Supply Chain Management

Lecture 21
Outline
Today
Finish Chapter 11
Sections 1, 2, 3, 7, 8
Skipping 11.2 Evaluating Safety Inventory Given Desired Fill rate
Start with Chapter 12
Sections 1, 2, 3
Section 2 up to and including Example 12.2
Friday
Homework 5 online
Due Thursday April 8 before class
Next week
Finish Chapter 12
Start with Chapter 14
Managing Inventory in Practice
Indias retail market
Retail market (not inventory) projected to reach
almost $308 billion by 2010
Due to its infrastructure (many mom-and-pop stores
and often poor distribution networks) lead times are
long
ss = F
s
-1
(CSL)o
L

Managing Inventory in Practice
Department of Defense
DOD reported (1995) that it had a secondary
inventory (spare and repair parts, clothing, medical
supplies, and other items) to support its operating
forces valued at $69.6 billion
About half of the inventory includes items that are not
needed to be on hand to support DOD war reserve or
current operating requirements
Safety Inventory
A new technology allows books to be printed in ten
minutes. Borders has decided to purchase these
machines for each store. They must decide which
books to carry in stock and which books to print on
demand using this technology. Would you
recommend Borders to use the new technology for
best-sellers or for other books?
Measuring Product Availability
1. Cycle service level (CSL)
Fraction of replenishment cycles that end with all customer
demand met
Probability of not having a stockout in a replenishment cycle
2. Product fill rate (fr)
Fraction of demand that is satisfied from product in inventory
Probability that product demand is supplied from available
inventory
3. Order fill rate
Fraction of orders that are filled from available inventory
Product Fill Rate
ESC = 10
inventory
inventory
time
time
0
0
Q = 1000
Q = 1000
fr = 1 10/1000 = 1 0.01 = 0.99
fr = 1 970/1000 = 1 0.97 = 0.03
ESC = 970
Expected Shortage per
Replenishment Cycle
Expected shortage during the lead time


If demand is normally distributed


L
ROP x
D f(x) dx x f ROP x ESC of pdf is where ) ( ) (

=
=
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|

\
|
+

|
|
.
|

\
|
=
L
s L
L
s
ss
f
ss
F ss ESC
o
o
o
1
Does ESC decrease or increase with ss?
Product Fill Rate
fr: is the proportion of customer
demand satisfied from stock.
Probability that product
demand
is supplied from inventory.
ESC: is the expected shortage
per replenishment cycle (is
the demand not satisfied from
inventory in stock per
replenishment cycle)
ss: is the safety inventory
Q: is the order quantity
|
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|

\
|
+
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|
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|

\
|
=
=
o
o
o
L
S
L
L
S
ss
f
ss
F
ss ESC
Q
ESC
fr
} 1 {
1
Example 11-3: Evaluating fill rate
given a replenishment policy
Recall that weekly demand for Palms at B&M is
normally distributed, with a mean of 2,500 and a
standard deviation of 500. The replenishment
lead time is two weeks. Assume that the
demand is independent from one week to the
next. Evaluate the fill rate resulting from the
policy of ordering 10,000 Palms when there are
6,000 Palms in inventory.
Example 11-3: Evaluating fill rate
given a replenishment policy
Lot size Q =
Average demand during
lead time
D
L
=
Standard dev. of demand
during lead time
o
L
=
Expected shortage per
replenishment cycle


ESC =
Product fill rate

fr =
10,000
LD = 2*2,500 = 5,000
SQRT(L)o
D
=
SQRT(2)*500 = 707
-ss(1-F
s
(ss/oL))+o
L
f
s
(ss/oL) =
-1000*(1-F
s
(1,000/707) +
707f
s
(1,000/707) =
25.13
1 ESC/Q =
1 25.13/10,000 = 0.9975
Cycle Service Level versus Fill
Rate
What happens to CSL and fr when the safety
inventory (ss) increases?
What happens to CSL and fr when the lot
size (Q) increases?
Lead Time Uncertainty
Why do some firms have zero tolerance for
early/late deliveries?
Example 11-6: Impact of lead time
uncertainty on safety inventory
Inventory
Time
0
Reorder point
Lead time
Demand during lead time
o
L
= SQRT(Lo
2
D
+ D
2
s
2
L
)
Example 11-6: Impact of lead time
uncertainty on safety inventory
Daily demand at Dell is normally distributed, with
a mean of 2,500 and a standard deviation of
500. A key component in PC assembly is the
hard drive. The hard drive supplier takes an
average of L = 7 days to replenish inventory at
Dell. Dell is targeting a CSL of 90 percent for its
hard drive inventory. Evaluate the safety
inventory of hard drives that Dell must carry if
the standard deviation of the lead time is 7 days.
Example 11-6: Impact of lead time
uncertainty on safety inventory
Demand D =
Standard dev. of demand o
D
=
Lead time L =
Demand during lead time D
L
=
Standard dev. of lead time s
L
=
Standard dev. of demand
during lead time

o
L
=
Safety inventory

ss =
2,500
500
LD = 5,000
SQRT(Lo
D
2
+ D
2
s
L
2
) =
SQRT(7*500
2
+ 2500
2
*7
2
) =
17,550
F
s
-1
(CSL)o
L
=
F
s
-1
(0.90)*17,550 = 22,491
7
7
Summary
2 2 2
L D L
s D L + = o o
o
L
: Standard deviation of
demand during lead time
s
L
: Standard deviation of
lead time
D L
Lo o =
When lead time is uncertain
When lead time is constant
Summary
L: Lead time for
replenishment
D: Average demand per unit
time
o
D:
Standard deviation of
demand per period
D
L
:

