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Inventory Management and

Risk Pooling



Converts raw materials

Into finished products



Finished products
distributed to customers

Forms of Inventory:
Raw material inventory
Work-in-process inventory
Finished product inventory


Reasons for keeping inventory

1.To protect firm from unexpected changes in
customer demand; uncertainty in customer
demand is due to:
Short life cycle of an increasing number of products
Presence of many competing brands in the
marketplace; makes it difficult to predict demand for a
specific model

2. To protect against uncertainty in the quantity

and quality of the supply, supplier costs and
delivery times.

Reasons for keeping inventory

3. Economies of scale offered by transportation
companies which encourage firms to transport
large quantities of items and therefore hold large
Managing inventory effectively is difficult ; pg 42.
Basically there are two important issues in
inventory management:
Demand forecasting
Order quantity calculation

Single warehouse example

Factors affecting inventory policy include:
Customer demand
Replenishment lead time
Number of different products stored at the warehouse
Length of planning horizon

Order cost


Inventory holding cost



Cost of product
Transportation cost
Taxes and insurance on inventories
Maintenance costs
Obsolescence costs
Opportunity costs

Service level requirement

100% is maximum level

Economic Lot size model

Introduced in 1915
Model assumptions:
Single item
Demand is constant at a rate of D items per day
Order quantities are fixed at Q items per order; that is, each time the
warehouse places an order, it is for Q items
A fixed setup cost K is incurred everytime the warehouse places an
An inventory carrying cost, h, also referred to as holding cost is
accrued for every unit held in inventory per day
Lead time is zero
Initial inventory is zero
Planning horizon is infinite

For every cycle

Q units are used up at rate D.
=> T=Q/D

Inventori, I(t)

Gradient = demand


Cycle time

Economic Lot size model

Total inventory cost in a cycle of length T:
K + hTQ
Since fixed cost is charged per order, and
holding cost is for every unit held in
inventory per day ( altogether there are
T Q inventories in one cycle)
Dividing by T and by using Q=TD
Total cost per unit time:
G(Q)= KD hQ

Economic Lot size model

Can be shown that the optimal order
quantity that will minimize the cost function
Popularly known as economic order quantity
or EOQ

Sensitivity Analysis
How sensitive is the cost function to errors in
calculating Q (or if we deliberately order
something different that Q*)?
Let G* be the optimal cost:
G*= KD/Q* + hQ*/2
h 2 KD

2 KD / h


Sensitivity Analysis
Can be shown that
G(Q)/G* = (KD/Q + hQ/2)

= [ Q*/Q + Q/Q*]
By substituting values, can be shown that G(Q) is
relatively insensitive to errors in Q.
For instance, 100% error in Q results only 25%
error in G(Q) (Table 3.1)

Optimal policy balances between inventory
cost per unit time and setup cost per unit
time (Figure 3.2); if we equate hQ/2 and
KD/Q, we will get the EOQ formula.
Total inventory cost is insensitive to order

Demand uncertainty
Case: Swimsuit example:
Importance of incorporating demand
uncertainty and forecast demand
Importance of characterizing the impact of
demand uncertainty on the inventory policy

Case example
Motivates a powerful inventory policy used
in practice to manage inventory:
Whenever the inventory is below a certain
value, say s, we order or produce to increase
the level to S.
Also known as the (s,S) policy or a min max
s is the reorder point and S is the order-up-to
In the swimsuit example reorder point is 8500
units and the order-up to level is 12,000 units

Multiple order
So far we only consider only a single
ordering decision for entire planning
For some products it might be true because of
short selling season and there is no
opportunity to reorder products

Usually a decision maker may order

products repeatedly during a planning

Multiple order

Consider a case where a distributor of TV sets

(pg 51).
Here distributor faces random demand for the product
Manufacturer cannot instantly satisfy orders
There is a fixed lead time

Distributor has to keep inventory because:

To satisfy demand that occurs during lead time
To protect against uncertainty in demand
To balance annual inventory holding costs and annual
fixed order costs
More frequent orders lead to lower inventory levels and
hence lower holding costs but higher fixed costs

Distributor has to decide on an inventory policy

i.e when and how much to order

No fixed order costs

Daily demand is random and follows a normal
No fixed order cost; every time the distributor orders,
it pays an amount proportional to the quantity ordered
Inventory holding cost is charged per item per unit
If customer order arrives when there is no inventory
on hand, the order is lost
Distributor specifies a required service level; the
probability of not stocking out

No fixed order costs

Information needed:
AVG= average daily demand faced by
STD= standard deviation of daily demand faced
by distributor
L = replenishment lead time from supplier to
distributor in days
h = cost of holding one unit of inventory per day
at distributor
= service level

No fixed order costs

Inventory position at any point in time is the
actual inventory at the warehouse plus items
ordered by the distributor that has not yet arrived
Distributor can use (s,S) policy where s=S.
When distributor inventory drops below S it will
order a quantity that will bring the inventory
position up to S.
What is value of S?
It consists of 2 components:
Average inventory during lead time; to make sure
there is enough inventory until next order arrives
Safety stock; inventory the distributor needs to keep
to safeguard against variations in demand

