Size Model

Two major questions are of interest in formulating

and solving the economic order quantity (EOQ)
model.

 How much should be ordered when the inventory

for a given item is to be replenished?
 When the order for a given item should be
placed?

11
 Economic Lot Size Model

Assumptions Made in EOQ Model:

 Demand is known and constant, without seasonality.

 Order processing costs are known and constant (do
not vary with quantity ordered).
 Carrying cost rate is known and constant.
 Total carrying cost is a linear function of carrying cost
rate and quantity ordered.
 Item cost per unit is known and constant (no quantity
discounts).
 The entire lot is delivered at one time, instantaneously
(zero lead time).

12
 1. You receive an order quantity Q. 4. The cycle then repeats.

Number
of units
on hand Q Q Q

R
L L
2. Your start using
them up over time. 3. When you reach down to
Time a level of inventory of R,
R = Reorder point
Q = Economic order quantity you place your next Q
L = Lead time sized order.
13
 Cost Minimization Goal
By
Byadding
addingthe
theitem,
item,holding,
holding,andandordering
orderingcosts
costs
together,
together,we
wedetermine
determinethe
thetotal
totalcost
costcurve,
curve,which
whichinin
turn
turnis
isused
usedtotofind
findthe
theQQopt inventory order point that
opt inventory order point that
minimizes
minimizestotal
totalcosts
costs

Total Cost
C
O
S
T Holding
Costs
Annual Cost of
Items (DC)

Ordering Costs

QOPT
Order Quantity (Q)
Basic Fixed-Order Quantity (EOQ) TC=Total
TC=Totalannual
annual
cost
cost
Model Formula
DD=Demand
=Demand
Total Annual Annual Annual CC=Cost
=Costperperunit
unit
Annual = Purchase + Ordering + Holding QQ=Order
=Orderquantity
quantity
Cost Cost Cost Cost SS=Cost
=Costofofplacing
placing
an
anorder
orderororsetup
setup
cost
cost
RR=Reorder
=Reorderpointpoint
LL=Lead
=Leadtime
time
H=Annual
H=Annualholding
holding
D
D Q
Q and
andstorage
storagecost
cost
TC
TC == DC
DC ++ SS++ H H per
perunit
unitof
ofinventory
inventory

Q
Q 22
Deriving the EOQ
 Using
Using calculus,
calculus, we
we take
take the
the first
first derivative
derivative of
of
the
the total
total cost
cost function
function with
with respect
respect to
to Q,
Q, and
and
set
set the
the derivative
derivative (slope)
(slope) equal
equal to
to zero,
zero, solving
solving
for
for the
the optimized
optimized (cost
(cost minimized)
minimized) value
value of
of Q
Qopt
opt

2DS
2DS = 2(Annual
2(Annual DDem
em and)(Order
and)(Order oror Setup
Setup Cost)
Cost)
QQOPT =
OPT = HH = Annual
Annual Holding
Holding Cost
Cost
__
We
Wealso
alsoneed
needaa RReorder
eorder point,
point, RR == dd LL
reorder
reorderpoint
pointto
to _
tell
tellus
uswhen
whento
to d = average daily demand (constant)
place
placeananorder
order L = Lead time (constant)
EOQ Example (1) Problem Data

Given
Given the
theinformation
information below,
below,what
what are
arethe
theEOQ
EOQand
and
reorder
reorder point?
point?

Annual Demand = 1,000 units

Days per year considered in average
daily demand = 365
Cost to place an order = $10
Holding cost per unit per year = $2.50
Lead time = 7 days
Cost per unit = $15
EOQ Example (1) Solution
2DS
2DS = 2(1,000
2(1,000 )(10)
)(10) = 89.443 units or 90 units
Q
QOPT =
OPT = H = 2.50 = 89.443 units or 90 units
H 2.50

1,000
1,000 units
units // year
year = 2.74 units / day
dd == = 2.74 units / day
365 days / year
365 days / year

__
Reorder
Reorderpoint,
point, RR == dd LL== 2.74units
2.74units//day
day(7days)
(7days)==19.18
19.18 or
or 20
20 units
units

