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Inventory Management in Supply Chain

Dr. R K Singh Associate Professor, IIFT, Delhi

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Outline

Need for Inventory Management

Single stage inventory control


EOQ model Single period models Multiple order opportunities Risk Pooling

Centralized vs. Decentralized Systems Practical Issues in Inventory Management


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Definitions

Inventory-A physical resource that a firm holds in stock with the intent of selling it or transforming it into a more valuable state.

Inventory System- A set of policies and controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be

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Sources: plants vendors ports

Regional Warehouses: stocking points

Field Warehouses: stocking points

Customers, demand centers sinks

Supply

Inventory & warehousing costs Production/ purchase costs Transportation costs Inventory & warehousing costs Transportation costs
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Reasons for Inventories


Improve customer service Economies of purchasing Economies of production Transportation savings Hedge against future Unplanned shocks (labor strikes, natural disasters, surges in demand, etc.) To maintain independence of supply chain

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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 Reliance Industries, Tata motors, Maruti, Pantaloon, Big Bazar

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Goals: Reduce Cost, Improve Service

By not managing inventory successfully

In 1994, IBM continued to struggle with shortages in their ThinkPad line In 1993, Dell Computers was sharply off in its forecast of demand, resulting in inventory write downs The average carrying cost of inventory across all mfg.. in the U.S. is 30-35% of its value. Indian Oil, Bharat Petroleum, FCI

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Inventory Management-Demand Forecasts

Uncertain demand makes demand forecast critical for inventory related decisions:
What to order? When to order? How much is the optimal order quantity?

Approach includes a set of techniques

INVENTORY POLICY!!

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Supply Chain Factors in Inventory Policy


Estimation of customer demand Replenishment lead time The number of different products being considered The length of the planning horizon Costs

Order cost:

Product cost Administration cost (Purchase orders, receiving the orders) Transportation cost
State taxes, property taxes, and insurance on inventories Maintenance costs Obsolescence cost Opportunity costs

Inventory holding cost, or inventory carrying cost:


Service level requirements


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Single Stage Inventory Control


Single supply chain stage Variety of techniques/approaches


Economic Lot Size Model Single Period Models Multiple Order Opportunities Continuous Review Policy Periodic Review Policy

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Economic Order Quantity (EOQ)Model

FIGURE Inventory level as a function of time

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Assumptions

D items per day: Constant demand rate Q items per order: Order quantities are fixed, K, fixed setup cost, incurred every time the warehouse places an order. h, inventory carrying cost accrued per unit held in inventory per day that the unit is held (also known as, holding cost) Lead time = 0 (the time that elapses between the placement of an order and its receipt) Initial inventory = 0

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Deriving EOQ
Average inventory level: Q/2 No of Orders=D/Q Average total cost per unit time:

KD hQ Q 2

(EOQ) Q =
*

2 KD h
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EOQ: Costs

FIGURE Economic lot size model: total cost per unit time

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Sensitivity Analysis
Total inventory cost relatively insensitive to order quantities Actual order quantity: Q Q is a multiple b of the optimal order quantity Q*. For a given b, the quantity ordered is Q = bQ*
b Increase in cost .5 25% .8 2.5% .9 0.5% 1 0 1.1 .4% 1.2 1.6% 1.5 8.9% 2 25%

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Demand Uncertainty

The forecast is not 100% correct. The longer the forecast horizon, the worse the forecast Aggregate forecasts are more accurate.

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Single Period Models


Short lifecycle products One ordering opportunity only Order quantity to be decided before demand occurs

Order Quantity > Demand => Dispose excess inventory Order Quantity < Demand => Lose sales/profits

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Single Period Models

Using historical data

identify a variety of demand scenarios

Given a specific inventory policy

determine the profit associated with a particular scenario

Order the quantity that maximizes the average profit.

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Relationship Between Optimal Quantity and Average Demand

Compare marginal profit of selling an additional unit and marginal cost of not selling an additional unit Marginal profit/unit = Selling Price - Variable Ordering (or, Production) Cost

Marginal cost/unit = Variable Ordering (or, Production) Cost - Salvage Value


If Marginal Profit > Marginal Cost => Optimal Quantity > Average Demand If Marginal Profit < Marginal Cost => Optimal Quantity < Average Demand

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Multiple Order Opportunities


REASONS

To balance annual inventory holding costs and annual fixed order costs. To satisfy demand occurring during lead time. To protect against uncertainty in demand.

