Case Study: TV Distributor

Suppose a distributor of TV sets is trying to set inventory policies at the warehouse for one of the TV models. The figure provides data on the number of TV sets sold in each of the last 12 months. Every time the warehouse places an order to the manufacturer, the replenishment time (i.e., the lead time) is about two weeks. The distributor would like to ensure that the service level is about 97%. Assuming there is no fixed ordering cost, what is the order-up-to level that the distributor should use?
Rahul Caprihan, Dayalbagh Educational Institute

Demand Variability: TV Distributor

Product Demand
350 300 250 200 150 100 50 0 309 246 198 156 98 200 152 100 221 176 151 287

Demand

Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Month

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When to Re-Order with EOQ Ordering

EOQ models answer the question of how much to order, but not the question of when to order. When to order is the function of models that identify the reorder point (ROP) in terms of a quantity. The ROP occurs when the quantity on hand drops to a predetermined amount. That amount generally includes the expected demand during lead time plus an extra cushion of stock, which serves to reduce the probability of experiencing a stock-out during lead time. When the quantity on hand of an item drops to this amount, the reorder point, the item is reordered. The basic concern of the manager is to place an order when the amount of inventory on hand is sufficient to satisfy demand during the time it takes to receive that order (i.e., lead time). There are four determinants of the reorder point quantity: (1) The rate of demand (usually based on a forecast); (2) The lead time; (3) The extent of demand and/or lead time variability; and (4) The degree of stock-out risk acceptable to the management.
Rahul Caprihan, Dayalbagh Educational Institute

When to Re-Order with EOQ Ordering

With variable demand or lead times, theres a possibility that actual demand will exceed expected demand; therefore, it becomes necessary to carry additional inventory, called safety stock, to reduce the risk of running out of inventory (a stock-out) during lead time. The reorder point then increases by the amount of the safety stock:

ROP = Expected demand during lead time + Safety stock

Because it costs money to hold safety stock, a manager must carefully weigh the cost of carrying safety stock against the reduction in stock-out risk it provides. Order cycle service level (or simply, service level) is defined as the probability that demand will not exceed supply during lead time (i.e., that the amount of stock on hand will be sufficient to meet demand); a service level of 95 percent implies a probability of 95 percent that demand will not exceed supply during lead time. The service level increases as the stock-out risk decreases; i.e., the service level is complement of the stock-out risk: Service level = 100 percent Stock-out risk
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Purpose of Safety Stock

Quantity

Maximum probable demand during lead time Expected demand during lead time

ROP Safety stock

LT
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Time

Reorder Point

Service level Risk of a stockout (Probability of no stockout)

ROP

Expected demand 0

Quantity Safety stock z z-scale

ROP based on a normal distribution of LT demand

Rahul Caprihan, Dayalbagh Educational Institute

Service Level Issues

The amount of safety stock depends on the following factors:
Average demand rate and average lead time Demand and lead time variability Desired service level

For a given order cycle service level, the greater the variability in either demand rate or lead time, the greater the amount of safety stock that will be needed to achieve that service level; similarly, for a given amount of variation in demand rate or lead time, achieving an increase in the service level will require increasing the amount of safety stock. Selection of a service level may reflect stock-out costs (e.g., lost sales, customer dissatisfaction) or it might simply be a policy variable (e.g., the manager wants to achieve a specified service level for a certain item). Inventory Position at any time is the actual inventory plus items already ordered, but not yet delivered.
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Notation
ROP = quantity on hand at reorder point D = demand rate LT = (replenishment) lead time in days AVGD = average demand rate AVGLT = average lead time STDD = standard deviation of demand rate STDLT = standard deviation of lead time STDLTD = standard deviation of lead time demand (= STDD LT) z = standard normal deviation h = holding cost of one unit for one day SL = service level (for example, 95%); this implies that the probability of stocking out is 100%-SL (for example, 5%)

Rahul Caprihan, Dayalbagh Educational Institute

ROP Models
ROP = Expected demand during lead time + Safety stock
Model 1:

Constant demand rate and lead time:

ROP = D LT Model 2: (1)

Variable demand rate and constant lead time:

ROP = (AVGD LT) + (z STDLTD) = (AVGD LT) + (z STDD LT) Model 3: (2)

Constant demand rate and variable lead time:

ROP = (D AVGLT) + (z D STDLT) Model 4: (3)

Variable demand rate and variable lead time:

ROP = (AVGD AVGLT) + (z (AVGLT STDD2 + AVGD2 STDLT2)) (4)
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Explanation for ROP Model Formulas

The logic of the formula for the reorder point may not be immediately obvious. The first part of the formula is the expected demand, which is the product of daily (or weekly) demand and the number of days (or weeks) of lead time. The second part of the formula is z times the standard deviation of lead time demand. For the formula in which only demand is variable (Model 2), daily (or weekly) demand is assumed to be normally distributed and has the same mean and standard deviation (see figure). The standard deviation of demand for the entire lead time is found by summing the variances of daily (or weekly) demands, and then finding the square root of that number because, unlike variances, standard deviations are not additive. Hence, if the daily standard deviation is STDD, the variance is STDD2, and if lead time is four days, the variance of lead time demand will equal the sum of the 4 variances, which is 4STDD2. The standard deviation of lead time demand will be the square root of this, which is equal to 2STDD. In general, this becomes STDD LT and, hence, the last part of formula (2). When only lead time is variable, the standard deviation of lead time demand is equal to the constant daily demand multiplied by the standard deviation of lead time.
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Analysis
The reorder point has two components: To account for average demand during lead time: LT AVGD To account for deviations from average (we call this safety stock): Safety Stock = z STDD LT where z is chosen from statistical tables to ensure that the probability of stockouts during leadtime is 100% - SL.

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A View of the (s,S) Policy

S
Inventory Position

Inventory Level

Lead Time

s 0 Time

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Case Study: TV Distributor

Suppose a distributor of TV sets is trying to set inventory policies at the warehouse for one of the TV models. The figure provides data on the number of TV sets sold in each of the last 12 months. Every time the warehouse places an order to the manufacturer, the replenishment time (i.e., the lead time) is about two weeks. The distributor would like to ensure that the service level is about 97%. Assuming there is no fixed ordering cost, what is the order-up-to level that the distributor should use?
Rahul Caprihan, Dayalbagh Educational Institute

Demand Variability: TV Distributor

Product Demand
350 300 250 200 150 100 50 0 309 246 198 156 98 200 152 100 221 176 151 287

Demand

Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Month

Rahul Caprihan, Dayalbagh Educational Institute

ROP for TV Distributor Example

From the data, the average monthly demand is calculated to be 191.17 and the standard deviation of monthly demand is 66.63. Since the LT is defined in weeks, we transform the monthly averages into weekly averages as below: AVGWD = 191.17 / 4.3 = 44.6; STDWD = 66.63 / 4.3 = 32.1 Further, we are given the following information: LT = 2 weeks; SL = 97% ( z = 1.88)

Using Model 2:
ROP = Expected demand during lead time + Safety stock ROP = (AVGWD LT) + (z STDWD LT) ROP = (44.6 2) + (1.88 32.1 2) ROP = 89.2 + 85.4 = 174.5 175

Therefore, the reorder point is thus 175, or about 3.9 weeks of supply at warehouse and in the pipeline

Rahul Caprihan, Dayalbagh Educational Institute

The (s,S) Policy With Fixed Costs

Suppose that in addition to previous costs, a fixed cost Co is paid every time an order is placed. We have seen that this motivates an (s,S) policy, where reorder point and order quantity are different. In order to meet the service requirement, the reorder point will be the same as the previous model: s = (AVGD LT) + (z STDD LT) What about the order up to level?
Rahul Caprihan, Dayalbagh Educational Institute