In
Insummary,
summary,youyouplace
placeananoptimal
optimalorder
orderof
of90
90units.
units. In
In
the
thecourse
courseof
ofusing
usingthe
theunits
unitsto
tomeet
meetdemand,
demand,when
when
you
youonly
onlyhave
have2020units
unitsleft,
left,place
placethe
thenext
nextorder
orderof
of9090
units.
units.
EOQ Example (2) Problem Data
Determine
Determine thethe economic
economic order
order quantity
quantity
and
and the
the reorder
reorder point
point given
given the
the following…
following…

Annual Demand = 10,000 units

Days per year considered in average daily
demand = 365
Cost to place an order = $10
Holding cost per unit per year = 10% of cost
per unit
Lead time = 10 days
Cost per unit = $15
EOQ Example (2) Solution
2DS
2DS 2(10,000
2(10,000 )(10)
)(10) = 365.148 units, or 366 units
Q
QOPT = =
OPT = H = 1.50 = 365.148 units, or 366 units
H 1.50

10,000
10,000 units
units// year
year = 27.397 units / day
dd == = 27.397 units / day
365 days / year
365 days / year

__
RR == dd LL== 27.397
27.397 units
units//day
day (10
(10 days)
days)== 273.97
273.97 or
or 274
274 units
units

Place
Placean
anorder
orderfor
for366
366units.
units. When
Whenin inthe
thecourse
courseofof
using
usingthe
theinventory
inventoryyou
youare
are left
left with
withonly
only274
274units,
units,
place
placethe
thenext
next order
orderofof366
366units.
units.
 EOQ: Optimal Order Quantity

Example:
Suppose that an annual demand for an outdoor
carpet is 20,000yds. The cost of placing an order is
estimated at $50 per order, whereas the carrying
cost rate per year is 20% and the item cost is $10.
How many yards of outdoor carpet should be
stocked?

D=20,000yds
s=$50
i=0.20
c=10

21
 EOQ Model: An Example

EOQ = Q* =  25020000/(0.2010)
= 1000 yds.

22
 EOQ Model: An Example

The company must order 1000 yards when ever it

orders. At this EOQ

Annual order processing costs

=50(20000/ Q*)
= 50(20000/1000)
= $1000

Annual Carrying Costs

=(0.2010)(Q*/2)
= (0.2010)(1000/2)
= $1000

23
 EOQ Model: An Example

Annual TIC*= Annual order processing costs +

Annual carrying costs
= $1000 + $1000
= $2000

Annual TC* = Annual order processing costs +

Annual carrying costs + Item
Costs
= $1000+$1000+1020000
= $202000

24
 The Effect of
Demand Uncertainty

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.
Recent technological advances have increased the
level of demand uncertainty:
 Short product life cycles.
 Increasing product variety.

25
 Demand Forecast

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.

26
 SnowTime Sporting Goods

 Fashion items have short life cycles, high variety

of competitors.
 SnowTime Sporting Goods
 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 13,100, but there is a
chance that demand will be greater or less than this.

27
 Supply Chain Time Lines

Jan 00 Jan 01 Jan 02

Design Production Retailing

Feb 00 Sep 00 Feb 01 Sep 01

Production

28
 SnowTime Demand Scenarios

Demand Scenarios
P ro b a b ilit y

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

Sales

29
 SnowTime 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

*the amount expected to be realized upon the sale or other

disposition of the asset when it is no longer useful to the
program

30
 SnowTime 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

31
 SnowTime Best Solution

 Find the order quantity that maximizes the

average profit.
 Question: Will this quantity be less than, equal
to, or greater than average demand?

32
 What to Make?

Question: Will this quantity be less than, equal

to, or greater than average demand?

 Average demand is 13,100.

 Look at marginal cost Vs. marginal profit
 If a extra jacket sold during the season:
Marginal profit = 125-80 = $45
 If it is not sold during the season:
Marginal cost = 80-20 = $60

 So Snow Time should make less than average

demand.

