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Lecturer : K. Badarinath

Lecture 4-6

16/1/2018, 19/1/2018 and

23/1/2018

Roadmap for this course

2

Supply Chain - Overview

• What is a supply chain ?

– Schematic of a typical supply chain – its

components

• Supply Chain management (SCM)

– Definition

– Importance

– Difficulties associated with SCM

• Two key objectives

– Maintaining service levels

– Global optimizations

• Key issues in Supply Chain management 3

A typical supply chain

Figure from : “Designing and managing the supply chain – Concepts, strategies and case studies ”Simchi Levi et al.

4

Components of supply chain

• Suppliers

• Manufacturing/Assembly plants

• Warehouses/distribution centres

• Retail outlets

• End-customer

Costs

• Material costs

• Manufacturing costs

• Transportation (components, finished goods)

• Inventory carrying costs

5

Supply chain management

• “Supply chain management is a set of

approaches utilized to efficiently integrate

suppliers, manufacturers, warehouses and

stores, so that merchandise is produced at the

right quantities, to the right locations, and at

the right time, in order to minimize system-

wide costs while satisfying service level

requirements”

6

Key objectives

• Global optimization : Minimize system-wide

costs – across the entire network rather than

individual costs (for suppliers, or plants or

warehouses)

• Maximize service level – availability of product

to the customer at the right time, right

quantity and right location.

7

Why SCM?

• Example – National semiconductor – one of

the world’s largest chipmakers

• Facilities locations

– 4 Wafer Fabrication sites – 3 in US, 1 in UK

– Test and Assembly sites – Malaysia and Singapore

– Customers – manufacturing facilities all over the

world incl. Compaq, Ford, Siemens etc.

Complexity and global presence of companies

makes supply chain efficiencies critical.

8

Why SCM?

• Certain product lines have most of their parts

supplied by a few companies.

E.g: Computer manufacturers

The supply chain efficiencies then become the

differentiating factor.

• Manufacturing costs have been reduced as

much as possible in many established

industries

• The costs involved in logistics is significant –

any improvements will save a lot of money. 9

Difficulties in SCM

1. It is difficult to operate even a single facility

to minimize costs and maintain service levels.

Global optimization is even more difficult.

2. Uncertainty – in customer demand,

transportation times, break-down of plants,

equipment etc.

10

Global optimization difficulties

1. Complex globally spread network of facilities

2. Different and conflicting objectives of

different facilities

3. Time-varying demand, customer preferences,

competition strategies, prices

11

Managing uncertainty - difficulties

1. Challenge in matching supply and demand –

often manufacturers need to commit to

specific production numbers much before

demand is realized.

2. Short-life cycles of products – to predict

demand is difficult.

3. Natural and man-made disasters affect

globally distributed facilities.

12

Key issues in SCM

1. Distribution network configuration

How and where to locate warehouses,

production facilities (and capacities), and set

transportation flows between production

warehouse dealer, in an optimal manner?

2. Inventory Control

• When to re-order a new batch of product,

how much to order (for retailer)?

• Manufacturer - How much safety stock to

maintain for different products?

13

Key issues

3. Production sourcing – Trade-off between

production vs. transportation costs

E.g: Larger batches save costs – but require

fewer large facilities (increased transportation

costs)

4. Supply contracts – Relationship between

suppliers and retailers which specify pricing,

revenue sharing, return policy, lead times etc.

14

Key issues

5. Distribution strategy

– Centralized warehousing or spread out locations

– When should products be transported by air (at

higher cost) to meet service needs?

6. Outsourcing and offshoring strategies

– What to produce in-house, what to outsource?

– Risks of outsourcing and ensuring service levels.

15

Key issues

7. Product design

– Can we redesign products to reduce logistics

costs?

8. Using Information Technology for improving

supply chain designs

16

Inventory management

• Types of inventory

– Raw material inventory

– Work-in-process (WIP) inventory

– Finished goods inventory

17

Inventory

• Why hold inventory at all?

– Unexpected changes in customer demand – to

prevent lost opportunities when increase happens

– Uncertainty in delivery times, ordering and set-up

costs

– Lead times for raw-material, product etc.

– WIP inventory also decouples different machines.

If one breaks down production can still continue.