The Order-Up-To Level With Fixed Costs

We have used the EOQ model to balance fixed and variable costs: Q=(2 Co AVGD)/h If there was no variability in demand, we would order Q when inventory level was at AVGD LT. Why? Since there is variability, we need safety stock, where Safety Stock = z STDD LT The total order-up-to level is: S = max{Q, AVGDLT} + (z STDD LT)

Rahul Caprihan, Dayalbagh Educational Institute

ROP for TV Distributor Example with Fixed Costs

Consider the previous example, but with the following additional info: Fixed order cost (Co) of $4500 when an order is placed Unit product cost (Cu) = $250 (i.e., cost for each TV set) Carrying cost 18% of product cost (i.e., interest carrying charge) Weekly carrying cost: h = (.18 250) / 52 = 0.87 Therefore, the order quantity is calculated to be: Q=(2 4500 44.6 / 0.87 = 679 Hence, the order-up-to level: S = ROP + Q = 175 + 679 = 854 i.e., order-up-to level = 854 TVs Therefore, the distributor should place an order to raise the inventory position to 854 TV sets whenever the inventory level is below or at (s=) 175 units

Rahul Caprihan, Dayalbagh Educational Institute

Case: ACME Electronics

ACME is a company that produces and distributes electronic equipment in the Northeast of the United States. The current distribution system partitions the Northeast into two markets, each of which has a single warehouse. One warehouse is located in Paramus, New Jersey, and the second is located in Newton, Massachusetts. Customers, typically retailers, receive items directly from the warehouses; in the current distribution system, each customer is assigned to a single market and receives deliveries from the corresponding warehouse. The warehouses receive items from a manufacturing facility in Chicago. Lead time for delivery to each of the warehouses is about one week and the manufacturing facility has sufficient production capacity to satisfy any warehouse order. The current distribution strategy provides a 97 percent service level; that is, the inventory policy employed by each warehouse is designed so that the probability of a stockout is 3 percent. Of course, unfilled orders are lost to the competition and thus cannot be satisfied by future deliveries. Since the original distribution system was designed over seven years ago, the company's newly appointed CEO has decided to review the current logistics and distribution system. ACME handles about 1,500 different products in its supply chain and serves about 10,000 accounts in the Northeast.
Rahul Caprihan, Dayalbagh Educational Institute

Risk Pooling
The existing (decentralized) system is as follows:

Warehouse One Supplier Warehouse Two

Market One

Market Two

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10

Case: ACME Electronics

ACME is considering the following alternative strategy: Replace the two warehouses with a single warehouse located between Paramus and Newton that will serve all customer orders. We will refer to this proposed system as the centralized distribution system. The CEO insists that the same service level, 97 percent, be maintained regardless of the logistics strategy employed. Obviously, the current distribution system with two warehouses has an important advantage over the single warehouse system because each warehouse is close to a particular subset of customers, decreasing delivery time. However, the proposed change also has an important advantage; it allows ACME to achieve either the same service level of 97 percent with much lower inventory or a higher service level with the same amount of total inventory. Intuitively this is explained as follows. With random demand, it is very likely that a higherthan-average demand at one retailer will be offset by a lower-than-average demand at another. As the number of retailers served by a warehouse goes up, this likelihood also goes up. How much can ACME reduce inventory if the company decides to switch to the centralized system but maintain the same 97 percent service level?
Rahul Caprihan, Dayalbagh Educational Institute

Risk Pooling
The proposed centralized system is as follows:

Market One Supplier Warehouse Market Two

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Case: ACME Electronics

To answer that question, we need to perform a more rigorous analysis of the inventory policy that ACME should use in both the current system and the centralized system. We will explain this analysis for two specific products, Product A and Product B, although the analysis must be conducted for all products. For both products, an order from the factory costs $60 per order and inventory holding costs are $0.27 per unit per week. In the current distribution system, the cost of transporting a product from a warehouse to a customer is, on average, $1.05 per product. It is estimated that in the centralized distribution system, the transportation cost from the central warehouse is, on average, $1.10 per product. For this analysis, we assume that delivery lead time is not significantly different in the two systems. Tables A1 provides historical data for both Products A and B. The table includes weekly demand information for each product for the last eight weeks in each market area. Observe that Product B is a slow-moving product the demand for Product B is fairly small relative to the demand for Product A. Table A2 provides a summary of average weekly demand and the standard deviation of weekly demand for each product. It also presents the coefficient of variation of demand faced by each warehouse.
Rahul Caprihan, Dayalbagh Educational Institute

