Inventory Management, Supply Contracts and Risk Pooling

Dr. A. K. Dey

Dr. A. K. Dey

Outline of the Presentation

Introduction to Inventory Management The Effect of Demand Uncertainty

(s,S) Policy Periodic Review Policy Supply Contracts Risk Pooling Centralized vs. Decentralized Systems Practical Issues in Inventory Management

Dr. A. K. Dey

Inventory
Where do we hold inventory? Suppliers and manufacturers warehouses and distribution centers retailers Types of Inventory WIP raw materials finished goods Why do we hold inventory? Economies of scale Uncertainty in supply and demand Lead Time, Capacity limitations
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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
Dr. A. K. Dey 4

Goals: Reduce Cost, Improve Service

By not managing inventory successfully

In 1994, IBM continues to struggle with shortages in their ThinkPad line (WSJ, Oct 7, 1994) In 1993, Liz Claiborne said its unexpected earning decline is the consequence of higher than anticipated excess inventory (WSJ, July 15, 1993) In 1993, Dell Computers predicts a loss; Stock plunges. Dell acknowledged that the company was sharply off in its forecast of demand, resulting in inventory write downs (WSJ, August 1993)
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Understanding Inventory
1. The inventory policy is affected by:

Demand Characteristics Lead Time Number of Products Objectives

Service level Minimize costs

Cost Structure

Dr. A. K. Dey

Cost Structure
Order costs

Fixed Variable Insurance Maintenance and Handling Taxes Opportunity Costs Obsolescence
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Holding Costs

EOQ: A Simple Model

Book Store Mug Sales

Demand is constant, at 20 units a week Fixed order cost of $12.00, no lead time Holding cost of 25% of inventory value annually Mugs cost $1.00, sell for $5.00 How many, when to order?

Question

Dr. A. K. Dey

EOQ: A View of Inventory

Note: No Stockouts Order when no inventory Order Size determines policy

Inventory
Order Size Avg. Inven
Dr. A. K. Dey

Time

EOQ: Calculating Total Cost

Purchase Cost Constant

Holding Cost: (Avg. Inven) * (Holding Cost)

Ordering (Setup Cost):

Number of Orders * Order Cost Goal: Find the Order Quantity that Minimizes These Costs:

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EOQ: Total Cost

160 140 120 100

Cost

80 60 40 20 0 0 500 1000 1500 Order Quantity

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EOQ: Optimal Order Quantity

Optimal Quantity =

[(2*Demand*Setup Cost)/holding cost]

So for our problem

The optimal quantity is 316

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EOQ: Important Observations

Tradeoff between set-up costs and holding

costs when determining order quantity. In fact, we order so that these costs are equal per unit time Total Cost is not particularly sensitive to the optimal order quantity

Order Quantity 50% 80% 90% 100% 110% 120% 150% 200% Cost Increase 125% 103% 101% 100% 101% 102% 108% 125%

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The Effect of Demand Uncertainty

Most companies treat the world as if it were

predictable:

Production and inventory planning are based on forecasts of demand made far in advance of the selling season Companies are aware of demand uncertainty when they create a forecast, but they design their planning process as if the forecast truly represents reality

Recent technological advances have increased the

level of demand uncertainty:

Short product life cycles Increasing product variety

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Demand Forecast
The three principles of all forecasting

techniques:

Forecasting is always wrong The longer the forecast horizon the worst is the forecast Aggregate forecasts are more accurate

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Swim Suit Sporting Goods

Fashion items have short life cycles, high variety of

competitors Swim Suit Sporting Goods New designs are completed One production opportunity Based on past sales, knowledge of the industry, and economic conditions, the marketing department has a probabilistic forecast The forecast averages about 13,000, but there is a chance that demand will be greater or less than this.
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Supply Chain Time Lines

Jan 00 Design

Jan 01 Production

Jan 02 Retailing

Feb 00

Sep 00

Feb 01

Sep 01

Production

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Swim Suit Demand Scenarios

Demand Scenarios
30% 25% 20% 15% 10% 5% 0%

Probability

80 00 10 00 0

12 00 0

14 00 0

16 00 0

Sales
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18 00 0

Swim Suit Costs

Production cost per unit (C): $80

Selling price per unit (S): $125

Salvage value per unit (V): $20 Fixed production cost (F): $100,000 Q is production quantity, D demand Profit =

Revenue - Variable Cost - Fixed Cost + Salvage

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Swim Suit Scenarios

Demand 8000 10000 12000 14000 16000 18000 Average Probability 0.110 0.110 0.275 0.225 0.185 0.095 13100
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Key questions
What is the best production quantity?

