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ME 4030 Operations Research

Lecturer : K. Badarinath
Lecture 4-6
16/1/2018, 19/1/2018 and
23/1/2018
Roadmap for this course

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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.

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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.

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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.

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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

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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.

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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?
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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.

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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.

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Key issues
7. Product design
– Can we redesign products to reduce logistics
costs?
8. Using Information Technology for improving
supply chain designs

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Inventory management
• Types of inventory
– Raw material inventory
– Work-in-process (WIP) inventory
– Finished goods inventory

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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.

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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
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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
CK
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 ?
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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

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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

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Newsvendor model
𝑥
EP = 𝑟 − 𝑠 −∞
𝑤𝑓 𝑤 𝑑𝑤 + s − c xF x +
r − c x[1 − F x ]

The expression in red above =x[ s − c 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)

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Newsvendor model
𝑑𝐸𝑃
We now calculate = 𝑟 − 𝑠 𝑥𝑓 𝑥 +
𝑑𝑥
s − c F x + s − c xf x + r − c [1 −

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Newsvendor model
𝑑𝐸𝑃
• If = 0 𝑖. 𝑒 𝑎𝑡 𝑥 ∗ , we have
𝑑𝑥
(𝑟 − 𝑐) (𝑟 − 𝑐)
𝐹 𝑥∗ = =
(𝑟 − 𝑠) 𝑟 − 𝑐 + (𝑐 − 𝑠)

Now we also have EP = 0 when x = 0 and EP


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)

• This can also be understood as F(x*) =


𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
.
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡+𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑙𝑜𝑠𝑠

𝑥∗
• Recall F(x*) is a probability ( −∞
𝑓 𝑤 𝑑𝑤)

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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

• We know the probability distribution of


demand (normal or discrete) . Apply the
above derived expression to it.
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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)

z = 0.431, this gives


𝑄 = 45000 ∗ 0.431 + 150000 = 169395 𝑢𝑛𝑖𝑡𝑠

The expression in red can also be thought of as safety


stock while planning for average demand.
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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

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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

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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
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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

Probability 0.11 0.11 0.28 0.22 0.28


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)

• Very useful for practical situations.

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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.

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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.

Lead time : The time from placement of order to


receipt of goods.
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Model types

• Continuous Review Policy : Inventory is


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=

• Inventory position : defined as inventory on


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.

• Also known as ‘Base-stock’ policy

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

• 𝐴𝑉𝐺 = 191.17 Feb


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)

Manufacturer Distributor Wholesaler Retailer

Consider now a distribution chain as shown above.


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

Q: How would you decide on inventory to keep/order at each stage?

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)

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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

• E.g: For manufacturer, lead time = 1 week


(from its suppliers) + 3 weeks (to all its
downstream echelons)
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Example -MEIM
• Cost parameters and order quantities are
2𝐾𝐷
(Note : Q = )

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

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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

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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.

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Risk pooling
• Reduced variability allows
– Decrease in safety stock to maintain.
– Reduction in average inventory.

• Measure of variability - Coefficient of variation

𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐶. 𝑉. =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑

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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

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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)

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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)
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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)

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