Risk Pooling Example

Table A1:

Week Prod A, Market 1 Prod A, Market 2 TOTAL Prod B, Market 1 Product B, Market 2 TOTAL

1 33 46 79 0 2 2

2 45 35 80 2 4 6

3 37 41 78 3 0 3

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

TOT 314 309

36 113 623 3 0 3 0 0 0 9 10 19

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Risk Pooling Example

Table A2: WAREHOUSE Market 1 Market 2 PRODUCT A A AVERAGE 39.3 38.6

CV =

Standard Deviation Average

STD. DEV. 13.2 12.0

CV 0.34 0.31

TOTAL
Market 1 Market 2

A
B B

77.9
1.125 1.25

20.71
1.36 1.58

0.27
1.21 1.26

TOTAL

2.375

1.9

0.81

STD =

( X X )2
i =1

= (79 77.9)2 + (80 77.9)2 + (78 77.9)2 + (8 1)

Rahul Caprihan, Dayalbagh Educational Institute

n 1

Risk Pooling Example

Table A3: Warehouse
Market 1 (A) Market 2 (A) Market 1 (B) Market 2 (B) Cent. (A) Cent (B)
1. 2. 3. 4.

AVGD STDD 39.3 38.6 1.125 1.25 77.9 2.375 13.2 12.0 1.36 1.58 20.7 1.9

CV .34 .31 1.21 1.26 .27 .81

SS 24.821 22.80 2.58 3.00 39.35 3.61

s Q =ROP 652 1323 62 4 5 118 6 131 25 24 186 33

S 1974 193 29 29 304 39

Av. Q 915 88 15 15 132 20

% Dec.

26% 33%

SS = z STDD LT = 1.88 13.2 1 = 24.82 s = (LT AVGD) + (z STDD LT) = (1 39.3) + (24.82) = 64.1 65 (= ROP) Q = (2CoS/Cui) = (2Co AVGD /Cui) = (2 60 39.3 / 0.27) = 132.1 132 S = ROP + Q = 65 + 132 = 197

5. Av.Q = SS + Q/2 = 24.82 + 132/2 = 24.82 + 66 = 90.82 91

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13

Risk Pooling: Important Observations

Centralizing inventory reduces both safety stock and average inventory in the system. Intuitively this is explained as follows. In a centralized distribution system, whenever demand from one market area is higher than average while demand in another market area is lower than average, items in the warehouse that were originally allocated for one market can be reallocated to the other. The process of reallocating inventory is not possible in a decentralized distribution system where different warehouses serve different markets. The higher the coefficient of variation, the greater the benefit obtained from centralized systems; that is, the greater the benefit from risk pooling. This is explained as follows. Average inventory includes two components: one proportional to average weekly demand (AVGD) and the other proportional to the standard deviation of weekly demand (safety stock). Since reduction in average inventory is achieved mainly through a reduction in safety stock, the higher the coefficient of variation (because of higher SD) the larger the impact of safety stock on inventory reduction. The benefits from risk pooling depend on the behavior of demand from one market relative to demand from another. We say that demand from two markets is positively correlated if it is very likely that whenever demand from one market is greater then average, demand from the other market is also greater than average. Similarly, when demand from one market is smaller than average, so is demand from the other. Intuitively, the benefit from risk pooling decreases as the correlation between demands from the two markets becomes more positive.

