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Inventory and (Yield) Management

Inventory Management - Victor Araman

Best Buys Lesson


In the 1990s, Eric Morley, Best Buys director of transportation, remembers $15 million worth of personal computers were on the way to stores in time for the holidays when chip maker Intel Corp. unexpectedly announced it was going to introduce a new Pentium processor, which wouldnt be available until after the New Year. We were stuck, Morley says. It became the Christmas without a PC. Thats when we learned that you dont

buy inventory just in case - you buy it just in

time

Inventory Management Victor Araman

Agenda
A First Look at Inventory Management
Motivation

Continuous Replenishment Model


Economic Order Quantity (EOQ) EOQ variants

Periodic Review Model


News Vendor LL Bean (see other slides)

Supply Chain Inventory

Inventory Management Victor Araman

Agenda
A First Look at Inventory Management
Motivation

Continuous Replenishment Model


Economic Order Quantity (EOQ) EOQ variants

Periodic Review Model


News Vendor LL Bean (see other slides)

Supply Chain Inventory

Inventory Management Victor Araman

What Is Inventory?
Inventory is the stock or store of an item or a resource used by an organization. Different types of inventory Finished Goods (FGI) | Work in Process (WIP) | Raw Material Examples Cash in an ATM/bank Half assembled engines in a car manufacturing plant Phones in a retail store Silicon in a semiconductor manufacturing plant Seats in a plane Advertising slots for a TV broadcaster
Inventory Management Victor Araman

Inventory Management Victor Araman

Inventory Management Victor Araman

Period Ending Assets Current Assets Cash And Cash Equivalents Short Term Investments

2-Mar-12 25-Feb-11 26-Feb-10

1,199,000

1,103,000

1,826,000

22,000

90,000

Net Receivables

2,288,000

2,348,000

2,020,000

Inventory Inventory

5,731,000 5,731,000
1,079,000

5,897,000 5,897,000
1,103,000

5,486,000 5,486,000
1,144,000

30-36% of Total Assets


Total Current Assets

Other Current Assets

10,297,000 140,000 3,471,000 1,335,000 359,000 403,000 -

10,473,000 328,000 3,823,000 2,454,000 336,000 435,000 -

10,566,000 324,000 4,070,000 2,452,000 438,000 452,000 -

Long Term Investments Property Plant and Equipment Goodwill Intangible Assets Accumulated Amortization Other Assets Deferred Long Term Asset Charges

Total Assets

16,005,000

17,849,000

18,302,000

Inventory Management Victor Araman

Importance of Inventory

Inventory Management Victor Araman

Importance of Inventory
Inventories represent a major commitment of monetary resources Inventories affect virtually all aspects of a companys daily operations Inventories represent a lethal weapon Example: Dell, Wal-Mart, Zara

Inventory Management Victor Araman

Why Do Companies Hold Inventory?


To meet anticipated customer demand To protect against stock-outs To take advantage of economic order cycles To maintain independence of operations To allow for smooth and flexible production operations To hedge against inflation and price increases To take advantage of quantity discounts

Inventory Management Victor Araman

Inventory Sales Ratio

Inventory Management Victor Araman

Inventory Sales Ratio

Inventory Management Victor Araman

Impact of Inventory on Valuation


Abnormal inventory growth vs. On year ahead earnings

Inventory Management Victor Araman

Why Do Companies Hold Inventory?

WSJ-09-09-04
Inventory Management Victor Araman

Inventory Measures
Average aggregate inventory value: Average of the total value of all items held in inventory Weeks of supply =
Average aggregate inventory value Cost of Goods Sold per week
Cost of Goods Sold per week

Inventory turns = Average aggregate inventory value Some of these measures can be customized for specific settings/industry Retail: sales per sqm of shelf space Restaurant: sales per available seat-hour Media: sales per slot per impression
Inventory Management Victor Araman

Inventory Turns
Common industry benchmark Example (K-Mart: 2002)
Inventory value = 4.825 B $ Cost of Goods Sold = 26.258 B $/year Average time to turn a dollar (cost) to a dollar = 4.825/26.258 year = 0.183 years = 67 days. (Littles law) What is the financial significance of this time? Kmart improved this figure from 88 days in 1998.

