Inventory Management

&
Risk Pooling

Introduction
General Motors in 1984:

Logistic network consisted of 20,000 supplier plants, 133

parts plants, 31 assembly plants, and 11,000 dealers.

Freight transportation costs were about $4.1 billion, of

which 60 percent for material shipments.

GM inventory was valued at $7.4 billion, of which 70

percent was WIP and the rest was finished vehicles.

Response:Inventory Management in Supply Chain

Goals of Inventory Management

Reduce Cost, Improve Service
By effectively managing inventory:
GM has reduced parts inventory and transportation costs
Financial
Inventory Levels
by 26% annually
Investment
Xerox eliminated $700 million inventory from its supply
chain
Wal-Mart became the largest retail company utilizing
efficient inventory management

Operational
Need

Inventory

Where do we hold inventory?

Suppliers and manufacturers

warehouses and distribution centers

retailers

Types of Inventory: General classification

WIP

raw materials

finished goods

Functions of Inventory
To meet

anticipated demand

To smooth

production requirements

To decouple
To protect

operations

against stock-outs

To take

advantage of order cycles

To help

hedge against price increases

To take

advantage of quantity discounts

Factors Affecting Inventory Policy

Demand Characteristics: known in advance or random

Lead Time

Number of Different Products Stored in the Warehouse

Economies of scale offered by suppliers & transport

companies

Length of Planning Horizon

Service level desired

Economic Order Quantity Model

350
300

Economic Order Quantity

os
C
l
Tota

ts

250
C
or

200

ng
i
y
rr

sts
o
C

Trade-offs between setup costs and iinventory

holding costs,
g
n
ld
o
150
but ignores
issues such as demand
H uncertainty and forecasting.
100
Ordering (Acquisition)Costs

50
0
1000

2000

3000

4000

5000

Assuming demand certainty

6000

Single Period Model

Without Initial Inventory

Case: Swimsuit Production

A company designs, produces, and sells summer fashion
items such as swinsuits.
The company has to commit itself six months before summer
to specific production quantities for all its products
predicting demand for each product.
The trade-offs are clear: overestimating customer demand
will result in unsold inventory while underestimating
customer demand will lead to inventory stockouts and
loss of potential customers.

Demand forecast
The marketing department uses historical data from the last
five years, current economic conditions, and other factors to
construct a probabilistic forecast of the demand.

forecast averages about 13,000

Swimsuit 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

Swimsuit Two 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

Scenario

Two:

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

Swimsuit Best Questions ?

Find

order quantity that maximizes

weighted average profit?

Will

this quantity be less than, equal to, or

greater than average demand?

How much to Make?

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

Swimsuit Expected Profit

Swimsuit : Important Observations

Tradeoff between

ordering enough to meet demand

and ordering too much
Several quantities have the same average profit
Average profit does not tell the whole story
9000 and 16000 units lead to about the same average
profit, so which do we prefer?

Swimsuit Expected Profit

Case: Swimsuit Production

But

Need to understand risk associated with certain

decisions.
A frequency

histogram provides information about

potential profit for the two given production

quantities, 9,000 units and 16,000 units. The
possible risk and possible reward increases as we
increase the production size.

Probability of Outcomes

Key Points from this Case

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

Single Period Model With

Initial Inventory

Initial Inventory
Suppose

that one of the jacket designs is a

model produced last year.
Some inventory is left from last year
Assume the same demand pattern as before
If only old inventory is sold, no setup cost
Question:

If there are 7000 units remaining,

what should the company do? What should
they do if there are 10,000 remaining?

Initial Inventory and Profit

The case motivates a powerful (s,S) inventory policy (or a min max
policy): s is the reorder point and S is the order-up-to-level

Multi-Order Opportunities
under Uncertainties

Inventory Policies
Continuous

review policy

in which inventory is reviewed every day and a decision

is made about whether and how much to order.

Periodic review policy

in which the inventory level is reviewed at regular

intervals and an appropriate quantity is ordered after
each review.

Variable Demand with a Fixed ROP

Inventory level

Reorder
point, R

LT

LT
Time

Result of
uncertainty

Inventory level

Reorder Point with a Safety Stock

Q
Reorder
point, R

Safety Stock

LT

LT
Time

The amount of safety stock needed is based on the degree of

uncertainty in the lead time demand and desired customer service level

Determinants of the Reorder Point

The rate of demand

The lead time

Demand and/or lead time variability

Stockout risk (safety stock)

Continuous Review Policy

AVG

= Average daily demand faced

STD = Standard deviation of daily demand faced
L = Replenishment lead time
h = Cost of holding one unit of the product per unit time
= service level (the probability of stocking out is 1 )
p =shortage cost

ph

Continuous Review Policy

The inventory position at any point in time is the actual

inventory at the warehouse plus items ordered by the
distributor that have not yet arrived minus items that are
backordered.
The reorder level, R consists of two components: the
average inventory during lead time, which is the product of
average daily demand and the lead time; and the safety
stock, which is the amount of inventory that the distributor
needs to keep at the warehouse and in the pipeline to protect
against deviations from average demand during lead time.