Average demand during
lead time
o
L
: Standard deviation of
demand during lead time
CSL: Cycle service level
ss: Safety inventory
ROP: Reorder point
) , , (
) , , (
1
o
o
o o
L L
L L
L
D L
L
D
D
D
D
CSL F ROP
ROP F CSL
ss ROP
L
LD

=
=
+ =
=
=
Average Inventory = Q/2 + ss
Summary
fr is the product fill rate (fraction
of demand satisfied from
inventory)
ESC is the expected shortage
per replenishment cycle (the
demand not satisfied from
inventory per replenishment
cycle)
ss is the safety inventory
Q is the order quantity
|
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|

\
|
+
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|
.
|

\
|
=
=
o
o
o
L
S
L
L
S
ss
f
ss
F
ss ESC
Q
ESC
fr
} 1 {
1
Example Question
Weekly demand for canned fruit at a grocery
store is normally distributed, with a mean of 250
and a standard deviation of 50. The lead time is
two weeks. Assuming a continuous review
replenishment policy, how much safety inventory
should the store carry to achieve a CSL of 90
percent?
1.28
314.08
340.62
564.08
590.62
None of the formulas can be
used to calculate the safety
inventory
Example Question
You may use the table below to calculate the
safety inventory
F
-1
(0.9, 250, 50)
F
-1
(0.9, 250, 70.71)
F
-1
(0.9, 500, 50)
F
-1
(0.9, 500, 70.71)
F
s
-1
(0.9)
Safety Inventory
Why is Amazon.com able to provide a large variety of
books and music with less safety inventory than a
bookstore chain selling through retail stores?
Borders versus Amazon
~500 Borders stores versus ~20 Amazon warehouses
Demand D 100
Stddev of demand o D 40
Lead time L 1
Demand during lead time D_L 100
Stddev of demand during lead time o _L 40
Cycle service level CSL 0.95
Safety inventory ss
Total safety inventory for 25 stores 25*ss
Demand D 2500
Stddev of demand o D 200
Lead time L 1
Demand during lead time D_L 2500
Stddev of demand during lead time o _L 200
Cycle service level CSL 0.95
Safety inventory ss
Safety inventory for 1 warehouse 1*ss
ss = F
s
-1
(CSL)o
L
Demand D 100
Stddev of demand o D 40
Lead time L 1
Demand during lead time D_L 100
Stddev of demand during lead time o _L 40
Cycle service level CSL 0.95
Safety inventory ss 65.79
Total safety inventory for 25 stores 25*ss 1644.9
Demand D 2500
Stddev of demand o D 200
Lead time L 1
Demand during lead time D_L 2500
Stddev of demand during lead time o _L 200
Cycle service level CSL 0.95
Safety inventory ss 328.97
Safety inventory for 1 warehouse 1*ss 328.97
Amazon versus Borders
Company-wide, Borders has knocked eight days off
of its days inventory outstanding through
improvements in its supply chain. Nevertheless,
inventory stuck around 176 days in 1999, turning just
over twice a year. That's not very often. Barnes &
Noble turned its inventory 2.5 times last year, and
Amazon managed nine turns. If Borders could turn its
inventory as often as Barnes & Noble, it would free up
an additional $400 million for use during the year.
Soure: Brian Lund (TMF Tardior), May 19, 2000
Safety Inventory
In the 1980s, paint was sold by color and size in paint
retail stores. Today paint is mixed at the paint store
according to the color desired. What impact did this
change had on safety inventories in the supply chain?
Importance of the Level of Product
Availability
Product availability (also known as customer
service level) is measured by
CSL (Cycle service level)
fr (Product fill rate)
Product availability affects supply chain
responsiveness and costs
High levels of product availability increased
responsiveness and higher revenues
High levels of product availability increased
inventory levels and higher costs
The Newsboy/Newsvendor
Problem
The Newsboy/Newsvendor
Problem
One time decision under uncertainty
Demand is uncertain
Plan inventory for a single cycle
Trade-off
Ordering too much
(waste, salvage value < cost)
Ordering too little
(excess demand is lost)
Examples
Restaurants
Fashion
High tech
The Christmas Tree Problem
Sell price p = 100
Cost c = 20
Ordering Too Much
Cost c = 20
Salvage value s = 5
Cost of overstocking
C
o
= c - s
Versus Ordering Too Little
Sell price p = 100
Cost c = 20
Cost of understocking
C
u
= p - c
Factors Affecting the Optimal Level
of Product Availability
Cost of overstocking (C
o
= c s)