Kmart Inventory Turns in 2002 = (1/0.183) = 5.44 Turns/year

Example (Walmart: 2002)


Inventory value = 22.75 B$, COGS = 171.56 B $ Time to turn a dollar = 43 days Inventory Turns = 7.7
Inventory Management Victor Araman

Inventory Turns: Importance


Consider a retailer whose inventory holding cost is 0.3 $/$/year (we will discuss the components of inventory costs later) That is, incur 30 cents to hold one unit of a good that costs 1 $ for 1 year Say, this retailer turns inventory 4 times per year So, on average, each unit stays in inventory for (1/4) of a year So, the cost that the retailer incurs just due to holding inventory is 30/4 = 7.5 cents per dollar In other words, when we buy a product for $100 at this retailer, $7.5 are paid towards the retailers inventory holding costs

Inventory Management Victor Araman

Inventory Turns: Importance


Think about profit margins for two Retailers (A and B) in the same market (selling the same products) If Retailer A turns 4 times per year, 7.5 cents is the inventory cost/$. If Retailer B turns 8 times per year, only 3.75 cents is the inventory cost per $ (by better Inventory management) All else being the same, the profit margin of B is 3.75 % higher than A! Typically, net profits in the retail industry can be as low as 2 % !

Inventory Management Victor Araman

Inventory Turns in the Retail Sector


Gross Margin

Compare: Wal-Mart : 7.54 turns per year K-Mart : 5.44 turns per year

45% 40% 35% 30% 25% 20% 0 5 10 Inventory Turns 15

Inventory Management Victor Araman

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ABC Analysis
Divides on-hand inventory into 3 classes A class, B class, C class Basis is usually annual $ volume $ volume = Annual demand x Unit cost Policies based on ABC analysis Develop class A suppliers more Give tighter physical control of A items Forecast A items more carefully

Inventory Management Victor Araman

Classifying Items as ABC


80-20 rule % Annual $ Usage
100 80 60 40 20 0 0 50 100 Class A B C % $ Vol 80 15 5 % Items 15 30 55

A B C

% of Inventory Items
Inventory Management Victor Araman

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Inventory Decisions Driven by Cost


Ordering cost. (per order/transaction) cost incurred each time an order is placed with a supplier or production is ordered with its own shop Holding cost. (per unit of inventory per unit time) cost associated with maintaining an item in inventory until it is used or sold Stockout or shortage cost. (per unit of lost sale) occurs when the demand for an item exceeds its supply Item cost. (per unit of inventory) Under constant demand: becomes relevant if a quantity discount is available

Inventory Management Victor Araman

Inventory Holding Costs


Category Housing costs Material handling costs Labor cost from extra handling Investment costs Pilferage, scrap, and obsolescence Cost as % of Inventory Value 6% (3 - 10%) 3% (1 - 3.5%) 3% (3 - 5%) 11% (6 - 24%) 3% (2 - 5%)

(Approximate Ranges)
Inventory Management Victor Araman

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Agenda
A First Look at Inventory Management
Motivation

Continuous Replenishment Model


Economic Order Quantity (EOQ) EOQ variants

Periodic Review Model


News Vendor LL Bean (see other slides)

Supply Chain Inventory

Inventory Management Victor Araman

Economic Order Quantity - EOQ

Inventory Level

Time

Inventory Management Victor Araman

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Economic Order Quantity (EOQ)


Model Assumptions Single product or item Demand rate known and constant

Item produced in lots, or purchased in orders


Each lot or order received in single delivery Lead time known and constant Ordering, or setup costs are constant No backorders are allowed No quantity discounts are allowed

Inventory Management Victor Araman

Data & Costs Formulation

Demand = D units per year Ordering cost = S dollars per order placed Holding cost = H dollars per unit per year Order quantity = Q units

Holding Cost = H Q/2 per year Ordering Cost = S D/Q per year Total Cost = H Q/2 + S D/Q

Inventory Management Victor Araman

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EOQ Model: How Much to Order?


Annual Cost

H Q/2

Order (Setup) Cost Curve

S D/Q

Q* Optimal Order Quantity

Order Quantity (Q)

Inventory Management Victor Araman

EOQ: When to Order?

Inventory Level Average Inventory

Q* / 2
ROP Reorder Point LT Lead Time

Time

Inventory Management Victor Araman

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Solution of the EOQ Problem

Total Cost

TC(Q )

DS QH Q 2

Optimal Quantity

Q*

2DS (EOQ solution) H

Inventory Management Victor Araman

EOQ Model Equations


D = Demand per year S = Setup (order) cost per order H = Holding (carrying) cost d = Demand per day LT = Lead time in days Optimal Order Quantity Q* = 2DS H Reordering Point ROP = d LT d = D Working days / Year

Expected Number of Orders D N = Q* Expected Time between orders T = Working Days per year N

Inventory Management Victor Araman

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What if?
What if management is concerned by costs of emissions?
What if there are discounts based on the order quantity? What if demand or/and lead times are NOT deterministic?

