Inventory Management & Risk Pooling Part II

Prepared by Dr. A. K. Dey Based on Third Chapter of Simchi-Levi, Kaminsky & Simchi-Levi

Dr. A. K. Dey

Supply Contracts
Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$80 Selling Price=$125 Salvage Value=$20

Manufacturer

Manufacturer DC

Retail DC

Stores
Dr. A. K. Dey 2

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
Dr. A. K. Dey 3

18 00 0

Retailer Expected Profit

Expected Profit
500000 400000 300000 200000 100000 0 6000

8000

10000

12000

14000

16000

18000

20000

Order Quantity

Dr. A. K. Dey

Retailer Expected Profit

Expected Profit
500000 400000 300000 200000 100000 0 6000

8000

10000

12000

14000

16000

18000

20000

Order Quantity

Dr. A. K. Dey

Retailer orders for 12000 swimsuits

Revenue 125 Whole Sale Price 80 Fixed Cost Salvage Value 20 Retailer Profit Weighted Retail Average Manuf Profit Weighted Average Manuf Profit

Demand

Prob

8000 10000 12000 14000

0.11 0.11 0.275 0.225

1000000 1250000 1500000 1500000

960000 960000 960000 960000

100000 100000 100000 100000

80000 40000 0 0

120000 330000 540000 540000

13200 36300 148500 121500

440000 440000 440000 440000

48400 48400 121000 99000

16000
18000

0.185
0.095

1500000
1500000

960000
960000

100000
100000

0
0

540000
540000

99900
51300 470700

440000
440000

81400
41800 440000 910700

Total Expected Profit Total Supply Chain Profit

Dr. A. K. Dey

Supply Contracts (cont.)

Retailer optimal order quantity is 12,000 units Retailer expected profit is $470,000 Manufacturer profit is $440,000 Total Supply Chain Profit is $910,000
Is there anything that the distributor and manufacturer can do to increase the profit of both?
Dr. A. K. Dey 7

Supply Contracts
Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$80 Selling Price=$125 Salvage Value=$20

Manufacturer

Manufacturer DC

Retail DC

Stores
Dr. A. K. Dey 8

Buy back contract

Retailer proposes that unsold goods should be taken back by the manufacturer under Buy back arrangement for $55 per unit

Dr. A. K. Dey

Retailer orders for 12000 swimsuits with buy back arrangement Sales Price 125 8000 10000 12000 14000 16000 18000 0.11 0.11 0.275 0.225 0.185 0.095 1000000 1250000 1500000 1500000 1500000 1500000 Buy Back 55 220000 110000 0 0 0 0 Wholes le Price 80 960000 960000 960000 960000 960000 960000 Variale cost 35 420000 420000 420000 420000 420000 420000 Fixed cost 100000 100000 100000 100000 100000 100000 100000

Demand

Prob

Profit

Average Profit

Retailer 260000 400000 540000 540000 540000 540000

Manuf 220000 330000 440000 440000 440000 440000

Retailer 28600 44000 148500 121500 99900 51300

Manuf 24200 36300 121000 99000 81400 41800

Total Expected Profit TotalSupply Chain Profit

493800

403700 897500

Dr. A. K. Dey

10

Retailer orders for 14000 swimsuits with buy back arrangement Demand Prob Sales Price
125

Buy Back
55

Whole sale Price

80

Variable cost
35

Fixed cost
100000 Retailer

Profit

Average Profit

Manuf

Retailer

Manuf

8000 10000

0.11 0.11

1000000 1250000

330000 220000

1120000 1120000

490000 490000

100000 100000

210000 350000

200000 310000

23100 38500

22000 34100

12000
14000 16000 18000

0.275
0.225 0.185 0.095

1500000
1750000 1750000 1750000

110000
0 0 0

1120000
1120000 1120000 1120000

490000
490000 490000 490000

100000
100000 100000 100000

490000
630000 630000 630000

420000
530000 530000 530000

134750
141750 116550 59850 514500

115500
119250 98050 50350 439250 953750

Total Expected Profit Total Supply Chain Profit

Dr. A. K. Dey

11

Retailer orders for 16000 swimsuits with buy back arrangement

Demand

Prob

Sales Price

Buy Back

Whole Sale Price

Variable cost

Fixed cost

Profit

Average Profit

125 8000 10000 12000 14000 16000 18000 0.11 0.11 0.275 0.225 0.185 0.095 1000000 1250000 1500000 1750000 2000000 2000000

55 440000 330000 220000 110000 0 0

80 1280000 1280000 1280000 1280000 1280000 1280000

35 560000 560000 560000 560000 560000 560000

100000 100000 100000 100000 100000 100000 100000

Retailer 160000 300000 440000 580000 720000 720000

Manuf 180000 290000 400000 510000 620000 620000

Retailer 17600 33000 121000 130500 133200 68400 503700

Manuf 19800 31900 110000 114750 114700 58900 450050 953750

Best case Profits for both increase. With buy back arrangement manufacturer should push for 16000 units order.