The loss incurred by a firm for each unsold unit at the
end of the selling season
Cost of understocking (C
u
= p c)

The margin lost by a firm for each lost sale because
there is no inventory on hand
Includes the margin lost from current as well as future sales if
the customer does not return

Product Availability
Cost of overstocking
Liz Claiborne experiences unexpected earnings
decline as a consequence of higher-than-expected
excess inventories
The Wall Street Journal, July 19, 1993
On Tuesday, the network-equipment giant Cisco
provided the grisly details behind its astonishing
$2.25 billion inventory write-off in the third quarter
News.com, May 9, 2001
Cost of understocking
IBM struggles with shortages in ThinkPad line due to
ineffective inventory management
The Wall Street Journal, August 24, 1994
Example: Parkas at L.L. Bean
Expected demand = D
i
p
i
= 1,026 parkas
Demand Prob
D_i p_i
400 0.01
500 0.02
600 0.04
700 0.08
800 0.09
900 0.11
1000 0.16
1100 0.2
1200 0.11
1300 0.1
1400 0.04
1500 0.02
1600 0.01
1700 0.01
Cost c = $45
Price p = $100
Salvage value s = $5
What is the expected profit?
Example: Parkas at L.L. Bean
Expected profit = profit
i
p
i
= $49,900
Demand Prob
D_i p_i
400 0.01
500 0.02
600 0.04
700 0.08
800 0.09
900 0.11
1000 0.16
1100 0.2
1200 0.11
1300 0.1
1400 0.04
1500 0.02
1600 0.01
1700 0.01
Sold Unsold Profit
units units
400 600 19000
500 500 25000
600 400 31000
700 300 37000
800 200 43000
900 100 49000
1000 0 55000
1000 0 55000
1000 0 55000
1000 0 55000
1000 0 55000
1000 0 55000
1000 0 55000
1000 0 55000
Cost c = $45
Price p = $100
Salvage value s = $5
Example: Parkas at L.L. Bean
Demand Prob
D_i p_i
400 0.01
500 0.02
600 0.04
700 0.08
800 0.09
900 0.11
1000 0.16
1100 0.2
1200 0.11
1300 0.1
1400 0.04
1500 0.02
1600 0.01
1700 0.01
CSL (1-CSL)
0.01 0.99
0.03 0.97
0.07 0.93
0.15 0.85
0.24 0.76
0.35 0.65
0.51 0.49
0.71 0.29
0.82 0.18
0.92 0.08
0.96 0.04
0.98 0.02
0.99 0.01
1 0
Expected Expected Expected
Marg. benefit Marg. cost Marg. profit
1100 5500 x 0.49 = 2695 500 x 0.51 = 255 2440
Expected Expected Expected
Marg. benefit Marg. cost Marg. profit
1100 5500 x 0.49 = 2695 500 x 0.51 = 255 2440
1200 5500 x 0.29 = 1595 500 x 0.71 = 355 1240
Expected Expected Expected
Marg. benefit Marg. cost Marg. profit
1100 5500 x 0.49 = 2695 500 x 0.51 = 255 2440
1200 5500 x 0.29 = 1595 500 x 0.71 = 355 1240
1300 5500 x 0.18 = 990 500 x 0.82 = 410 580
1400 5500 x 0.08 = 440 500 x 0.92 = 460 -20
1500 5500 x 0.04 = 220 500 x 0.96 = 480 -260
1600 5500 x 0.02 = 110 500 x 0.98 = 490 -380
1700 5500 x 0.01 = 55 500 x 0.99 = 495 -440
What is the optimal order quantity?
(1 CSL)(p c) CSL(c s)
Optimal Level of Product
Availability
Expected marginal contribution of raising the
order size from O* to O*+1
(1 CSL*)(p c) CSL*(c s)

CSL* = Prob(Demand s O*) = =
p c
p s
O* = F
-1
(CSL*, u, o) = NORMINV(CSL*, u, o)
C
u
C
u
+ C
o

Example 12-1: Evaluating the optimal
service level for seasonal items
The manager at Sportmart, a sporting goods store, has
to decide on the number of skis to purchase for the
winter season. Based on past demand data and weather
forecasts for the year, management has forecast
demand to be normally distributed, with a mean 350 and
a standard deviation of 100. Each pair of skis costs $100
and retails for $250. Any unsold skis at the end of the
season are disposed of for $85. Assume that it costs $5
to hold a pair of skis in inventory for the season. How
many skis should the manager order to maximize
expected profits?
Example 12-1: Evaluating the optimal
service level for seasonal items
Average demand (mean)
u =
Standard deviation of
demand (stdev)
o =
Material cost
c =
Price
p =
Salvage value
s =
Cost of understocking
C
u
=

Cost of overstocking
C
o
=

Optimal cycle service level

CSL* =
Optimal order size

O* =
350
100
$100
$250
85 5 = $80
p c = 250 100 = $150
c s = 100 80 = $20
C
u
/(C
u
+ C
o
) = 150/170 =
0.88
NORMINV(CSL*, u, o) =
468