Inventory Management Victor Araman

EOQ Adjusted Costs of Emissions


Cost of reducing emissions

Inventory Management Victor Araman

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Out of Stock At Supermarkets

Inventory Management - Victor Araman

EOQ Adjusted Demand Uncertainty


Frequency

Service Level

P(Stockout)

Inventory Level
Q
SS Avg dLT
ROP

dLT

ROP
Avg dLT
SS

Safety Stock

Time
Lead Time Place order
Inventory Management - Victor Araman

Receive order

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Service Level & Safety Stock


How much & when to order ? Uncertain demand (and possibly uncertain lead time)
Lead Time Demand: Demand during leadtime Leadtime demand follows normal distribution (forecasting) Continuous replenishment

What is a service level? What is the differ


What is the difference between a service level and a fill rate?

How is the service level linked to the Safety Stock?


Service level = 1 - Probability of stockout Higher service level means more safety stock More safety stock means higher ROP ROP = Avg of leadtime demand + safety stock
Inventory Management - Victor Araman

Safety Stock Computation


Leadtime demand is a normal distribution with an average and standard deviation Decide on your TARGET Service Level
Likelihood that leadtime demand is smaller than ROP is a service level Example: SL = 99% means that you leave a 1% chance of stock-out during any cycle

Find the corresponding level of inventory: ROP


ROP = Avg dLT + Safety Stock
Normal
Service Level Avg dLT ROP

Using Excel the ROP is ROP = NORMINV(SL, Avg dLT, stdev)


Leadtime Demand

Inventory Management - Victor Araman

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Probabilistic Model: Examples


Demand during lead-time for one brand of TV is normally distributed with a mean of 36 TVs and a standard deviation of 15 TVs. What safety stock should be carried for a 90% service level? What is the appropriate reorder point?

Based on available information, the daily demand for CD-ROM drives averages 10 units (normally distributed), with a standard deviation of 1 drive. The lead-time is exactly 5 days. Management wants a 97% service level. What safety stock should be carried? What is the appropriate reorder point?

Inventory Management - Victor Araman

Agenda
A First Look at Inventory Management
Motivation

Continuous Replenishment Model


Economic Order Quantity (EOQ) EOQ variants

Periodic Review Model


News Vendor LL Bean (see other slides)

Supply Chain Inventory

Inventory Management Victor Araman

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Inventory Management: The Newsvendor model


Demand Uncertainty Fixed Price

Single Order Too many?

Inventory Management Victor Araman

Selling Newspapers

Economic parameters
buy at w = 1 sell at r = 1.5 salvage at s = 0.05

Random demand
a distribution is available (with an average 300 and a standard deviation 100 units)

The too much/too little problem


Order too much and there is a loss due to unsold newspapers Order too little and you lose potential sales (and profits)
Inventory Management Victor Araman

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Market Uncertainty & Ex-Ante Bet


There are consequences of getting this bet wrong

The expected profit maximization balances the too much too little costs
Inventory Management Victor Araman

Brief Comparative Analysis


EOQ Long lifecycle products with stationary demand No demand uncertainty Tradeoff between setup and holding costs, driven by the frequency of ordering The Newsvendor model Short lifecycle products One shot items
can be stocked only once at the beginning of the selling season)

Considerable demand uncertainty Tradeoff between


costs of excess leftover inventory (overstocking, holding or disposal costs) excess demand (stockout costs)

Examples
fashion clothing | toys | computer games | music albums | books, consumer electronics
Inventory Management Victor Araman

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The Newsvendor Concept


Overage cost per unit Co is the (opportunity) cost of one unit of excess inventory (over ordering)
What if you had ordered one fewer unit? Overage cost = Cost Salvage value = w s What if additional cost is required to dispose of a leftover inventory? Co = 0.95

Underage cost per unit Cu is the (opportunity) cost of one unit of lost sales (under ordering)
What if you had ordered one additional unit? Underage cost = Price Cost = r w what if a goodwill cost or penalty cost is incurred in addition to the lost margin? Cu = 0.50
Inventory Management - Victor Araman

The Newsvendor Order Quantity Q


We define the critical ratio CR =

CR measures the balance of power between marginal costs of shortage and leftover
how worse or better is too little compared to too much
Probability Distribution Risk of leftover