TWO POLICIES

Continuous review policy Periodic review policy

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Continuous Review Policy

Daily demand is random and follows a normal distribution. Inventory level is continuously reviewed

The distributor specifies a required service level.

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Continuous Review Policy


AVG = Average daily demand STD = Standard deviation of daily demand L = Replenishment lead time h = Cost of holding one unit of the product for one day at the distributor = service level.

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Continuous Review Policy


(Q,R) policy whenever inventory level falls to a reorder level R, place an order for Q units What is the value of R?

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Continuous Review Policy


Average demand during lead time: L x AVG z STD L Safety stock:

Reorder Level, R: L AVG z STD L

Order Quantity, Q:

2 K AVG Q= h
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Service Level & Safety Factor, z


Service Level
z

90% 91% 92% 93% 94%

95% 96% 97% 98% 99% 99.9%

1.29

1.34

1.41

1.48

1.56

1.65

1.75

1.88

2.05

2.33

3.08

z is chosen from statistical tables to ensure that the probability of stockouts during lead time is exactly 1 -

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Inventory Level Over Time


FIGURE : Inventory level as a function of time in a (Q,R) policy

Inventory level before receiving an order = z STD L Inventory level after receiving an order = Q z STD L Average Inventory =
Q 2

z STD L
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Continuous Review Policy Example


A distributor of TV sets that orders from a manufacturer and sells to retailers Fixed ordering cost = $4,500 Cost of a TV set to the distributor = $250 Annual inventory holding cost = 18% of product cost Replenishment lead time = 2 weeks Expected service level = 97%

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Continuous Review Policy Example


Month Sales Sept 200 Oct 152 Nov. 100 Dec. 221 Jan. 287 Feb. 176 Mar. 151 Apr. 198 May 246 June 309 July 98 Aug 156

Average monthly demand = 191.17 Standard deviation of monthly demand = 66.53

Average weekly demand = Average Monthly Demand/4.3


Standard deviation of weekly demand = Monthly standard deviation/4.3

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Continuous Review Policy Example


Parameter Average weekly demand Standard deviation of weekly demand Average demand during lead time 89.16 Safety stock Reorder point

Value

44.58

32.08

86.20

176

Weekly holding cost =

0.18 250 = 0.87 52

Optimal order quantity =

Q=

2 4,500 44 .58 = 679 .87

Average inventory level = 679/2 + 86.20 = 426


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Periodic Review Policy

Inventory level is reviewed periodically at regular intervals An appropriate quantity is ordered after each review Two Cases:

Short Intervals (e.g. Daily)

(s, S) policy

Longer Intervals (e.g. Weekly or Monthly

Base-stock level policy

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(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.

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Base-Stock Level Policy


Determine a target inventory level, the basestock level review the inventory position and order enough to raise the inventory position to the base-stock level Assume: r = length of the review period L = lead time AVG = average daily demand STD = standard deviation of this daily demand.

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Base-Stock Level Policy

FIGURE Inventory level as a function of time in a periodic review policy

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Base-Stock Level Policy

Average demand during an interval of r + L days= (r L) AVG

Safety Stock= z STD r L

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Service Level Optimization


. What is the appropriate level of service?

May be determined by the downstream customer


Retailer

may require the supplier, to maintain a specific service level Supplier will use that target to manage its own inventory

Facility may have the flexibility to choose the appropriate level of service the higher the service level, the higher the inventory level.

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Retail Strategy
Given a target service level across all products determine service level for each SKU so as to maximize expected profit. Everything else being equal, service level will be higher for products with:

high profit margin high volume low variability short lead time

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Risk Pooling

Demand variability is reduced Decrease in safety stock and therefore reduces average inventory. Demand Variation

Standard deviation Coefficient of variation

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Critical Points

The higher the coefficient of variation, the greater the benefit from risk pooling

risk pooling benefits are higher in situations where demands observed at warehouses are negatively correlated

Reallocation of items from one market to another easily accomplished in centralized systems.

