DOS3701/DSC3201

Supply Chain Management

Semester I, 2019/2020

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• Instructor
• Lucy G. Chen
• Associate Professor
• Department of Analytics and Operations
• Office: BIZ1 #08-60
• Email: bizcg@nus.edu.sg
• Phone: 6516-3013
• Consultation:
• Tue: 10:30am – 11:30am
• Or by appointment through email

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Inventory Management and
Risk Pooling
• Single Stage Inventory Control
• Constant Demand
• Economic Order Quantity Model
• The Effect of Demand Uncertainty
• Single Period Model
• Multiple Order Opportunities
• Risk Pooling
• Inventory Control in the Supply Chain

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Importance of Understanding Inventory
• $1.76 trillion in US (Nov 2014).
• 37.2% held by manufacturers, 31.8% held by
retailers, 31% by wholesalers
• If 20% of it (=352 billion) is freed for investment
• A modest return of 5% would yield 17.6 billion!!
• Inventory cost at 25% of the value is $440 billion per
year
• Inventories can represent high percentages of
current assets and working capital

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Types of Inventory
• Raw Materials (RM)
• No processing undergone yet
• Work-in-Process (WIP)
• Some processing undergone but not finished
• Finished Goods (FG)
• Finished processing, awaiting delivery or sale

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Why Hold Inventory?
• Pipeline inventory
• Inventory-in-transit/WIP
• Seasonal Inventory
• Due to temporary imbalance in supply and demand
• Cycle Inventory
• To take advantage of economy of scale
• Decoupling Inventory/Buffers
• To ensure independence of operations
• Safety Inventory
• To meet variation in product demand
• Speculative Inventory
• To hedge the price difference

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Reasons to Not Hold Inventory
• Expense

• Obsolescence

• Delayed (reduced) responsiveness

• Masking underlying problems

DSC 2006, NUS Business School, Lucy Chen 7

Costs of Inventory
• Order cost
• Fixed
• Variable
• Holding Cost
• Out-of-Pocket cost in space, insurance, handling,etc.
• Financial cost (opportunity cost)
• Obsolescence
• Shortage / stockout cost
• Expediting cost for emergency shipment
• Loss of profit
• Loss of goodwill

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Fundamental Questions in
Inventory Management
• How much to order or produce? (size)
• Too many: excess/overage cost
• Too few: shortage/underage cost
• When to order or produce? (timing)

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Economic Order Quantity
(EOQ)
• Annual jacket sales at a Palü Gear retail store is 3100
pieces. The store pays the manufacturer $250 for each
jacket. A shipment up to a full truck load was charged a
flat fee of $2,200. The store typically orders 1550
jackets at a time, twice a year. (Palü’s annual
inventory holding cost is approximately 20% of the
procurement cost for each jacket.)

What order size would you recommend for this Palü

store?
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EOQ: Assumptions and Data
• Assumptions
• Constant demand rate
• No stockout is allowed
• Lead-time is zero
• No quantity discounts when purchasing
• Data
D: demand rate (units/year)
K: fixed ordering cost per order ($)
c: purchasing cost per unit ($/unit)
h: annual holding cost ($/unit,year)

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EOQ: A View of Inventory

Inventory
Q
Order
Size

Avg. Inv.

Time

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EOQ: Tradeoff

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EOQ: Calculating Total Cost
• Variable order cost per year:
• Holding cost per year:
• (Avg Inv) * (Holding Cost)
• Fixed order (Setup) cost per year:
• (Number of Orders) * (Fixed Order Cost)
• Total annual cost

• Goal: Find the order quantity that minimizes the

total annual cost
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EOQ:Total Cost
160
140
120
Total Cost
100
Cost

80 Holding Cost
60
40 Order Cost
20
0
0 500 1000 1500
Order Quantity

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EOQ: Optimal Order Quantity
• Optimal Quantity
∗
$%&
! =
'
• The Palü Gear Example
• D=
• K=
• c=
• h=
• Q*=

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EOQ: Important Observations*
• At the optimal order quantity, the fixed
ordering/set-up cost per unit time is equal to
the holding cost per unit time
• Total Cost is not particularly sensitive to the
optimal order quantity
• Q=bQ*

b 0.5 0.8 0.9 1 1.1 1.2 1.5 2

Increase in 25% 2.5% 0.5% 0 .4% 1.6% 8.9% 25%
cost

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Order Lead-time
• Suppose D = 5200 units/year, Q = 200.
• Length of order cycle T= 2 weeks.
• 1. Lead-time = 1 week, reorder point =
• 2. Lead-time = 3 weeks, reorder point =
Inventory
200

100

Time/
0 lead-time = 1 week
weeks
lead-time = 3 weeks
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What if Demand is Uncertain?