Risk of shortage Critical Ratio CR

Inventory Management Victor Araman

Avg Dmd

Demand

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Expected Profit
Penalty cost = p = 0 If Q < D : Revenues = r Q ; If Q > D : Revenues = r D ; Salvage value = s (Q D ) Profit = r min{D , Q} + s (Q D )+ w Q
r
x

Sales

s x Leftover

News Boy Victor F. Araman

Cost of Demand Uncertainty


The mismatch Cost Gr(Q) = (r - w) E(D - Q)+ + (w S) E(Q - D)+
Cu : under-ordering x Expected Lost cost or lost margin Sales Co : over-ordering cost x Expected leftover or the overage cost

Profit = r min{D , Q} + s (Q D )+ - w Q

Expected Profit Pr (Q) = (r w) ED Gr (Q)


Risk free profit
News Boy Victor F. Araman

Simple manipulations

Mismatch Cost

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Marginal Analysis: Balancing the Risks


Ordering one more unit
D>Q Q+1 X Cu

X Cu Prob{D > Q } + Co Prob{D Q } + (X + Co) x Prob{D Q } DQ X+C


o

(X Cu) x Prob{D > Q }

Q+1 is better than Q if Co Prob{D Q } < Cu Prob{D > Q

Q
80

X
Expected marginal benefit of understocking

70
60 50 40

Expected gain or loss

As more units are ordered the average benefit from ordering one unit decreases (it becomes more likely to be left with inventory) while the average loss of ordering one more unit increases (it becomes less likely to be short in inventory)

30
20

Expected marginal loss of overstocking

10
0 0 800 1600 2400 3200 4000 4800 5600 6400

Inventory Management Victor Araman

Newsvendor Cost Tradeoff


Optimal Rule
Expected cost of ordering one extra unit = Expected cost of ordering one less unit So, the optimal quantity solves for C0 P(D Q) = Cu P(D > Q)
P{Demand Q} Underage Cost Overage Cost Underage Cost

The quantity

is known as the critical ratio.

In the newspaper example: critical ratio = 0.5/(0.95+0.5) = 0.345


Inventory Management - Victor Araman

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Newsvendor: Optimal Quantity to order


Probability Distribution

Risk of leftover

Risk of shortage Critical Ratio

Average Demand
Inventory Management - Victor Araman

Demand

A Normal Distribution
If demand distribution is normal Use Excel
s =100

Q* = Norminv(CR, m , s) = Norminv(0.345,300,100)
CR 0.345

= 260
m =300

Inventory Management Victor Araman

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Financial Performance
If seller orders the newsvendor quantity Q*
What should the seller expect in terms of profits ? What about averages sales? How many units will be discounted on average (salvage)? How much money is left on the table? (i.e. What is the fraction of demand unmet?)

Once lost sales are evaluated the rest follow trivially For normal distribution lost sales is known
tables that provide the values of lost sales excel functions that give the exact value of lost sales

If demand is not normal. Harder to get (need simulation)


Inventory Management Victor Araman

Average Lost Sales

Suppose demand can take one of these values D belongs to {0,10, 20,190, 200} Suppose Q=120 What is the average lost sales? If D<=Q : No lost sales = 0 If D = 130, lost sales = D - Q= 10 If D = 140, lost sales = D - Q = 20 Average Lost Sales = 10 x P(D=130) + 20 x P(D=140) + + 80 x P(D=200)

Inventory Management Victor Araman

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Average Lost Sales for Normal Dist.


Available information Demand (D) is Normal with avg: ED = 300 and stdev sD = 100 Assuming the previous economic parameters then CR = 0.325 and Q = 260 Formula for Average Loss Sales

sD x L(z)
s is the standard deviation (given) z = (Q ED) / sD e.g. z = (260-300)/100 = 0.4 L(z) = normdist(z, 0, 1, 0) z x (1 - normdist(z, 0, 1, 1)) e.g. L(-0.4) = 0.63 and Average Lost Sales = 100 x 0.63 = 63
Inventory Management Victor Araman

The Rest Indeed Follows


Sales + Lost Sales = Demand
Avg Sales = Avg Demand Avg Lost Sales = 300 63 = 237units

Leftover Inventory + Sales = Q


Avg leftover inventory = Q Avg Sales = 260 237=23units

Average Profit
Price x Avg Sales + Salvage x Avg Leftover Inv. Cost * Q = (Price Cost) x Avg Sales (Cost Salvage) x Avg Leftover Inv. = (1.5-1)*237-(1-0.06)*23 = $96.88 ~ $97

Inventory Management Victor Araman

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Yield Management in Action


Fare: New York - Chicago
Wednesday to Friday
1400 1200 1000 US$ US$ 800 600 400 200 0 August September October 1400 1200 1000 800 600 400 200 0 August September October

Fare: New York - Chicago


Thursday to Saturday

Wednesday-Friday fares are 15-20% higher than Thursday-Saturday fares!