Total Expected Profit Total Supply Chain Profit

Dr. A. K. Dey

12

Supply Contracts
Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$?? Selling Price=$125 Salvage Value=$20

Manufacturer

Manufacturer DC

Retail DC

Stores
Dr. A. K. Dey 13

Revenue Sharing Contract

Manufacturer and retailer have a revenue sharing contract Manufacturer agrees to decrease the whole sale price from $80 to $60 In return retailer provides 15% of the product revenue to the manufacturer

Dr. A. K. Dey

14

Retailer orders for 12000 swimsuits with revenue sharing arrangement

Sales Price Rev Share Wholesale Price Variable cost Fixed cost

Demand

Prob

Profit

Average Profit

125

15%

60

35

100000

Retailer

ManuF

Retailer

Manuf

8000 10000 12000 14000 16000 18000

0.11 0.11 0.275 0.225 0.185 0.095

1000000 1250000 1500000 1500000 1500000 1500000

150000 187500 225000 225000 225000 225000

720000 720000 720000 720000 720000 720000

420000 420000 420000 420000 420000 420000

100000 100000 100000 100000 100000 100000

130000 342500 555000 555000 555000 555000

350000 387500 425000 425000 425000 425000 SUM

14300 37675 152625 124875 102675 52725 484875

38500 42625 116875 95625 78625 40375 412625 897500

Total SC Profit

Dr. A. K. Dey

15

Retailer orders for 14000 swimsuits with revenue sharing arrangement

Wholesale Price Variable cost Fixed cost

Demand

Prob

Sales Price

Rev Share

Profit

Average Profit

125 8000 10000 12000 14000 16000 0.11 0.11 0.275 0.225 0.185 1000000 1250000 1500000 1750000 1750000

15% 150000 187500 225000 262500 262500

60 840000 840000 840000 840000 840000

35 490000 490000 490000 490000 490000

100000 100000 100000 100000 100000 100000

Retailer 10000 222500 435000 647500 647500

Manuf 400000 437500 475000 512500 512500

Retailer 1100 24475 119625 145688 119788

Manuf 44000 48125 130625 115313 94813

18000

0.095

1750000

262500

840000

490000

100000

647500

512500
SUM

61513
472188

48688
481563 953750

Best case. Profits for both increase. Retailer should negotiate for reduction in the wholesale price to $60 by committing to lift 14000 units.
Dr. A. K. Dey

Total SC Profit

16

Retailer orders for 16000 swimsuits with revenue sharing arrangement

Wholesale Price Variable cost Fixed cost

Demand

Prob

Sales Price

Rev Share

Profit

Average Profit

125

15%

60

35

100000

Retailer

Manuf

Retailer

Manuf

8000

0.11

1000000

150000

960000

560000

100000

-110000

450000

-12100

49500

10000

0.11

1250000

187500

960000

560000

100000

102500

487500

11275

53625

12000

0.275

1500000

225000

960000

560000

100000

315000

525000

86625

144375

14000

0.225

1750000

262500

960000

560000

100000

527500

562500

118688

126563

16000

0.185

2000000

300000

960000

560000

100000

740000

600000

136900

111000

18000

0.095

2000000

300000

960000

560000

100000

740000

600000 SUM

70300 411688

57000 542063 953750

Total SC Profit

Dr. A. K. Dey

17

Supply Contracts
Strategy Sequential Optimization Buyback Revenue Sharing Retailer Manufacturer 470,700 440,000 503,700 450,050 472,188 481,573 Quantity Sequential Optimization 12000 Buyback 16000 Revenue Sharing 14000 Total 910,700 953,750 953,761

Dr. A. K. Dey

18

Supply Contracts
Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$80 Selling Price=$125 Salvage Value=$20

Manufacturer

Manufacturer DC

Retail DC

Stores
Dr. A. K. Dey 19

Supply Chain Profit

1,200,000

Supply Chain Profit

1,000,000 800,000 600,000 400,000 200,000 0

60 00 70 00 80 00 90 00 10 00 0 11 00 0 12 00 0 13 00 0 14 00 0 15 00 0 16 00 0 17 00 0 18 00 0
Production Quantity
Dr. A. K. Dey 20