Rahul Caprihan, Dayalbagh Educational Institute

Centralized vs. Decentralized Systems

Safety stock: Clearly, safety stock decreases as a firm moves from a decentralized to a centralized system. The amount of decrease depends on a number of parameters including the coefficient of variation and the correlation between the demands from the different markets. Service level: When the centralized and decentralized systems have the same total safety stock, the service level provided by the centralized system is higher. As before, the magnitude of the increase in service level depends on the coefficient of variation and the correlation between the demands from the different markets. Overhead costs: Typically, these costs are much greater in a decentralized system because there are fewer economies of scale. Customer lead time: Since the warehouses are much closer to the customers in a decentralized system, response time is much lower. Transportation costs: The impact on transportation costs depends on the specifics of the situation. On one hand, as we increase the number of warehouses, outbound transportation costs the costs incurred for delivering the items from the warehouses to the customers decrease because warehouses are much closer to the market areas. On the other hand, inbound transportation costs the costs of shipping the products from the supply and manufacturing facilities to the warehouses increase. Thus, the net impact on total transportation cost is not immediately clear.
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14

Echelon Inventory Management

The inventory models and examples considered so far assume a single facility (e.g., a warehouse or a retail outlet) managing its inventory in order to minimize its own cost as much as possible. In a typical supply chain, the main objective is to reduce systemwide cost; thus it is important to consider the interaction of the various facilities and the impact this interaction has on the inventory policy that should be employed by each facility. For this purpose, consider a retail distribution system with a single warehouse serving a number of retailers. We make two important, but reasonable, assumptions: Inventory decisions are made by a single decision maker whose objective is to minimize systemwide cost. The decision maker has access to inventory information at each of the retailers and at the warehouse. Under these assumptions, an inventory policy based on the so-called echelon inventory is an effective way to manage the system; more importantly, this policy can be extended in a natural way to manage more complex supply chains.

Rahul Caprihan, Dayalbagh Educational Institute

Echelon Inventory Management

Concept of echelon inventory In a distribution system, each stage or level (i.e., the warehouse or the retailers) is often referred to as an echelon. Thus, the echelon inventory at any stage or level of the system is equal to the inventory on hand at the echelon, plus all downstream inventories. For example, the echelon inventory at the warehouse is equal to the inventory at the warehouse, plus all of the inventory in transit to and in stock at the retailers. Echelon inventory position at the warehouse is the echelon inventory at the warehouse, plus those items ordered by the warehouse that have not yet arrived (see figure). This suggests the following effective approach to managing the single warehouse multi-retailer system: First, the individual retailers are managed using the appropriate (s, S) inventory policy.
Second, the warehouse ordering decisions are based on the echelon inventory position at the warehouse. Specifically, the reorder point, s, and order-up-to-level, S, are calculated for each retailer using the approach previously described. Whenever the inventory position at a retailer falls below the reorder point, s, an order is placed to raise its inventory position to S. Similarly, a reorder point, s, and an order-up-to-level, S, are calculated for the warehouse. In this case, however, the warehouse policy controls its echelon inventory position; that is, whenever the echelon inventory position for the warehouse is below s, an order is placed to raise its echelon inventory position to S.

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15

Warehouse Echelon Inventory

Supplier

Warehouse Echelon Lead Time

Warehouse

Retailers

Centralized Decision

Warehouse Echelon Inventory

Rahul Caprihan, Dayalbagh Educational Institute

Echelon Inventory Management

How should the reorder point associated with the warehouse echelon inventory position be calculated ? In this case, the reorder point is: s = Le AVGD + z STDD Le 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

AVGD = average demand across all retailers (i.e., the average of the aggregate demand) STDD = standard deviation of (aggregate) demand across all retailers Example: Consider the TV distributor from the previous example where we determined the inventory policy for the warehouse. Now suppose that the warehouse supplies a group of retailers. The historical demand data shown in the figure is the aggregate demand data for the retailers. Finally, the two weeks' lead time is the echelon lead time the time it takes an order placed by the warehouse to reach a customer. Thus, the distributor needs to ensure that a total of 176 units of inventory, or about four weeks' supply, is somewhere in the system, either in the pipeline to the warehouse, at the warehouse, in transit to the retailers, or at the retailers.
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Echelon Inventory Management