How much is the profit if there is no beginning

inventory, manufacturer produces 12000 swimsuits while the demand is 13000 swimsuits? Calculate the profit if the company produces 12000 swimsuits and the demand is for 11000 swimsuits.

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Swim Suit Scenarios

Scenario One:

Suppose you make 12,000 jackets and demand ends up being 13,000 jackets. Profit = 125(12,000) - 80(12,000) - 100,000 = $440,000
Suppose you make 12,000 jackets and demand ends up being 11,000 jackets. Profit = 125(11,000) - 80(12,000) - 100,000 + 20(1000) = $ 335,000
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Scenario Two:

Key questions
What is the weighted average profit if the

company makes 9000 swimsuits? And if it makes 16000 swim suits?

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Weighted Average Profit for 9000 Swim Suits

Make 9000 Swim Suits
Demand Prob Revenue 125 Variable cost 80 Fixed Cost Salvage Value 20 Profit Weighted Average

8000 10000 12000 14000 16000 18000

0.11 0.11 0.275 0.225 0.185 0.095

1000000 1125000 1125000 1125000 1125000 1125000

720000 720000 720000 720000 720000 720000

100000 100000 100000 100000 100000 100000

20000 0 0 0 0 0

200000 305000 305000 305000 305000 305000

22000 33550 83875 68625 56425 28975 293450

Total Expected Profit

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Weighted Average Profit for 16000 Swim Suits

Make 16000 Swim Suits
Demand Prob Revenue 125 Variable cost 80 Fixed Cost Salvage Value 20 Profit Weighted Average

8000 10000 12000 14000 16000 18000

0.11 0.11 0.275 0.225 0.185 0.095

1000000 1250000 1500000 1750000 2000000 2000000

1280000 1280000 1280000 1280000 1280000 1280000

100000 100000 100000 100000 100000 100000

160000 120000 80000 40000 0 0

-220000 -10000 200000 410000 620000 620000

-24200 -1100 55000 92250 114700 58900 295550

Total Expected Profit

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Swim Suit Best Solution

Find order quantity that

maximizes weighted average profit. Question: Will this quantity be less than, equal to, or greater than average demand?

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What to Make?
Question: Will this quantity be less than,

equal to, or greater than average demand? Average demand is 13,100 Look at marginal cost Vs. marginal profit

if extra jacket sold, profit is 125-80 = 45 if not sold, cost is 80-20 = 60

So we will make less than average

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Swim Suit Expected Profit

Expected Profit
$400,000 $300,000

Profit

$200,000 $100,000 $0 8000

12000
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16000

20000
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Order Quantity

Swim Suit Expected Profit same for 9000 & 16000

Expected Profit
$400,000 $300,000

Profit

$200,000 $100,000 $0 8000

12000

16000

20000

Order Quantity
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Effect of Initial Inventory

Suppose the beginning inventory is 5000

swimsuits

If does not produce max 5000 swimsuits can be sold If starts production, fixed cost will be charged

Assuming same demand pattern Should the manufacturer start production?

If yes, how many swimsuits should be

produced?
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Expected profit 771000

Initial Inventory 5000 Swim Suits, Make 7000 more to have 12000 to sell
Demand Prob Revenue 125 Variable cost 80 Fixed Cost Salvage Value 20 Profit Weighted Average

8000
10000

0.11
0.11

1000000
1250000

560000
560000

100000
100000

80000
40000

420000
630000

46200
69300

12000
14000

0.275
0.225

1500000
1500000

560000
560000

100000
100000

0
0

840000
840000

231000
189000

16000
18000

0.185
0.095

1500000
1500000

560000
560000

100000
100000

0
0

840000
840000

155400
79800 770700
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Total Expected Profit

Dr. A. K. Dey

Initial Inventory 10000 Swim Suits, Make 2000 more to have 12000 to sell
Demand Prob Revenu 125 1000000 1250000 1500000 1500000 1500000 1500000 Variabl cost 80 160000 160000 160000 160000 160000 160000 Fixed Cost 100000 100000 100000 100000 100000 100000 Salvag Value 20 80000 40000 0 0 0 0 Profit Weighte Average 90200 113300 341000 279000 229400 117800 1170700

8000 10000 12000 14000 16000 18000

0.11 0.11 0.275 0.225 0.185 0.095

820000 1030000 1240000 1240000 1240000 1240000

Total Expected Profit

If only 10000 swimsuits are sold revenue and profit will be 1250000! Why produce more?

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Key Insights from this Model

The optimal order quantity is not necessarily

equal to average forecast demand The optimal quantity depends on the relationship between marginal profit and marginal cost As order quantity increases, average profit first increases and then decreases As production quantity increases, risk increases. In other words, the probability of large gains and of large losses increases
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