Supply Chain Profit

Global Optimization Strategy - Marginal Profit 90 (=125-35) vs Marginal loss 15 (=35-20) Make 16000
Demand Prob Sales Price Variable Cost Fixed cost Salvage Value Over all Profit Average Profit

125 8000 10000 0.11 0.11 1000000 1250000

35 560000 560000

100000 100000 100000

20 160000 120000 500000 710000 55000 78100

12000
14000 16000 18000

0.275
0.225 0.185 0.095

1500000
1750000 2000000 2000000

560000
560000 560000 560000

100000
100000 100000 100000

80000
40000 0 0

920000
1130000 1340000 1340000

253000
254250 247900 127300 1015550

Total Supply Chain Profit

Dr. A. K. Dey

21

Supply Contracts
Strategy Sequential Optimization Buyback Revenue Sharing Global Optimization Retailer Manufacturer 470,700 440,000 503,700 450,050 472,188 481,573 Total 910,700 953,750 953,761 1,015,550

Quantity Sequential Optimization 12000 Buyback 16000 Revenue Sharing 14000 Global Optimization 16000

Dr. A. K. Dey

22

Supply Contracts: Key Insights

Effective supply contracts allow supply chain partners to replace
sequential optimization by global optimization

Buy Back and Revenue Sharing contracts achieve this objective through
risk sharing

Dr. A. K. Dey

23

Supply Contracts: Case Study

Example: Demand for a movie newly released video cassette typically starts high and decreases rapidly
Peak demand last about 10 weeks

Blockbuster purchases a copy from a studio for $65 and rent for $3
Hence, retailer must rent the tape at least 22 times before earning profit

Retailers cannot justify purchasing enough to cover the peak demand

In 1998, 20% of surveyed customers reported that they could not rent the movie they wanted
Dr. A. K. Dey 24

Supply Contracts: Case Study

Starting in 1998 Blockbuster entered a revenue sharing agreement with the major studios
Studio charges $8 per copy Blockbuster pays 30-45% of its rental income

Even if Blockbuster keeps only half of the rental income, the breakeven point is 6 rental per copy The impact of revenue sharing on Blockbuster was dramatic
Rentals increased by 75% in test markets Market share increased from 25% to 31% (The 2nd largest retailer, Hollywood Entertainment Corp has 5% market share)
Dr. A. K. Dey 25

Other Contracts
Quantity Flexibility Contracts
Supplier provides full refund for returned items as long as the number of returns is no larger than a certain quantity

Sales Rebate Contracts

Supplier provides direct incentive for the retailer to increase sales by means of a rebate paid by the supplier for any item sold above a certain quantity
Dr. A. K. Dey 26

(s, S) Policies
For some starting inventory levels, it is better to not start production If we start, we always produce to the same level Thus, we use an (s,S) policy. If the inventory level is below s, we produce up to S. s is the reorder point, and S is the order-up-to level The difference between the two levels is driven by the fixed costs associated with ordering, transportation, or manufacturing
Dr. A. K. Dey 27

A Multi-Period Inventory Model

Often, there are multiple reorder opportunities Consider a central distribution facility which orders from a manufacturer and delivers to retailers. The distributor periodically places orders to replenish its inventory
Dr. A. K. Dey 28

Reminder:

The Normal Distribution

Standard Deviation = 5

Standard Deviation = 10

Average = 30
0 10 20 30
Dr. A. K. Dey

40

50

60
29

The DC holds inventory to:

Satisfy demand during lead time Protect against demand uncertainty Balance fixed costs and holding costs

Dr. A. K. Dey

30

The Multi-Period Continuous Review Inventory Model

Normally distributed random demand Fixed order cost plus a 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 distributor has a required service level. This is expressed as the likelihood that the distributor will not stock out during lead time. Intuitively, how will this effect our policy?
Dr. A. K. Dey 31

A View of (s, S) Policy

S
Inventory Position

Inventory Level

Lead Time

s 0 Time
Dr. A. K. Dey 32

The (s,S) Policy

(s, S) Policy: Whenever the inventory position drops below a certain level, s, we order to raise the inventory position to level S. The reorder point is a function of:
The Lead Time Average demand Demand variability Service level
Dr. A. K. Dey 33

Notation
AVG = average daily demand STD = standard deviation of daily demand LT = replenishment lead time in days h = holding cost of one unit for one day K = fixed cost SL = service level (for example, 95%). This implies that the probability of stocking out is (100%-SL) (for example, 5%) Also, the Inventory Position at any time is the actual inventory plus items already ordered, but not yet delivered.
Dr. A. K. Dey 34

Analysis
The reorder point (s) has two components:
To account for average demand during lead time: LTAVG To account for deviations from average (we call this safety stock) z STD LT where z is chosen from statistical tables to ensure that the probability of stockouts during leadtime is 100%-SL.