33
 SnowTime Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity

34
 SnowTime Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity

35
SnowTime: 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.

36
 Key Insights 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.

37
 Supply Contracts

Buyers and suppliers usually agree on supply

contracts. These contracts are very powerful tools
that can used to ensure adequate supply and
demand for goods.

In a supply contract the buyer and seller may agree

on:
 Pricing and volume discounts.
 Minimum and maximum purchase quantities.
 Delivery lead times.
 Product or material quality.
 Product return policies.

38
 Supply Contracts

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Stores

39
 Demand Scenarios

Demand Scenarios

30%
Probability

25%
20%
15%
10%
5%
0%

Sales

40
 Retailer Expected Profit

Expected Profit

500000

400000

300000

200000

100000

0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity

41
 Retailer Expected Profit

Expected Profit

500000

400000

300000

200000

100000

0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity

42
 Supply Contracts (Cont.)

 Retailer optimal order quantity is 12,000 units.

 Retailer’s expected profit is $470,000 See the
Figure on previous slide).
 Manufacturer profit is $440,000 (= 12000(80-35)-
100000).
 Supply Chain Profit is $910,000 (470000+440000).

Is there anything that the retailer and

manufacturer can do to increase the profit
of both?

43
 Supply Contracts (Cont’d)

 Buy-Back Supply Contracts.

 Revenue-Sharing Contracts.
 Global Optimization.
 Quantity-Flexibility Contracts.
 Sales Rebate Contracts.

44
 Supply Contracts

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Stores
45
 Retailer Profit Buy Back=$55)

Buy-Back Contracts:
Suppose the manufacturer offers to buy back
unsold jackets from the retailer for $55.

46
 Retailer Profit Buy Back=$55)

600,000

500,000
Retailer Profit

400,000

300,000
200,000
100,000

Order Quantity

47
 Retailer Profit (Buy Back=$55)

600,000
$513,800
500,000
Retailer Profit

400,000
300,000
200,000
100,000
0
00

00
00

00

0
00

00

00

00

00

00

00

00
00
60

80
70

90

11

13

14

16

18
10

12

15

17
Order Quantity

48
 Manufacturer Profit (Buy Back=$55)

600,000
Manufacturer Profit

500,000
400,000
300,000
200,000
100,000
0

Production Quantity

49
 Manufacturer Profit (Buy Back=$55)

600,000

$471,900
Manufacturer Profit

500,000
400,000

300,000
200,000

100,000

Production Quantity

50
 Buy-Back SC Profit (Buy back = 55)

Under buy back at $55:

Retailer’s profit = $513,800.

Manufacturer’s profit = $471,900.
SC profit = 513,800+471,900 = $985700.

51
 Supply Contracts (Cont’d)

Revenue-Sharing Contracts:
In revenue-sharing contracts, buyer shares some
of its revenue with the seller, in turn for a discount
on the wholesale price.

In this type a contract, manufacturer agrees to

reduce the whole price from $80 to $60, and in
return, the retailer provides 15% of the product
revenue to the manufacturer.

52
 Supply Contracts

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$60

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Stores
53
 Retailer Profit (Wholesale Price $60, RS
15%)

600,000
500,000
Retailer Profit

400,000
300,000
200,000
100,000
0

Order Quantity

54
 Retailer Profit (Wholesale Price $60, RS
15%)

600,000
$504,325
500,000
Retailer Profit

400,000
300,000
200,000
100,000
0

Order Quantity

55
Manufacturer Profit (Wholesale Price $60,
RS 15%)

700,000
Manufacturer Profit

600,000
500,000
400,000
300,000
200,000
100,000
0

Production Quantity

56
Manufacturer Profit (Wholesale Price $60,
RS 15%)

700,000
Manufacturer Profit

600,000
500,000 $481,375
400,000
300,000
200,000
100,000
0

Production Quantity

57
Revenue-Sharing SC Profit (Wholesale Price
$60, RS 15%)

Under this RS Contract:

Retailer’s profit = $504,325.

Manufacturer’s profit = $481,375.
SC profit = 504,325+481,375 = $985,700.