18

Considerations for inventory policy

• Customer demand – forecasts, historical data,

variability

• Replenishment Lead time

• Number of products – as space, time is limited

and one needs to decide which ones get

priority (E.g: ABC/VED)

• Costs – carrying cost and ordering cost

• Service level requirements

19

Economic Lot-Sizing Model

Assumptions

• Demand D items/day

• Q items per order

• Ordering cost K per order

• Holding cost h per unit of inventory per day

• Lead time = 0 (between order and receipt)

• Initial inventory = 0

• Planning horizon infinitely long

Economic lot-sizing model

• Let the order cycle time be ‘T’, then the cost per cycle is

hTQ

CK

2 hTQ 1

Which gives cost per unit time as

c (K ). (1)

2 T

Q

Here is the average inventory over ‘T’

2

Also Q DT (2)

Note : We would like to order when inventory = 0 which is

optimal.

Economic lot-sizing model

• Substituting for T from Equation 2 in equation 1, we

get K hQ KD hQ

c

T 2 Q 2

Also dc KD h d 2

and 2 c 2 KD

2

dQ Q 2 d Q Q3

Which gives the optimal (minimum) Q as Q*

2KD

h

dc

When 0

dQ

Economic Lot Sizing model

• Q* is known as Economic Order Quantity

(EOQ)

• At Q*, the cost of holding inventory is equal to

the cost of ordering.

Newsvendor model

• Given a perishable item – one order

opportunity

– Revenue per item = r

– Salvage value for each unsold item = s

– Cost per item = c

– Demand is given by a probability distribution

(continuous or discrete)

Question : How much should one order to maximize

expected profit ?

24

Newsvendor model

• Let the actual demand turn out to be ‘w’, and

the newspapers bought be ‘x’

• Revenue = 𝑟𝑥 𝑖𝑓 𝑥 ≤ 𝑤

= 𝑟𝑤 + 𝑠 𝑥 − 𝑤 𝑖𝑓 𝑥 > 𝑤

• Profit = (𝑟 − 𝑐)𝑥 𝑖𝑓 𝑥 ≤ 𝑤

= 𝑟𝑤 + 𝑠 𝑥 − 𝑤 − 𝑐𝑥 𝑖𝑓 𝑥 > 𝑤

= (𝑟 − 𝑠)𝑤 + (𝑠 − 𝑐)𝑥 𝑖𝑓 𝑥 > 𝑤

25

Newsvendor model

• Expected Profit

𝑥

= −∞ 𝑟 − 𝑠 𝑤 + 𝑠 − 𝑐 𝑥 𝑓 𝑤 𝑑𝑤

∞

+𝑥 𝑟 − 𝑐 𝑥 𝑓 𝑤 𝑑𝑤

𝑥 𝑥

= 𝑟−𝑠 𝑤𝑓 𝑤 𝑑𝑤 + s − c x 𝑓 𝑤 𝑑𝑤

−∞ −∞

∞

+ r−c x 𝑓 𝑤 𝑑𝑤

𝑥

26

Newsvendor model

𝑥

EP = 𝑟 − 𝑠 −∞

𝑤𝑓 𝑤 𝑑𝑤 + s − c xF x +

r − c x[1 − F x ]

r − c 1 − F x ] has the following behavior

When x = 0, above expression is 0

When x∞, last term goes to 0 (i.e. 1-F(x) term), and

the first term goes to -∞ ( as (s-c)<0)

27

Newsvendor model

𝑑𝐸𝑃

We now calculate = 𝑟 − 𝑠 𝑥𝑓 𝑥 +

𝑑𝑥

s − c F x + s − c xf x + r − c [1 −

28

Newsvendor model

𝑑𝐸𝑃

• If = 0 𝑖. 𝑒 𝑎𝑡 𝑥 ∗ , we have

𝑑𝑥

(𝑟 − 𝑐) (𝑟 − 𝑐)

𝐹 𝑥∗ = =

(𝑟 − 𝑠) 𝑟 − 𝑐 + (𝑐 − 𝑠)

becomes positive initially (x<w) and later goes to

-∞. So it should have a positive peak (maximum

value) at x* before it starts decreasing.

29

Newsvendor model

(𝑟−𝑐) (𝑟−𝑐)

• 𝐹 𝑥∗ = =

(𝑟−𝑠) 𝑟−𝑐 +(𝑐−𝑠)

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

.

