12/23/2009

Supply Chain Management

Ir. Ph.D. Fouad Riane

Louvain School of Management

www.lsm.be/riane

Inventory and Risk Pooling

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Issues
• Inventory Management

• The Effect of Demand Uncertainty

–

• Centralized vs. Decentralized Systems

• Practical Issues in Inventory Management

Inventory
• Where do we hold inventory?

• Types of Inventory

• Why do we hold inventory?

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Understanding Inventory
• The inventory policy is affected by:
– Demand Characteristics
– Lead Time
– Number of Products
– Objectives
• Service level
• Minimize costs
– Cost Structure

Cost Structure
• Order costs
–

• Holding Costs

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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
• Question
– How many, when to order?

EOQ: A View of Inventory*

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

Order
Size

Avg. Inven

Time

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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:

EOQ:Total Cost*

160
140
120 Total Cost
100
Holding Cost
Cost

80
60
40 Order Cost
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

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:

• Recent technological advances have

increased the level of demand uncertainty:

Demand Forecast
• The three principles of all forecasting
techniques:

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SnowTime Sporting Goods

• Fashion items have short life cycles, high variety
of competitors
• SnowTime Sporting Goods

SnowTime 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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SnowTime Demand Scenarios

Demand Scenarios
Probability

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

0
00

00

00

00

00

00
80

10

12

14

16

18
Sales

SnowTime Scenarios
• Scenario One:
–

• Scenario Two:

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SnowTime Best Solution

• Find order quantity that maximizes
weighted average profit.

• Question :

What to Make?
• Average demand is 13,100
• Look at marginal cost Vs. marginal profit
–

• So we will make less than average

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SnowTime Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity

SnowTime:
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

• Question:

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SnowTime Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity

Probability of Outcomes
100%
80%
Probability

60% Q=9000
40% Q=16000

20%
0%
0

00

00

00
00

00

00

00

00
00

00

10

30

50
-3

-1

Revenue

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Key Insights from this Model

• The optimal order quantity is not ..

• The optimal quantity depends …

• As order quantity increases, average profit …

• As production quantity increases, ….

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

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Demand Scenarios

Demand Scenarios

30%
Probability

25%
20%
15%
10%
5%
0%
00

0
00

00

00

00

00
80

10

12

14

16

18 Sales

Distributor Expected Profit

Expected Profit

500000

400000

300000

200000

100000

0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity

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Distributor Expected Profit

Expected Profit

500000

400000

300000

200000

100000

0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity

Supply Contracts (cont.)

• Distributor optimal order quantity is 12,000
units
• Distributor expected profit is $470,000
• Manufacturer profit is $440,000
• Supply Chain Profit is $910,000

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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

Retailer Profit
(Buy Back=$55)

600,000

500,000
Retailer Profit

400,000

300,000
200,000
100,000

0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18

Order Quantity

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Retailer Profit
(Buy Back=$55)

600,000
$513,800
500,000
Retailer Profit

400,000

300,000
200,000
100,000

0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18
Order Quantity

Manufacturer Profit
(Buy Back=$55)

600,000
Manufacturer Profit

500,000

400,000

300,000
200,000

100,000

0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18

Production Quantity

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Manufacturer Profit
(Buy Back=$55)

600,000
$471,900
Manufacturer Profit

500,000

400,000

300,000
200,000

100,000

0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18
Production Quantity

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

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Retailer Profit
(Wholesale Price $70, RS 15%)

600,000
500,000
Retailer Profit

400,000
300,000
200,000
100,000
0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18
Order Quantity

Retailer Profit
(Wholesale Price $70, RS 15%)

600,000
$504,325
500,000
Retailer Profit

400,000
300,000
200,000
100,000
0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18

Order Quantity

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Manufacturer Profit
(Wholesale Price $70, RS 15%)

700,000
Manufacturer Profit

600,000
500,000
400,000
300,000
200,000
100,000
0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18
Production Quantity

Manufacturer Profit
(Wholesale Price $70, RS 15%)

700,000
Manufacturer Profit

600,000
500,000 $481,375
400,000
300,000
200,000
100,000
0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18

Production Quantity

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Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700

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

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Supply Chain Profit

1,200,000
Supply Chain Profit

1,000,000
800,000
600,000
400,000
200,000
0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18
Production Quantity

Supply Chain Profit

1,200,000
$1,014,500
Supply Chain Profit

1,000,000
800,000
600,000
400,000
200,000
0
00

00

00

00

0
00

00

00

00

00

00

00

00

00
60

70

80

90
10

11

12

13

14

15

16

17

18

Production Quantity

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Supply Contracts

Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700
Global Optimization 1,014,500