Continuous Review Policy

Variable demand & fixed lead time

Average demand during lead time is exactly L AVG

Safety stock is

z STD

where z is a constant, referred to as the safety factor.

This constant is associated with the service level.

The reorder level is

L AVG z STD L

Economic lot size is

2 K AVG
Q
h

Continuous Review Policy

Variable demand & fixed lead time
The expected level of inventory before receiving the order
is

z STD

(lowest level i.e. Safety Stock)

The expected level of inventory immediately after receiving

the order is

Q z STD L

(highest level)

The average inventory level is the average of these two

values

Q
z STD
2

Continuous Review Policy

Variable demand & lead time

In many situation, the lead time to the warehouse must be

assumed to be normally distributed with average lead time
denoted by AVGL and standard deviation denoted by STDL.
In this case, the reorder point is calculated as
where AVG x AVGL represents average demand during lead
time, &
2
2
2
AVGL STD AVG STDL

is the standard deviation of demand during lead time. The

amount of safety stock that has to be kept is equal to

z AVGL STD 2 AVG 2 STDL2

Periodic Review Policy

Inventory level is reviewed periodically at regular

intervals and an appropriate quantity so as to arrive at
base stock level is ordered after each review .

Since inventory levels are reviewed at a periodic interval, the fixed

cost of placing an order is a sunk cost and hence can be ignored.

This level of the inventory position should be enough to

protect the warehouse against shortages until the next order
arrives, that is to cover demand during a period of r + L
days, with r being the length of review period and L being
the lead time.

Periodic Review Policy

Thus, the base-stock level should include two

components: average demand during an interval of r + L
days, which is equal to ( r L ) AVG

and the safety stock, which is calculated as

where z is a safety factor.
z STD

rL

Periodic Review Policy

Maximum inventory level is achieved immediately after
receiving an order, while the minimum level of inventory
is achieved just before receiving an order.
It is easy to see that the expected level of inventory after
receiving an order is

r AVG z STD r L

while the expected level of inventory before an order

arrives is just the safety stock

z STD r L

Hence, the average inventory level is the average of these

two values
r AVG

z STD r L

RISK POOLING

Risk Pooling

Consider these two systems:

Warehouse One

Market One

Warehouse Two

Market Two

Supplier

Market One
Supplier

Warehouse
Market Two

Questions:
Q1: For the same service level, which system will require more inventory?
Q2: For the same total inventory level, which system will have better service?

What is Risk Pooling?

The idea behind risk pooling is to redesign the supply chain,
the production process, or the product to either reduce the
uncertainty the firm faces or to hedge uncertainty so that
the firm is in a better position to mitigate the consequence
of uncertainty.
Location pooling
Product pooling
Lead Time pooling
Capacity pooling

Supplier

Lead Time Pooling

8-week lead time

Lead Time Pooling

Supplier

8-week lead time

Retail DC

1-week lead time

Capacity Pooling

3 Links no flexibility

Capacity Pooling

9 Links Total Flexibility

Advantages / Disadvantages
Location Pooling

Advantages

Disadvantages

reduce demand variability

creates distance between inventory and

customers

reduce expected inventory

investment needed to achieve a
target service level

Product Pooling

reduction in demand variability

potentially degrades product functionality

better performance in terms of

matching supply and demand

Lead Time Pooling

decrease lead time

extra costs of operating distribution center

keep inventory closer to customer

additional transportation costs

reduce inventory investment

Capacity Pooling

accommodate demand uncertainty

large costs to have flexibility

Summary Risk Pooling

Risk-pooling strategies are most effective when demands

are negatively correlated because then the uncertainty
with total demand is much less than the uncertainty
with any individual item/location

Risk-pooling strategies do not help reduce pipeline

inventory

Risk-pooling strategies can be used to reduce inventory

while maintaining the same service or they can be used
to increase service while holding the same inventory

Example
Q/2+SS
AVG STD

SS

Orderup-to Level

Average
Inventory

Warehouse 1 39.3

13.2

25.08

65

132

197

91

Warehouse 2 38.6

12.0

22.8

62

131

193

88

Centralized
Warehouse

20.7

39.35 118

186

304

132

77.9

Safety Stock SS = z STD L

Reorder Point R = AVGL + SS
Decentralized system:
Order Quantity Q = sqrt(2*C0*AVG/h)
total SS = 47.88
Order-up-to-level R + Q
total avg. invent. = 179
Average Inventory SS + Q/2

Lead Time= 1 week

Service Level:97%

k=1.88

Risk Pooling Effect of Correlation

The

benefits of risk pooling depend on the

behavior of demand from one market relative
to the demand from another market.