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Centralized vs. Decentralized Systems

Safety stock Service level Overhead costs Customer lead time Transportation costs

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Acme Risk Pooling Case


Electronic equipment manufacturer and distributor 2 warehouses for distribution in New York and New Jersey (partitioning the northeast market into two regions) Customers (that is, retailers) receiving items from warehouses (each retailer is assigned a warehouse) Warehouses receive material from Chicago Current rule: 97 % service level Each warehouse operate to satisfy 97 % of demand (3 % probability of stock-out)
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New Idea

Replace the 2 warehouses with a single warehouse (located some suitable place) and try to implement the same service level 97 % Delivery lead times may increase But may decrease total inventory investment considerably.

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Historical Data
PRODUCT A
Week Massachusetts New Jersey Total 1 33 46 79 2 45 35 80 3 37 41 78 4 38 40 78 5 55 26 81 6 30 48 78 7 18 18 36 8 58 55 113

PRODUCT B
Week Massachusetts New Jersey Total 1 0 2 2 2 3 4 6 3 3 3 3 4 0 0 0 5 0 3 3 6 1 1 2 7 3 0 3 8 0 0 0

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Summary of Historical Data


Statistics Product Average Demand Standard Deviation of Demand 13.2 1.36 12.0 1.58 Coefficient of Variation 0.34 1.21 0.31 1.26 Massachusetts Massachusetts New Jersey New Jersey A B A B 39.3 1.125 38.6 1.25

Total
Total

A
B

77.9
2.375

20.71
1.9

0.27
0.81

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Inventory Levels
Product Average Demand During Lead Time 39.3 1.125 38.6 1.25 77.9 2.375 Safety Stock Reorder Point Q

Massachusetts Massachusetts New Jersey New Jersey Total Total

A B A B A B

25.08 2.58 22.8 3 39.35 3.61

65 4 62 5 118 6

132 25 31 24 186 33

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Savings in Inventory

Average inventory for Product A:

At NJ warehouse is about 88 units At MA warehouse is about 91 units In the centralized warehouse is about 132 units Average inventory reduced by about 25 percent
At NJ warehouse is about 15 units At MA warehouse is about 14 units In the centralized warehouse is about 20 units

Average inventory for Product B:


Average inventory reduced by about 33 percent


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Managing Inventory in the Supply Chain

Echelons and echelon inventory

Echelon inventory at any stage or level of the system equals the inventory on hand at the echelon, plus all downstream inventory (downstream means closer to the customer)

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Echelon Inventory

FIGURE : A serial supply chain


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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 R = Le AVG z STD Le Reorder point

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4-Stage Supply Chain Example


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 distributor wholesaler manufacturer

250 200 205 500

45 45 45 45

1.2 .9 .8 .7

137 141 152 255

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Reorder Points at Each Stage


For the retailer, R=1*45+1.88*32*1 = 105 For the distributor, R=2*45+1.88*32*2 = 175 For the wholesaler, R=3*45+1.88*32*3 = 239 For the manufacturer, R=4*45+1.88*32*4 = 300

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More than One Facility at Each Stage

Follow the same approach Echelon inventory at the warehouse is the inventory at the warehouse, plus all of the inventory in transit to and in stock at each of the retailers. Similarly, the echelon inventory position at the warehouse is the echelon inventory at the warehouse, plus those items ordered by the warehouse that have not yet arrived minus all items that are backordered.
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Warehouse Echelon Inventory

FIGURE : The warehouse echelon inventory

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Practical Issues
Periodic inventory review. Tight management of usage rates, lead times, and safety stock. Reduce safety stock levels. Introduce or enhance cycle counting practice. ABC approach. Shift more inventory or inventory ownership to suppliers. Quantitative approaches. FOCUS: not reducing costs but reducing inventory levels. Significant effort in industry to increase inventory turnover

Annual _ Sales Inventory _ Turnover _ Ratio = Average _ Inventory _ Level


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SUMMARY

Matching supply with demand a major challenge Forecast demand is always wrong Longer the forecast horizon, less accurate the forecast Aggregate demand more accurate than disaggregated demand Need the most appropriate technique Need the most appropriate inventory policy

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