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡+𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑙𝑜𝑠𝑠

𝑥∗

• Recall F(x*) is a probability ( −∞

𝑓 𝑤 𝑑𝑤)

30

Summarizing

• Choose x (i.e. quantity to order ) such that the

probability of the demand being less than or

equal to x* i.e. Probability (d≤x*) is given by

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

the ratio .

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡+𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑙𝑜𝑠𝑠

demand (normal or discrete) . Apply the

above derived expression to it.

31

Examples – real life

• Can you identify some situations where

Newsvendor model can be applied?

• In general a situation where there is one order

opportunity and a profit, and salvage cost

associated with it.

• Any short period fashion item can come in this

category.

32

Examples

• E.g: How many T-shirts to print for say, ‘Elan’?

(Assumption : T-shirts are sold for profit

during fest, and leftover shirts at a discounted

price (to IITians ) after the fest.)

33

Numerical example

• Let demand d~N(150000, 45000)

• r = Rs. 150 ; c = Rs. 50 ; s = 0

𝑟−𝑐

We should order Q such that Pr(𝑑 ≤ 𝑄) =

𝑟−𝑠

150−50

= = 0.667

150−0

34

Numerical example

• Since d~N(150000, 45000)

𝑑−𝜇 𝑄−𝜇

we have Pr(d≤Q) = Pr( ≤ )

𝜎 𝜎

𝑄−150000

i.e. Pr(𝑧 ≤ 45000

) = 0.667 (𝑓𝑟𝑜𝑚 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑝𝑎𝑔𝑒)

𝑄 = 45000 ∗ 0.431 + 150000 = 169395 𝑢𝑛𝑖𝑡𝑠

stock while planning for average demand.

35

Example 2- Discrete

• Let us try to estimate the number of T-shirts

that should be produced for a short period of

sales.

• We can make a simplistic assumption on the

demand as Demand Probability

800 0.11

1000 0.11

1200 0.28

1400 0.22

1600 0.18

1800 0.10

36

Probability distribution

Probability

0.30

0.25

0.20

0.15

0.10

0.05

0.00

800.00 1000.00 1200.00 1400.00 1600.00 1800.00

37

Example 2 continued

• Further let us assume the following (per unit)

• Selling price during fest = Rs. 125

• Cost price (for production) = Rs. 80

• Discounted price (after fest) = Rs. 20

We also assume there is a fixed production cost

of Rs. 10000 (irrespective of number of units

provided it is greater than 0).

38

Example 2

• The profit you get is dependent on how much you

produce, and also what the demand turns out to be.

For example

• Case 1 – Production = 1000 units, demand = 1200

units

• Profit (Rs)= 125 ∗ 1000 − 80 ∗ 1000 −

10000 𝑓𝑖𝑥𝑒𝑑 = Rs. 35000

• Case 2 – Production = 1000 units, Demand = 800

units

• Profit (Rs) = 125 ∗ 800 + 20 ∗ 200 − 80 ∗ 1000 −

10000(fixed) = Rs. 14000

39

Example 2

• We use knowledge of demand distribution to

get expected profit under the production

quantity equal to each specific value.

Production Expected Profit

800 26000

1000 32690

1200 37070

1400 35570

1600 29450

1800 19550

40

Expected Profit vs. production

Expected Profit

40000

35000

30000

25000

20000

15000

10000

5000

0

800 1000 1200 1400 1600 1800

41

Insights into the problem

1. Expected Profit peaks at around 1200 units .

Weighted average (demand) = 1310.

• (The quantity to produce depends on the

marginal profit and marginal cost).

• Here Marginal profit = 45, Marginal cost = 60,

• So it makes sense to produce lesser than

average, than above average.

42

Insight 2

• You earn the same profit if you produce say

900 or 1600 units. So how much should you

produce (order)? Profit

900 29345

1600 29450

• We estimate the risks with each decision

Probability 0.11 0.89

Profit at 900 20000 30500

Profit at 1600 -22000 -1000 -1600 41000 62000

43

What if there was initial inventory?

• Assume now that there were 500 shirts from

previous year (which can still be used). What

changes does it introduce?

1. First, one can save on the fixed cost by not

ordering (producing) anything.

Profit = (125-80)*500= Rs. 22500 without any

changes made.