• Balance fixed costs and holding costs

• Satisfy demand during lead-time

• Protect against demand uncertainty

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The Multi-Period Inventory Model
• Normally distributed random demand
• Fixed order cost plus a variable order 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 firm has a required service level.
• Expressed as the the likelihood that the firm will not stock out
during lead time.
• Intuitively, how will this affect our policy?

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Reminder:
The Normal Distribution

Standard Deviation = 5

Standard Deviation = 10

Average = 30

0 10 20 30 40 50 60

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TWO POLICIES
• Continuous review policy
• Inventory is reviewed continuously
• An order is placed when the inventory reaches a
particular level
• Periodic review policy
• Inventory is reviewed at regular intervals
• Appropriate quantity is ordered after each review.

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Continuous Review – (Q,R) Policy
• (Q,R) policy – whenever the inventory level
falls to a reorder level R, place an order for Q
units
• The reorder point R is a function of
• The lead-time
• Average demand
• Demand variability
• Service level

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 A View of (Q,R) Policy
Q+R
Inventory Position
Inventory Level

Lead
Time

0
Time
Inventory level as a function of time in a (Q,R) policy
Continuous Review – (Q,R) Policy
• AVG = average daily demand
• STD = standard deviation of daily demand
• L = replenishment lead time in days
• h = holding cost of one unit for one day
• ⍺ = service level (e.g., 95%)
• The probability of stocking out is hence 1- ⍺ (e.g., 5%).
• Also, the Inventory Position at any time is the actual
inventory plus items already ordered, but not yet
delivered.

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Continuous Review – (Q,R) Policy
• The reorder point R has two components
• To account for average demand during lead-time
!×#$%
• To account for deviations from average (we call this
safety stock)
&×'()× !
• z is called safety factor
• * = ,×-./ + 1×234× ,
• Order quantity
67×-./
5=
8
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 Service Level and Safety Factor, z

• The safety factor, z, is chosen from statistical

tables to ensure that the probability of stockout
during lead-time is 1-⍺.
Service 90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 99.9%
Level
z 1.29 1.34 1.41 1.48 1.56 1.65 1.75 1.88 2.05 2.33 3.08

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Example
• A distributor of TV sets has historically observed
weekly demand of:
AVG = 44.6 STD = 32.1
• Replenishment lead-time is 2 weeks, and desired
service level SL = 97%
• Fixed ordering cost = $4,500
• Cost of a TV set to the distributor = $250
• Annual inventory holding cost = 18% of product cost
• What inventory order strategy should be used?

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What if Lead-Time is Random
• The information we need about the lead-time
• AVGL: average lead-time
• STDL: standard deviation of the lead-time
• The reorder point becomes
• ! = #$%×#$%' + )× #$%'×*+,- + #$%×*%,'-
• Order Quantity Q
-/×#$%
.=
0

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Periodic Review – (s,S) Policy
• Calculate the Q and R values as if this were a
continuous review model
• Set s equal to R
• Set S equal to R+Q.
• Applies to short review intervals (e.g. daily)

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 A View of (s, S) Policy

S
Inventory Position
Inventory Level

Lead
Time

0
Time
Periodic Review – Base-stock Policy

• Applies to longer review Intervals (e.g. Weekly

or Monthly)
• May make sense to always order after an inventory
level review.
• Determine a target inventory level, the base-stock
level
• During each review period, the inventory position is
reviewed
• Order enough to raise the inventory position to the
base-stock level.