Since there is a fixed cost, we order more than up to the reorder point: Q=(2 K AVG)/h The total order-up-to level is: S=Q+s
Dr. A. K. Dey 35

TV Distributor
Trying to set inventory policies Fixed ordering cost of $4500 Cost of TV set $250 and annual inventory holding cost 18% of product cost Replenishment lead time is 2 weeks Average weekly demand is 44.58 and the standard deviation of monthly demand is 32.08 Desired CSL 97%
Dr. A. K. Dey 36

Example
The distributor has historically observed weekly demand of: AVG = 44.58 STD = 32.08 Replenishment lead time is 2 weeks, and desired service level SL = 97% Average demand during lead time is: 44.6 2 = 89.2 (or 90) Safety Stock is: 1.88 32.1 2 = 85.3 (or 86) Reorder point is thus 176, or about 3.9 weeks of supply at warehouse and in the pipeline
Dr. A. K. Dey 37

Example, Cont.
Weekly inventory holding cost: 0.87
Therefore, Q=679

Order-up-to level thus equals:

Reorder Point + Q = 176+679 = 855

Distributor should place order to raise the inventory position to 855 TV sets whenever the inventory level is below or at 176 Average inventory level is (679/2)+86= 426
Dr. A. K. Dey 38

Periodic Review
Suppose the distributor places orders every month What policy should the distributor use? What about the fixed cost?
Dr. A. K. Dey 39

Base-Stock Policy
r r L

L
Inventory Position

Inventory Level

Base-stock Level

0 Time
Dr. A. K. Dey 40

Periodic Review Policy

Each review echelon, inventory position is raised to the base-stock level. The base-stock level includes two components:
Average demand during r+L days (the time until the next order arrives): (r+L)*AVG Safety stock during that time: z*STD* r+L
Dr. A. K. Dey 41

TV Distributor .
Suppose the distributor places order every three weeks Average demand during five weeks is 223 Standard deviation is (1.88x32.1xSqRt 5) = 134.94 (or 135) Base stock level is (223+135) = 359 TVs Average inventory level 202
Dr. A. K. Dey 42

Risk Pooling
Consider these two systems:
Warehouse One
Supplier Warehouse Two Market Two Market One

Market One Supplier Warehouse Market Two

Dr. A. K. Dey 43

Risk Pooling
For the same service level, which system will require more inventory? Why? For the same total inventory level, which system will have better service? Why? What are the factors that affect these answers?

Dr. A. K. Dey

44

Risk Pooling Example

Compare the two systems:
two products maintain 97% service level $60 order cost $0.27 weekly holding cost $1.05 transportation cost per unit in decentralized system, $1.10 in centralized system 1 week lead time
Dr. A. K. Dey 45

Risk Pooling Example

Week Prod A, Market 1 Prod A, Market 2 Total A Prod B, Market 1 Product B, Market 2 Total B 1 33 46 79 0 2 2 2 45 35 80 2 4 6 3 37 41 78 3 0 3
Dr. A. K. Dey

4 38 40 78 0 0 0

5 55 26 81 0 3 3

6 30 48 78 1 1 2

7 18 18

8 58 55

36 113 3 0 3 0 0 0
46

Risk Pooling Example

Warehouse Product Market 1 Market 2 A A AVG 39.3 38.6 STD 13.2 12.0 CV .34 .31

Market 1

1.125

1.36

1.21

Market 2

1.25

1.58

1.26

Dr. A. K. Dey

47

Risk Pooling Example

Product Average Demand Std Dev Coeff Var Safety Stock Reorder Point EOQ Order upto level Average Inventory Round Up % Decline

Mkt 1 Mkt 1

A B A B A B

39.3 1.1

13.2 1.4

0.34 1.21

25.08 2.58

64.4 3.7

132.2 22.4

196.5 26.1

91.16 13.76

92 14

Mkt 2

38.6

12.0

0.31

22.80

61.4

131.0

192.4

88.29

89

Mkt 2

1.3

1.6

1.26

3.00

4.3

23.6

27.8

14.79

15

Total

77.9

20.7

0.27

39.35

117.2

186.1

303.3

132.38

133

36

Total

2.4

1.9

0.80

3.61

6.0

32.5

38.5

19.85

20

45

Dr. A. K. Dey

48

Risk Pooling: Important Observations

Centralizing inventory control reduces both safety stock and average inventory level for the same service level. This works best for
High coefficient of variation, which increases required safety stock. Negatively correlated demand. Why?