Inventory Management - Victor Araman

Yield Management
Yield Management: term used in many service industries to describe techniques to allocate limited resources, such as airplane seats or hotel rooms, among a variety of customers, such as business or leisure travelers.
By adjusting this allocation a firm can optimize the total revenue or "yield on the investment in capacity Since these techniques are used by firms with extremely perishable goods, or by firms with services that cannot be stored at all, these concepts and tools are often called perishable asset revenue management. American Airlines credits yield management techniques for a revenue increase of $500 million/year and Delta Airlines uses similar systems to generate additional revenues of $300 million per year.
Inventory Management - Victor Araman

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Yield Management
Marriott Hotels credits its yield management system for additional revenues of $100 million per year, with relatively small increases in capacity and costs Broadcasting companies use yield management to determine how much inventory (advertising slots) to sell now to the "upfront market" and how much to reserve and perhaps sell later at a higher price to the "scatter market The core logic is similar to the newsvendor model

Inventory Management - Victor Araman

Agenda
A First Look at Inventory Management
Motivation

Continuous Replenishment Model


Economic Order Quantity (EOQ) EOQ variants

Periodic Review Model


News Vendor LL Bean (see other slides)

Supply Chain Inventory

Inventory Management Victor Araman

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A Simple Supply Chain


m Manufacturer w, Q Retailer r, D End consumer

The manufacturers profit is given by Pm = (w m) Q*


where, m is the production unit cost incurred by the manufacturer and Q* is the optimal quantity ordered by the retailer

News Boy Victor F. Araman

Supply Chain Inventory Insights


Double marginalization effect Postponement strategies Risk sharing and supply chain maximum value
Refer to Newsvendor Problems

Inventory Management Victor Araman

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Supply Contracts: Real Options


Retailer buys q call options at unit cost c
Call option: right to buy one unit at the exercise price x Options bought ahead of season, but exercised after demand is observed Induce the retailer to buy more units at the expense of sharing the risk (demand uncertainty)

Retailers Expected profit pr(q) = E[(R - x) min{D, q}] c q

News Boy Victor F. Araman

Comparing to Original Newsvendor


Standard Newsvendor Max Expected Profit r min{D , Q} + s (Q D )+ - w Q Newsvendor with Options Max Profit (r - x) min{D, q} c q Set rrx |wc|s0 By analogy, solution must be given by Critical Ratio ku = r x c | ko = c CF =
+

Solution given by Critical Ratio Cu = r w | Co = w s CR =


+

P(D Q) = CR Q*= norminv(CF, Avg D, sD)

P(D q) = CF q*= norminv(CF, Avg D, sD)

Profit Manufacturer (w m) Q*
Inventory Management Victor Araman

Profit Manufacturer E (c - m)q + x min{D, q} + S (q - D)+

32

Retailers Expected Profit


Retailers Expected profit pr(q) = E[(R - x) min{D, q}] c q Re-writing the profit pr(q) = (R - x - c) ED gr(q) gr(q) = (R - x - c) E[(D - q)+] + c E[ (q - D)+]
ku = R - x - c : opportunity cost (too few options) k0 = c : opportunity cost (too many options)

gr(q*) = s (ku + k0) Normdist(Normsinv(ku /(ku + k0)),0,1,false)


News Boy Victor F. Araman

Manufacturers Expected Profit


Expected profit

Sales

Leftover

pm(q) = E[(c - M) q + x min{D, q} + S (q - D)+]


Net revenues from Revenues from exercised options selling q options Revenues from nonexercised options

See notes for an Excel formulation of this profit under normal demand!

News Boy Victor F. Araman

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Key Learnings
Inventory is the result of the imbalance between Supply and Demand It serves as a buffer to
Smooth seasonality Reduce risk/cost of stockouts Alleviate production scheduling Take advantage of economies of scale

Inventory is not free EOQ. Simple and Commonly used model


Tradeoff between setup and holding costs

Newsvendor. Commonly used for One Shot Items


Critical Ratio measures the imbalance between too much and too little

Supply Chain Inventory


Inventory Management Victor Araman

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