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Periodic Review – Base-stock Policy
• Assume:
• r = length of the review period
• L = lead-time
• AVG = average daily demand
• STD = standard deviation of the daily demand
• Average demand during an interval of r+L days
! + # ×%&'
• Safety stock
(×)*+× ! + #
• Base-stock level = ! + # ×%&' + (×)*+× ! + #

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Risk Pooling
• Consider these two systems:

Warehouse One Market One

Supplier
Warehouse Two Market Two

Market One
Supplier Warehouse

Market Two
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Risk Pooling Example
• Compare the two systems
• Two products
• Maintain 97% service level
• $60 fixed order cost
• $.27 weekly holding cost
• $1.05 transportation cost per unit in decentralized
system, $1.10 in centralized system
• 1 week lead-time

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Risk Pooling Example
Week 1 2 3 4 5 6 7 8
Prod A, 33 45 37 38 55 30 18 58
Market 1
Prod A, 46 35 41 40 26 48 18 55
Market 2
Prod B, 0 2 3 0 0 1 3 0
Market 1
Product B, 2 4 0 0 3 1 0 0
Market 2

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Risk Pooling Example
Warehouse Product AVG STD CV

Market 1 A 39.3 13.2 0.34

Market 2 A 38.6 12.0 0.31

Market 1 B 1.125 1.36 1.21

Market 2 B 1.25 1.58 1.26

Cent. A 77.9 20.71 0.27
Cent. B 2.375 1.9 0.81

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Risk Pooling Example
Warehouse Product Safety R Q Avg. %
Stock Inv. Reduction
Market 1 A 24.8 65 132 91

Market 2 A 22.6 62 131 88

Market 1 B 2.5 4 22 14

Market 2 B 3 5 24 15
Cent. A 38.9 117 186 132 26%
Cent. B 3.6 6 33 20 31%

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Risk Pooling:
Important Observations
• Centralizing inventory control reduces both
safety stock and average inventory level for the
same service level.
• When does risk pooling work best?
• High coefficient of variation, which reduces required
safety stock.
• Negatively correlated demand. Why?
• What other kinds of risk pooling will we see?

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To Centralize or not to Centralize

• What is the impact on:

• Safety stock?
• Service level?
• Overhead?
• Lead-time?
• Transportation Costs?

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Managing Inventory in the Supply
Chain
• Inventory decisions are made by a single
decision maker whose objective is to minimize
the system-wide cost
• The decision maker has access to inventory
information at each of the retailers and at the
warehouse
• Echelons and echelon inventory
• Echelon inventory at any stage of the system
= the inventory on hand at the stage
+ all downstream inventory

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Echelon Inventory

A serial supply chain

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Distributor’s Reorder Point with
Echelon Inventory
• Le = echelon lead-time,
• Lead-time between the retailer and the distributor
plus the lead-time between the distributor and its
supplier, the wholesaler.
• AVG = average demand at the retailer
• STD = standard deviation of demand at the
retailer
• Reorder point
R = Le ´ AVG + z ´ STD ´ Le

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Example: A 4-Stage Supply Chain

• Average weekly demand faced by the retailer

is 45
• Standard deviation of demand is 32
• At each stage, management is attempting to
maintain a service level of 97% (z=1.88)
• Lead-time between each of the stages, and
between the manufacturer and its suppliers is 1
week

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Costs and Order Quantities

K D h Q
Retailer 250 45 1.2
Distributor 200 45 .9
Wholesaler 205 45 .8
Manufacturer 500 45 .7

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Reorder Points at Each Stage
• For the retailer

• For the distributor

• For the wholesaler

• For the manufacturer

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More than One Facility at Each
Stage
• Follow the same approach as in a serial supply chain
• Echelon inventory at the warehouse
= the inventory at the warehouse
+ all of the inventory in transit to and in stock
at each of the retailers.
• Echelon inventory position at the warehouse
= echelon inventory at the warehouse
+ those items ordered by the warehouse but
have not yet arrived
- all items that are backordered.

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Warehouse Echelon Inventory

The warehouse echelon inventory

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Warehouse’s Reorder Point with
Echelon Inventory
• Le = echelon lead time
• Lead-time between the retailers and the warehouse
plus the lead time between the warehouse and its
supplier
• AVG = average demand across all retailers
• STD = standard deviation of (aggregate)
demand across all retailers
• Reorder point
R = Le ´ AVG + z ´ STD ´ Le

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Readings
• Chapter 2.1-2.5, excluding Chapter 2.2.3-2.2.4

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