What other kinds of risk pooling will we see? Dr. A. K. Dey

49

Risk Pooling: Types of Risk Pooling*

Risk Pooling Across Markets Risk Pooling Across Products Risk Pooling Across Time Daily order up to quantity is:
LTAVG + z AVG LT

Orders

10

11
Dr. A. K. Dey

12

13

14

15
50

Demands

To Centralize or not to Centralize

What is the effect on:
Safety stock? Service level? Overhead? Lead time? Transportation Costs?

Dr. A. K. Dey

51

Centralized Systems*
Supplier

Warehouse

Retailers

Centralized Decision
Dr. A. K. Dey 52

Centralized Distribution Systems*

Question: How much inventory should management keep at each location? A good strategy: The retailer raises inventory to level Sr each period The supplier raises the sum of inventory in the retailer and supplier warehouses and in transit to Ss If there is not enough inventory in the warehouse to meet all demands from retailers, it is allocated so that the service level at each of the retailers will be equal.

Dr. A. K. Dey

53

Inventory Management: Best Practice

Periodic inventory reviews Tight management of usage rates, lead times and safety stock ABC approach Reduced safety stock levels Shift more inventory, or inventory ownership, to suppliers Quantitative approaches
Dr. A. K. Dey 54

Changes In Inventory Turnover

Inventory turnover ratio = annual sales/avg. inventory level Inventory turns increased by 30% from 1995 to 1998 Inventory turns increased by 27% from 1998 to 2000 Overall the increase is from 8.0 turns per year to over 13 per year over a five year period ending in year 2000.
Dr. A. K. Dey 55

Inventory Turnover Ratio

Industry
Dairy Products Electronic Component Electronic Computers Books: publishing Household audio & video equipment Household electrical appliances Industrial chemical

Upper Quartile 34.4 9.8 9.4 9.8 6.2 8.0 10.3

Median 19.3 5.7 5.3 2.4 3.4 5.0 6.6

Lower Quartile 9.2 3.7 3.5 1.3 2.3 3.8 4.4

56

Dr. A. K. Dey

Factors that Drive Reduction in Inventory

Top management emphasis on inventory reduction Reduce the Number of SKUs in the warehouse Improved forecasting Use of sophisticated inventory management software Coordination among supply chain members Others

Dr. A. K. Dey

57

Factors that Drive Inventory Turns Increase

Better software for inventory management Reduced lead time Improved forecasting Application of SCM principals More attention to inventory management Reduction in SKU Others
Dr. A. K. Dey 58

Forecasting
Recall the three rules Nevertheless, forecast is critical General Overview:
Judgment methods Market research methods Time Series methods Causal methods
Dr. A. K. Dey 59

Judgment Methods
Assemble the opinion of experts Sales-force composite combines salespeoples estimates Panels of experts internal, external, both Delphi method
Each member surveyed Opinions are compiled Each member is given the opportunity to change his opinion
Dr. A. K. Dey 60

Market Research Methods

Particularly valuable for developing forecasts of newly introduced products Market testing
Focus groups assembled. Responses tested. Extrapolations to rest of market made.

Market surveys
Data gathered from potential customers Interviews, phone-surveys, written surveys, etc.
Dr. A. K. Dey 61

Time Series Methods

Past data is used to estimate future data Examples include
Moving averages average of some previous demand points. Exponential Smoothing more recent points receive more weight Methods for data with trends:
Regression analysis fits line to data Holts method combines exponential smoothing concepts with the ability to follow a trend

Methods for data with seasonality

Seasonal decomposition methods (seasonal patterns removed) Winters method: advanced approach based on exponential smoothing

Complex methods (not clear that these work better)

Dr. A. K. Dey 62

Causal Methods
Forecasts are generated based on data other than the data being predicted Examples include:
Inflation rates GNP Unemployment rates Weather Sales of other products
Dr. A. K. Dey 63

Selecting the Appropriate Approach:

What is the purpose of the forecast?
Gross or detailed estimates?

What are the dynamics of the system being forecast?

Is it sensitive to economic data? Is it seasonal? Trending?

How important is the past in estimating the future? Different approaches may be appropriate for different stages of the product lifecycle:
Testing and intro: market research methods, judgment methods Rapid growth: time series methods Mature: time series, causal methods (particularly for long-range planning)

It is typically effective to combine approaches.

Dr. A. K. Dey 64