44

Expected profit vs. production

50000

45000

40000

35000

30000

25000

20000

15000

10000

5000

0

800 900 1000 1100 1200 1300 1400 1500 1600 1700 1800

Blue line – not including production costs

45

Red line – including production costs

Notes on plot (slide #45)

• The blue line shows the profit that would be

obtained if there were no fixed production

cost – in other words, if the entire quantity

was sourced from inventory.

• The Red line is the same as the expected profit

line (slide # 41), assuming initial inventory = 0.

46

Summary

• Trade-off between fixed cost to produce vs.

profit incurred by having additional inventory

• If you produce, you always produce up to the

optimal value (1200 in this case).

• There is an inventory value above which you

would earn more profit by not producing

anything (850 in this case)

47

Insight 3- Inventory policy (s,S)

• If inventory falls below ‘s’, order to increase

inventory to ‘S’ units. Here the policy is (850,

1200)

48

Multiple order opportunity models

• Example – A company distributor facing

demand for a consumer goods item like

televisions.

• He can order periodically from the

manufacturer of T. V. sets based on demand

he sees.

49

Why should distributor hold

inventory?

1. To satisfy demand during lead time since

orders are not met immediately.

2. Uncertainty in demand

3. To balance fixed order costs with annual

inventory holding costs.

receipt of goods.

50

Model types

reviewed every day and decision made on

whether and how much to order.

• Useful when inventory can be easily tracked –

like computerized systems.

51

Continuous Review Policy

• Assumptions (for distributor)

– Daily demand ~𝑁(𝐴𝑉𝐺, 𝑆𝑇𝐷)

– Order cost – ‘K’ which includes a) Fixed cost + b) a

variable cost proportional to order quantity

– h – holding cost for one unit of product per day

– L = Replenishment lead time from manufacturer

– 𝛼 – Service level i.e. probability of stock-out is

1−𝛼

– Inventory is reviewed every day

52

Continuous Review Policy

• (Q, R) policy – When inventory level falls to re-

order level (R) order Q units.

• Re-order level R

– It should satisfy demand during lead time. (DDLT)

– It should also have safety stock for uncertainty in

demand.

• DDLT will also be normally distributed* with

Average of 𝐷𝐷𝐿𝑇 = 𝐿 ⨯ 𝐴𝑉𝐺

Standard deviation of DDLT = 𝑆𝑇𝐷 ⨯ 𝐿

(*Recall Central limit theorem ?)

53

Continuous Review Policy

• Also we know desired service level = α

Find the ‘z’ value corresponding to

𝑃𝑟𝑜𝑏 𝐷𝐷𝐿𝑇 ≤ 𝑅 = 𝛼

𝐷𝐷𝐿𝑇−𝐿×𝐴𝑉𝐺 𝑅−𝐿×𝐴𝑉𝐺

i.e. 𝑃𝑟𝑜𝑏 ≤ = 𝛼 ---(1)

𝑆𝑇𝐷 𝐿 𝑆𝑇𝐷 𝐿

Now, find ‘z’ (also called safety factor) from

given α. Then calculate the Re-order level ‘R’ as

𝑅−𝐿×𝐴𝑉𝐺

≥ 𝑧 (from 1), So

𝑆𝑇𝐷 𝐿

𝑅 = 𝐿 × 𝐴𝑉𝐺 + 𝑧 × 𝑆𝑇𝐷 × 𝐿 54

Continuous Review Policy

• Estimating reorder quantity ‘Q’

• We use the EOQ model to determine Q as

2𝐾×𝐴𝑉𝐺

• 𝑄=

ℎ

hand + goods in transit

55

Average inventory level in (Q,R)

• In order to estimate the average level of

inventory, we check the minimum and

maximum inventory levels.

• Minimum : Just before order is received.

