Chapter 3 Inventory Management

In Supply Chains

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

Inventory
Where do we hold inventory?
Suppliers and manufacturers warehouses and distribution centers retailers

Types of Inventory
WIP raw materials finished goods

Why do we hold inventory?

Economies of scale Uncertainty in supply and demand

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 Lead Time Number of Products Objectives
Service level Minimize costs

Cost Structure

Cost Structure
Order costs
Fixed Variable

Holding Costs
Insurance Maintenance and Handling Taxes Opportunity Costs Obsolescence

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
Annual Cost

Total Cost Curve

Holding Cost Order (Setup) Cost Order Quantity

Optimal Order Quantity (Q*)

EOQ: Optimal Order Quantity

Optimal Quantity (Q):
2 Annual Demand Ordering Cost Q 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
Order Qty 50% 80% 90% 100% Cost Increase 25% 3% 1% 00.0% Order Qty 110% 120% 150% 200% Cost Increase 1% 2% 8% 25%

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

Demand Forecasts
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

(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.

Supply Chain and Product Flow

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 150 100 75 50 61 48 53 150 125 104 45 225

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

10

20

Average = 30

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. This is expressed as the the likelihood that the distributor will not stock out during lead time. Intuitively, what will a good policy look like?

A View of (s, S) Policy

S
Inventory Level
Inventory Position

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:
The Lead Time Average demand Demand variability Service level

Notation
AVG = average daily demand STD = standard deviation of daily demand LT = replenishment lead time in days h = holding cost of one unit for one day SL = service level (for example, 95%). This implies that the probability of stocking out is 100%-SL (for example, 5%) 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)

where z is chosen from statistical tables to ensure that the probability of stockouts during leadtime is 100%-SL.

Safety Stock z LT d

Example
The distributor has historically observed weekly demand of: AVG = 44.6 STD = 32.1 Replenishment lead time is 2 weeks, and 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.

S ( LT )( Avg ) ( z )( Avg ) LT
The reorder point will be the same as the previous model, in order to meet meet the service requirement: 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: 2 K ( Avg ) Q 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

Order-up-to level: s + Q = 85 + 679 = 765

(2)(4500)(44.6) 679 0.87

Risk Pooling
Consider these two systems:
Warehouse One Market One

Supplier
Warehouse Two Market Two

Market One

Supplier

Warehouse Market Two

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 $.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 A A 39.3 38.6 STD 13.2 12.0 CV .34 .31

Market 1 Market 2

B B

1.125 1.25

1.36 1.58

1.21 1.26

Risk Pooling Example

Warehouse Product AVG Market 1 Market 2 Market 1 Market 2 Cent. Cent A A B B A B 39.3 38.6 STD CV 13.2 .34 12.0 .31 s 65 62 S 158 154 26 27 Avg. % Inven. Dec. 91 88 15 15 132 20 26% 33%

1.125 1.36 1.21 4 1.25 1.58 1.26 5 77.9 20.7 .27 2.375 1.9 .81

118 226 6 37

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

Decentralized System
Supplier

Warehouses

Retailers

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 Turn Over Ratios

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