Calculating demand variability

: correlation coefficient of D , D
D : (system
, )
of centralized
2, ,
== ++ ++2
1

Warehouse 1
Warehouse 2

Market 1
Market 2

Market 1
Warehouse
Market 2

D2: (2, )
2
2

Conclusions:
Conclusions:
1.1.Stdev
Stdevofofaggregated
aggregateddemand
demandisis
less
lessthan
thanthe
thesum
sumofofstdev
stdevofofindividual
individual
demands
demands
2.2.IfIfdemands
demandsare
areindependent
independentoror
negatively
negativelycorrelated,
correlated, the
thestd
stdofof
aggregated
aggregateddemand
demandisismuch
muchless
less
As (safety) stock is based on standard deviation
Square Root Law: stock for combined demands
usually less than the combined stocks

22

where-1
-111
where

D1+D2: (, 2)
= 1 + 2
= ??

21

2
1+
1+
2
1. If D1, D2 positively correlated, > 0
2. If D1, D2 are independent, = 0
3. If D1, D2 negatively correlated, < 0

1+2
12 22

-1

N.C.

Ind.

P.C.

Risk Pooling
Effect of Coefficient of Variation

The higher the C.V. of demand observed in one market,

the greater the benefit from risk pooling

COV= Standard deviation/Avg. demand

Centralized vs. Decentralized

Centralized
Safety Stock
Service Level
Overhead
Costs Facility/Labor cost
Responsiveness to customers
(lead time)
Inbound transportation cost
(from factories to warehouses)
Outbound transportation cost
(from warehouses to retailers)

Decentralized

(Adapted from Simchi-Levi, Chen, and Bramel,

The Logic of Logistics, Springer, 2004)

Case Study

PART 2
CHARLESTON ($7)

14
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32
PART 7
CHARLESTON ($30)

PART 3
AUSTIN ($2)

14

14
PART 4
BALTIMORE ($220)

PART 1
DALLAS ($260)

15

55

14

14

below stage = processing time

# in white box = CST
In this solution, inventory is held of finished
product and its raw materials

A Pure Pull System

PART 2
CHARLESTON ($7)

14
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32
PART 7
CHARLESTON ($30)

PART 3
AUSTIN ($2)

14

14
PART 4
BALTIMORE ($220)

7
55

14

14

Produce

to order
Long CST to customer
No inventory held in system

PART 1
DALLAS ($260)

15

77

A Pure Push System

PART 2
CHARLESTON ($7)

14
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32
PART 7
CHARLESTON ($30)

PART 3
AUSTIN ($2)

14

14
PART 4
BALTIMORE ($220)

PART 1
DALLAS ($260)

15

55

14

14

Produce

to forecast
Zero CST to customer
Hold lots of finished goods inventory

A Hybrid Push-Pull System

PART 2
CHARLESTON ($7)

7
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32
PART 7
CHARLESTON ($30)

8
14

PART 3
AUSTIN ($2)

14
PART 4
BALTIMORE ($220)

PART 1
DALLAS ($260)

30

15

push/pull boundary

14

Part

of system operated produce-tostock, part produce-to-order

Moderate lead time to customer

CST vs. Inventory Cost

Push System

$14,000

Inventory Cost ($/year)

$12,000

Push-Pull System

$10,000
$8,000
$6,000
$4,000

Pull System

$2,000
$0
0

10

20

30

40

50

60

Committed Lead Time to Customer (days)

70

80

Echelon Inventory System

Supplier

Warehouse
echelon lead
time

Warehouse

Retailers

Warehouse
echelon
inventory

Managing Inventory in the Supply

Chain

How should the reorder point associated with the warehouse

echelon inventory position be calculated? The reorder point
is
e
e

s L AVG z STD L

where Le = echelon lead time, defined as the lead time between the
retailers and the warehouse plus the lead time between the
warehouse and its supplier
AVG = average demand across all retailers (i.e., the
average of the aggregate demand)
STD = standard deviation of (aggregate) demand across
all retailers

Forecasting
Recall

the three rules

Nevertheless, forecast is critical
General Overview:
Judgment

methods
Market research methods
Time Series methods
Causal methods

THANKYOU