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

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Contracts and Supply Chain

Performance
• Contracts for Product Availability and
Supply Chain Profits
–

• Contracts to :
–

Contracts for Product Availability

and Supply Chain Profits
• Many shortcomings in supply chain
performance occur because …

• Total supply chain profits might therefore

…

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Contracts for Product Availability

and Supply Chain Profits
• Double marginalization results in
suboptimal order quantity

• An approach to dealing with this problem is

to design a contract that encourages a
buyer to purchase more and increase the
level of product availability

• The supplier must share in some of the

buyer’s demand uncertainty, however …

Supply Contracts: Case Study

• Example: Demand for a movie newly released
video cassette typically starts high and
decreases rapidly

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(s, S) Policies
• (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

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 …

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Reminder:
The Normal Distribution

Standard Deviation = 5

Standard Deviation = 10

Average = 30

0 10 20 30 40 50 60

The DC holds inventory to:

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

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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.

• Intuitively, how will this effect our policy?

A View of (s, S) Policy

S
Inventory Position
Inventory Level

Lead
Time

0
Time

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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:
–

Notation
• AVG =
• STD
• LT =
• h=
• K=
• SL =

• Also, the Inventory Position at any time is the actual

inventory plus items already ordered, but not yet
delivered.

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Analysis
• The reorder point (s) has two components:
–
–

• Since there is a fixed cost, we order more than up to the

reorder point:

• The total order-up-to level is:

Periodic Review
• Suppose the distributor places orders
every month
• What policy should the distributor use?
• What about the fixed cost?

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Base-Stock Policy

r r

L L L
Base-stock
Level Inventory
Inventory Level

Position

0
Time

Periodic Review Policy

• Each review echelon, inventory position is
raised to the base-stock level.
• The base-stock level includes two
components:
–

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

Market One
Supplier Warehouse

Market Two

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?

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Risk Pooling Example

• Compare the two systems:
– two products
– maintain 97% service level
– $60 order cost
– $.27 weekly holding cost
– $1.05 transportation cost per unit in
decentralized system, $1.10 in centralized
system
– 1 week lead time

Risk Pooling Example

Week 1 2 3 4 5 6 7 8
Prod A, 33 45 37 38 55 30 18 58
Market 1
Prod A, 46 35 41 40 26 48 18 55
Market 2
Prod B, 0 2 3 0 0 1 3 0
Market 1
Product B, 2 4 0 0 3 1 0 0
Market 2

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Risk Pooling Example

Warehouse Product AVG STD CV

Market 1 A 39.3 13.2 .34

Market 2 A 38.6 12.0 .31

Market 1 B 1.125 1.36 1.21

Market 2 B 1.25 1.58 1.26

Risk Pooling Example

Warehouse Product AVG STD CV s S Avg. %

Inven. Dec.
Market 1 A 39.3 13.2 .34 65 197 91
Market 2 A 38.6 12.0 .31 62 193 88
Market 1 B 1.125 1.36 1.21 4 29 14
Market 2 B 1.25 1.58 1.26 5 29 15
Cent. A 77.9 20.7 .27 118 304 132 36%
Cent B 2.375 1.9 .81 6 39 20 43%

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Risk Pooling:
Important Observations
• Centralizing inventory control reduces …

• This works best for

• What other kinds of risk pooling will we

see?

To Centralize or not to Centralize

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

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Centralized Systems*

Supplier

Warehouse

Retailers

• Centralized Decision

Centralized Distribution
Systems*
• Question: How much inventory should management
keep at each location?
• A good strategy:
–

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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

Changes In Inventory Turnover

• Inventory turnover ratio =
annual sales/avg. inventory level
•

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Inventory Turnover Ratio

Industry Upper Median Lower

Quartile Quartile
Dairy Products 34.4 19.3 9.2
Electronic Component 9.8 5.7 3.7
Electronic Computers 9.4 5.3 3.5
Books: publishing 9.8 2.4 1.3

Household audio & 6.2 3.4 2.3

video equipment
Household electrical 8.0 5.0 3.8
appliances
Industrial chemical 10.3 6.6 4.4

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

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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

Forecasting
• Recall the three rules
• Nevertheless, forecast is critical
• General Overview:
– Judgment methods
– Market research methods
– Time Series methods
– Causal methods

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Judgment Methods
• Assemble the opinion of experts
•

Market Research Methods

• Particularly valuable for developing
forecasts of newly introduced products
•

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Time Series Methods

• Past data is used to estimate future data
•

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

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Selecting the Appropriate

Approach:
• What is the purpose of the forecast?
–
• What are the dynamics of the system being forecast?
–

• How important is the past in estimating the future?

• Different approaches may be appropriate for different
stages of the product lifecycle:

• It is typically effective to combine approaches.

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