Expected inventory level = safety stock

𝑀𝑖𝑛 = 𝑧 × 𝑆𝑇𝐷 × 𝐿

• Maximum : Just after order is received

Expected inventory level is

𝑀𝑎𝑥 = 𝑄 + 𝑧 × 𝑆𝑇𝐷 × 𝐿

56

Average inventory level

• Average level for (Q,R) policy is

𝑀𝑖𝑛+𝑀𝑎𝑥 𝑄

• 𝐴𝑣𝑔 = = + 𝑧 × 𝑆𝑇𝐷 × 𝐿

2 2

57

Variable lead times

• If the lead time itself is variable, we assume it

to be normally distributed as

𝐿~𝑁(𝐴𝑉𝐺𝐿, 𝑆𝑇𝐷𝐿)

• Here re-order quantity ‘Q’ remains same

• Re-order point ‘R’ is changed as

𝑅 = 𝐴𝑉𝐺𝐿 × 𝐴𝑉𝐺 + 𝑧 ×

𝐴𝑉𝐺 2 × 𝑆𝑇𝐷𝐿2 + 𝐴𝑉𝐺𝐿 × 𝑆𝑇𝐷 2

58

Periodic Review Policy

• Periodic Review Policy : Inventory is reviewed

at regular fixed intervals (weekly, monthly)

and appropriate quantity is ordered.

• Useful where it is not practical to track

inventory daily.

59

Features

• Since inventory is reviewed periodically, the

concept of re-order point is not needed.

• Review period – r

• Lead time – L

• Demand ~𝑁 𝐴𝑉𝐺, 𝑆𝑇𝐷

• No fixed ordering cost – it is a sunk cost as the

review period itself is determined based on

the cost of ordering.

60

Base-stock policy

• Base-stock or order upto level is given as

follows

• Once order is placed, next order is placed

after ‘r’. Also lead time is ‘L’. So current order

should fulfill demand for period 𝑟 + 𝐿

• If service level is 𝛼, find the corresponding

safety factor ‘z’. Then

𝐵𝑎𝑠𝑒 𝑠𝑡𝑜𝑐𝑘

= 𝑟 + 𝐿 × 𝐴𝑉𝐺 + 𝑧 × 𝑆𝑇𝐷 × 𝑟 + 𝐿

61

Average inventory level

• Minimum expected inventory – just before

order is received is ‘safety stock’

• 𝑀𝑖𝑛 = 𝑧 × 𝑆𝑇𝐷 × 𝑟 + 𝐿

• Maximum expected inventory – just after

order is received is

• 𝑀𝑎𝑥 = 𝑟 × 𝐴𝑉𝐺 + 𝑧 × 𝑆𝑇𝐷 × 𝑟 + 𝐿

𝑟×𝐴𝑉𝐺

• 𝐴𝑣𝑔 = + 𝑧 × 𝑆𝑇𝐷 × 𝑟 + 𝐿

2

62

Example

• Consider a distributor of T.V. sets who orders from a

manufacturer and sells to retailers. The fixed

ordering cost for distributor = Rs. 45000 per order.

Cost of each T.V. set to distributor is Rs. 2500, and

the annual inventory holding cost is 18% of the cost

of one set. Replenishment lead time is 2 weeks.

The historical demand data is given in table for the past

one year. If the distributor would like to ensure 97%

service level, what should be his re-order level, and

order quantity?

63

Example

• Demand data Month Sales

The average and Sep 200

standard deviation Oct 152

Nov 100

(per month) can be Dec 221

calculated and are Jan 287

Mar

176

151

• STD = 66.53 Apr 198

May 246

Jun 309

Jul 98

Aug 156

64

Example

• We have L = 2 weeks

• Assume a month to have 30 days, then AVG

per week is

• 𝐴𝑉𝐺𝑤 = 44.6, 𝑆𝑇𝐷𝑤 = 32.14

2×45000×44.6

𝑄= 0.18 = 682 ( Assume 52 weeks in a

( ∗2500)

52

year)

65

Example

• For service level of 97%, corresponding z value

is 1.88

• For R we have

• 𝑅 = 2 × 44.6 + 1.88 × 32.14 × 2 = 174.6

• Average inventory level

𝑄 682

= + 𝑧 × 𝑆𝑇𝐷 × 𝐿 = + 1.88 × 32.14 × 2

2 2

=426.4 (approximately 9+ weeks of inventory)

66

Example for base stock

• Instead, suppose that the distributor places an

order every 3 weeks , what should be the

base-stock level?

• Here r = 3 weeks, also L = 2 weeks. So his

order should cover demand for 5 weeks

• 𝐵𝑆 = 5 × 44.6 + 1.88 × 32.15 × 5 = 358.1

• So he should keep a stock of 359 units.