No fixed order costs

S = (L AVG) + (z STD L)
Constant z is chosen from statistical tables, to
ensure that the probability of stockouts during
lead time is exactly 1-
(table 3.2)
That the order-up-to level, S must satisfy,
P (demand during lead time S) = 1-
Read up on ex: 3.2.1

Fixed order costs

Assume a fixed order cost of K for every item
order placed
In this case (s,S) inventory policy is used.
s = (L AVG) + (z STD L)
(the same as no fixed order cost)
S = max {Q, L AVG} + z STD L
Where Q =
From the economic lot size model

ACME Problem
Current distribution system uses different
warehouses to serve separate markets
We have warehouses in Newton,
Massachusetts and Parasmus, New Jersey
The ACME example considers locating only
one warehouse (somewhere between
Parasmus and Newton) to replace the existing
two, which is named central in the example
Conducts a detailed inventory analysis based on
two products and discover that a significant
reduction of average inventory can be achieved
for both products

Risk pooling
Important concept in scm
Replace existing warehouses with fewer strategically placed
ACME example considers replacing two warehouses with one
Use the concept of coefficient of variation
Coeff of var = std dev/ avg demand
Measures variability wrt average demand as opposed to standard deviation
which measures absolute variabilty of customer demand

Suggests that demand variability is reduced if we

aggregate demand across locations
Because high demand from one customer will be offset by low
demand from another
Allows reduction in safety stock and therefore reduce inventory

Risk Pooling
Essentially it is a centralized distribution system
Critical points:
1. Centralizing inventory reduces safety stock
and average inventory in the system.
---reallocation not possible in a decentralized
distribution system where different warehouses serve
different markets
2. The higher the coefficient of variation, the greater the
benefit obtained from centralized systems
3. The benefits from risk pooling depend on the
behavior of demand from one market relative to
demand from another.
Benefit decreases as correlation between demand
from two markets become more positive

Centralized vs decentralized
Safety stock
Safety stock decreases for centralized

Service level
Centralize is higher when both centralize and decentralize have same
safety stock

Overhead costs
Costs are greater in a decentralized system because fewer economies
of scale

Customer lead time

Decentralize is shorter

Transportation costs
If we increase number of warehouses, outbound transportation costs
decreases because warehouse are closer to markets
Inbound transportation cost increases
Net impact is not totally clear
Depends on situation

Managing inventory in the supply

Models described concerns a single facility
managing its inventory in order to minimize its
own cost as much as possible.
In a supply chain the objective is reduce
systemwide cost
=> We have to consider the interaction of the
various facilities and the impact of this
interaction on the inventory policy employed by
each facility

Managing inventory in the supply

Consider a retail distribution system with a
single warehouse serving a number of
retailers. Two assumptions:
Inventory decisions are made by a single
decision maker whose objective is to minimize
systemwide cost
Decision maker has access to inventory
information at each of retailers and at the

Managing inventory in the supply


Echelon inventory concept

Echelon is defined as the stage or level in a supply
Echelon inventory is defined as the on hand
inventory at any echelon plus all the
downstream inventory.
Eg: Echelon inventory at warehouse= inv at
warehouse + inv in transit to and in stock at
Echelon inventory position at warehouse =
echelon inventory at warehouse + items ordered
by warehouse that has not yet arrived

Managing inventory in the supply

=>the following effective approach in managing the single warehouse multiretailer system:
Individual retailers are managed as described before (see model (s,S)
etc); i.e when inventory position at retailer falls below s, it will send an
order to warehouse to raise its inventory position to S.
Warehouse ordering decision is based echelon inventory position at
warehouse; also (s,S); this means that when echelon inventory position
falls below s, it will order from its supplier so as to raise echelon inventory
position to S.
s = (Le AVG) + (z STD Le)
Where Le= echelon lead time, defined as lead time between the retailers and
the warehouse plus leadtime between warehouse and its supplier
AVG= average demand across all retailers
STD= standard deviation of demand across all retailers
This technique can be extended to more complex supply chains

Inventory reduction strategies

Referring to a survey in 1998; identified 5 top strategies
Periodic inventory review policy
Inventory is reviewed at a fixed time interval and
every time it is reviewed, a decision is made on order
Possible to identify slow moving and obsolete
products and allows for reduction of inventory
Tight management of usage rates, lead times and safety
Allows firm to make sure inventory is kept at the
appropriate level
Can identify situations where usage rates decrease
for a few months which implies an increase in
inventory levels over the same period

Inventory reduction strategies

ABC approach
Here items are classified into 3 categories
Class A-all high value products, accounts for about
80% of annual sales
Class B- accounts for 15% of annual sales
Class C- low value items, no more than 5% of
Reduce safety stock levels
Can be achieved by focusing on lead time reduction
Quantitative approaches
Similar to the models described earlier