58
 Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700

59
 Supply Contracts (Cont’d)

Global Optimization:
Both the manufacturer and the retailer are
considered as two members of the same
organization, causing the transfer of money
between the two parties is ignored.

In this case, the supply chain marginal profit is

$90=$125-$35, and the marginal loss is $15 = $35-
$20.

60
 Supply Contracts

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Selling Price=$125
Salvage Value=$20

Manufacturer Manufacturer DC Retail DC

Stores
61
 Supply Chain Profit

1,200,000
S upply Cha in P rofit

1,000,000
800,000
600,000
400,000
200,000
0

Production Quantity

62
 Supply Chain Profit

1,200,000
$1,014,500
Supply Chain Profit

1,000,000
800,000
600,000
400,000
200,000
0

Production Quantity

63
 Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700
Global Optimization 1,014,500

64
 Supply Contracts: Key Insights

 Effective supply contracts allow supply chain

partners to replace sequential optimization by
global optimization.

 Buy Back and Revenue Sharing contracts

achieve this objective through risk sharing.

65
 Supply Contracts: Case Study

 Example: Demand for a movie newly released

video cassette typically starts high and
decreases rapidly
 Peak demand last about 10 weeks
 Blockbuster purchases a copy from a studio for
$65 and rent for $3
 Hence, retailer must rent the tape at least 22 times
before earning profit
 Retailers cannot justify purchasing enough to
cover the peak demand
 In 1998, 20% of surveyed customers reported that
they could not rent the movie they wanted

66
 Supply Contracts: Case Study

 Starting in 1998 Blockbuster entered a revenue

sharing agreement with the major studios
 Studio charges $8 per copy
 Blockbuster pays 30-45% of its rental income
 Even if Blockbuster keeps only half of the rental
income, the breakeven point is 6 rental per copy
 The impact of revenue sharing on Blockbuster
was dramatic
 Rentals increased by 75% in test markets
 Market share increased from 25% to 31% (The 2nd
largest retailer, Hollywood Entertainment Corp has 5%
market share)

67
 Other Contracts

 Quantity Flexibility Contracts

 Supplier provides full refund for returned

items as long as the number of returns is no

larger than a certain quantity
 Sales Rebate Contracts
 Supplier provides direct incentive for the

retailer to increase sales by means of a

rebate paid by the supplier for any item sold
above a certain quantity

68
 SnowTime Costs: Initial Inventory

 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

69
 SnowTime Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity

70
 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?

71
 (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.

72
 Risk Pooling

Consider these two systems:

Warehouse One Market One

Supplier
Warehouse Two Market Two

Market One
Supplier Warehouse

Market Two
73
 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?

74
 Risk Pooling:
Important Observations

 Centralizing inventory control reduces

both safety stock and average inventory
level for the same service level.

 What other kinds of risk pooling will we

see?

75
 Risk Pooling:
Types of Risk Pooling

 Risk Pooling Across Markets

 Risk Pooling Across Products
 Risk Pooling Across Time
 Daily order up to quantity is:

 LTAVG + z  AVG  LT

Orders

10 11 12 13 14 15

Demands 76
 To Centralize Or Not To Centralize

 What is the effect on:

 Safety stock?

 Service level?

 Overhead?

 Lead time?

 Transportation Costs?

77
 Centralized Systems

Centralized Decision:
Supplier

Warehouse

Retailers

78
Factors that Drive Reduction in Inventory

 Top management emphasis on inventory

reduction (19%).
 Reduce the Number of SKUs in the warehouse
(10%).
 Improved forecasting (7%).
 Use of sophisticated inventory management
software (6%).
 Coordination among supply chain members
(6%).
 Others.

79
Factors that Drive Inventory Turns
Increase
 Better software for inventory management
(16.2%).
 Reduced lead time (15%).
 Improved forecasting (10.7%).
 Application of SCM principles (9.6%).
 More attention to inventory management (6.6%).
 Reduction in SKU (5.1%).
 Others.

80
End of the Session

Thank You

81