(3×44.6)

• Average inventory level = + 1.88 ×

2

32.15 × 5 = 202.01(~5 weeks inventory)

67

Service level optimization

• Approach till now – Given a target service

level, determine the inventory level to keep.

• Question : How to optimize service level

(assuming flexibility exists) while minimizing

inventory costs/maximizing profit?

68

Variation of service level

• Other things being equal –

– higher service level requires higher inventory.

– To maintain a service level, a higher lead time

would require higher inventory.

– To maximize profit, service level will be higher for

products with

• High profit margins

• High volume

• Low variability

• Short lead time.

69

Multi-echelon inventory

management (MEIM)

Each of the ‘stages’ is called an ‘Echelon’.

70

Assumptions

• Inventory at all the above ‘echelons’ are

managed by a single decision maker

• Objective : To minimize system-wide costs

• Decision maker has access to inventory

information at each ‘echelon’

71

Approach used

• Echelon inventory policy

• Echelon inventory : The inventory on hand at a

particular echelon plus all downstream

inventory (Downstream : those closer to the

customer)

• Here re-order point at echelon ‘e’ is

• 𝑅 = 𝐿e× 𝐴𝑉𝐺 + 𝑧 × 𝑆𝑇𝐷 × 𝐿𝑒 where Le is

known as echelon lead time.

72

Example - MEIM

• Suppose the average weekly demand faced by

the retailer is 45 (AVG), with a standard

deviation of 32 (STD).

• Also assume that each stage is attempting to

maintain 97% service level (α),

• Lead time between one stage and the next is 1

week (including for the manufacturer from its

supplier)

73

MEIM approach

Re-order point (R) calculation

• Echelon lead time Le : the lead time between

the echelon and its supplier + the lead time

between the echelon and all its downstream

echelons

(from its suppliers) + 3 weeks (to all its

downstream echelons)

74

Example -MEIM

• Cost parameters and order quantities are

2𝐾𝐷

(Note : Q = )

ℎ

K D h Q

Retailer 250 45 1.2 137

Distributor 200 45 0.9 141

Wholesaler 205 45 0.8 152

Manufacturer 500 45 0.7 255

75

Example -MEIM

• Re-order quantities at each echelon using the

formula

• 𝑅 = 𝐿e× 𝐴𝑉𝐺 + 𝑧 × 𝑆𝑇𝐷 × 𝐿𝑒 is

– Retailer : 𝑅 = 1 × 45 + 1.88 × 32 × 1 = 105

– Distributor : 𝑅 = 2 × 45 + 1.88 × 32 × 2 = 175

– Wholesaler : 𝑅 = 3 × 45 + 1.88 × 32 × 3 = 239

– Manufacturer : 𝑅 = 4 × 45 + 1.88 × 32 × 4 = 300

76

Risk pooling

• A powerful tool used to address variability in

the supply chain.

• Idea: Demand variability is reduced if one

aggregates demand across locations.

Why so ?

Greater likelihood that high demand from one

location will be offset by lower demand from

another.

77

Risk pooling

• Reduced variability allows

– Decrease in safety stock to maintain.

– Reduction in average inventory.

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛

𝐶. 𝑉. =

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑

78

Risk pooling example

Refer to case (tables 3.5-3.8)

• Lead time L = 1 week

• Fixed ordering cost K = $60

• Holding cost per unit per week ‘h’ = $0.27

79

Risk Pooling

• Key insights

– Centralizing (pooling) inventory reduces both

safety stock and average inventory in the system

– The higher the C.V., the greater the benefit from

centralized systems.

– The benefits of risk pooling depend on the

behavior of demand from one market relative to

demand from another. (As correlation becomes

more +ve, the benefits decrease)

80

Practical issues in inventory

management

• Effective inventory reduction strategies (as

identified by company executives)

1. Performing periodic inventory review

– Helps identify slow moving and obsolete

products and thus reduce inventory.

2. Provide tight management of usage rates,

lead times and safety stock

3. Reduce safety stock levels (through focus on

lead-time reduction)

81

Practical issues

4. Introduce or enhance cycle counting practice

as opposed to annual inventory count

exercise

5. Follow ABC approach

6. Shift more inventory or inventory ownership

to suppliers

7. Follow quantitative approaches (like Q,R

policy, base-stock policy)

82

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