What about the retailers? In this case, we need to perform exactly the same calculations, but this time utilizing the specific demand faced by each retailer and the associated lead time from the warehouse to that retailer. Suppose, for example, that the average weekly demand at a specific retailer is 11.6, with a standard deviation of 4.5. Furthermore, suppose that it takes one week for items to get from the warehouse to the retailer. Using the same approach as before to achieve a 97 percent service level, we find that the reorder level, s, for the retailer is 20. Thus, an order is placed whenever the retailer inventory position is 20. Obviously, if other retailers face different demand or lead times, they will have different reorder levels. Finally, it is important to point out that this technique can be extended to more complex supply chains

supply chains with additional levels

provided that the supply chains are

under centralized control and that inventory information from each of the echelons is available to the decision maker.

Rahul Caprihan, Dayalbagh Educational Institute

Demand Variability: TV Distributor

Product Demand
350 300 250 200 150 100 50 0 309 246 198 156 98 200 152 100 221 176 151 287

Demand

Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Month

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17

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.

Rahul Caprihan, Dayalbagh Educational Institute

Practical Issues
In a recent survey (Inventory Reduction Report, no.98-4 (April 1998) pp. 12-14), materials and inventory managers were asked to identify effective inventory reduction strategies. The top five strategies in this survey are: Periodic inventory review policy: In this strategy, inventory is reviewed at a fixed time interval and every time it is reviewed, a decision is made on the order size. The periodic inventory review policy makes it possible to identify slow-moving and obsolete products and allows management to continuously reduce inventory levels. Tight management of usage rates, lead times, and safety stock: This allows the firm to make sure inventory is kept at the appropriate level. Such an inventory control process allows the firm to identify, for example, situations in which usage rates decrease for a few months. If no appropriate action is taken, this decrease in usage rates implies an increase in inventory levels over the same period of time. ABC approach: In this strategy, items are classified into three categories. Class A items include all high-value products, which typically account for about 80 percent of annual sales and represent about 20 percent of inventory SKUs. Class B items include products which account for about 15 percent of annual sales while Class C products represent low- value items, products whose value is no more than 5 percent of sales. Because Class A items account for the major part of the business, a high- frequency periodic review policy (e.g., a weekly review) is appropriate in this case. Similarly, a periodic review policy is applied to control Class B products, although the frequency of review is not as high as that for Class A products. Finally, depending on product value, the firm either keeps no inventory of expensive Class C products, or keeps a high inventory of inexpensive Class C products.

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18

ABC Analysis
Items (SKUs; Part #s)
B (30%)

A (20%) C (50 %)

Value (Sales; Usage)

B (15%) C (5 %)

% of items: % of value:

A 20 80

B 30 15

C 50 5

A (80 %)

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Practical Issues

Reduce safety stock levels: This can perhaps be accomplished by focusing on lead
time reduction.

Quantitative approaches: These approaches are similar to those described in this chapter which focus on the right balance between inventory holding and ordering costs.
Importantly, the focus in the above survey was not on reducing cost but on reducing inventory levels. In the last few years we have seen a significant effort by industry to increase the

inventory turnover ratio defined as follows:

Inventory turnover ratio = Annual Sales / Average Inventory Level

This definition implies that an increase in inventory turnover leads to a decrease in average inventory levels. For instance, retailing powerhouse Wal-Mart has the highest inventory turnover ratio of any discount retailer. This suggests that Wal-Mart has a higher level of liquidity, smaller risk of obsolescence, and reduced investment in inventory. Of course, a low inventory level in itself is not always appropriate since it increases the risk of lost sales.
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19

Summary
Matching supply and demand in the supply chain is a critical challenge. To reduce cost and provide the required service level, it is important to take into account inventory holding and setup costs, lead time, and forecast demand. Unfortunately, the so-called first rule of inventory management states that forecast demand is always wrong. Thus, a single number, forecast demand, is not enough when determining an effective inventory policy. Inventory management strategies must take into account information about demand variability.
Rahul Caprihan, Dayalbagh Educational Institute

20