Introduction to inventory management
And risk pooling
Inventory management :-
- in many industries supply chains, inventory is one of the dominant costs. For
many managers , supply chain management is sysnonymous with reducing
inventory levels in the supply chain. The goal of effective inventory management
in the supply chain is to have the correct inventory at the right place at right time
to minimize system costs while satisfying customer service requirements .
- Inventory can appear in many places in supply chain,and in serval
forms:-
1- Raw material inventory.
2- work-in-process(WIP) inventory.
3- Finished product inventory.
Each of these needs its own inventory control mechanism or approach.
Types of Inventory How Inventory is Used:-
Anticipation or seasonal inventory.
Safety stock: buffer demand fluctuations.
Lot-size or cycle stock: take advantage of quantity discounts or purchasing
efficiencies.
Pipeline or transportation inventory.
Speculative or hedge inventory protects against some future event, e.g.
labor strike.
Maintenance, repair, and operating (MRO) inventories.
Objectives of Inventory Management:-
Provide acceptable level of customer service (on-time delivery).
Allow cost-efficient operations.
Minimize inventory investment.
Relevant Inventory Costs :-
Item Cost : Cost per item plus any other direct costs associated with getting
the item to the plant.
Holding Cost : Capital, storage, and risk cost typically stated as a % of the unit
value.
Ordering Cost : Fixed, constant dollar amount incurred for each order placed.
Shortage Cost : Loss of customer goodwill, back order handling, and lost sales
.
EOQ Total Cost ( Economic Order Quantity)
Economic Order Quantity
EOQ Assumptions:
Demand is known & constant - no safety stock is required
Lead time is known & constant
No quantity discounts are available
Ordering (or setup) costs are constant
All demand is satisfied (no shortages)
The order quantity arrives in a single shipment
EOQ: Total Cost Equation:-
cost setup or ordering
cost holding annual
ordered be o quantity t
demand annual
cost annual total
2
S
H
Q
D
TC
Where
H
Q
S
Q
D
TC
EOQ
Role of Inventory in Services:
Decoupling inventories.
Seasonal inventories.
Speculative inventories.
Cyclical inventories.
In-transit inventories.
Safety stocks.
considerations in Inventory Systems:-
Type of customer demand.
Planning time horizon .
Replenishment lead time .
Constraints and relevant costs .
The Effect of Demand Uncertainty:-
The previous model illustrates the trade-offs
between setup costs and inventory holding costs. It
ignores, however, issues such as demand uncertainty
and forecasting. hulced, many companies treat the
world as if it were predictable, making production IIlId
inventory decisions based on forecasts of the demand
made far in advance of the
:a'lling season. Although these companies are aware of demand
uncertainty when they I'f'l'ale a forecast, they design their planning
processes as if the initial forecast was an urcurate representation of
reality. In this case, one needs to remember the following principles of all
forecasts:-
1- The forecast is always wrong .
2- The longer the forecast horizon,
the worse the forecast.
3- Aggregate forecasts are more accurate.
Single Period Models:-
To better understand the impact of demand uncertainty, we
consider aseries of increasingly detailed and complex
situations. To start, we consider a product that has a short
lifecycle and hence the firm has only one ordering
opportunity. Thus, before demand occurs, the firm must
decide how much to stock in order to meet demand. If the
firm stocks too much, it will be stuck with excess inventory it
has to dispose of. If the firm stocks too little, it will forgo
some sales, and thus some profits.Using historical data, the
firm can typically identify a variety of demand scenariosand
determine a likelihood or probability that each of these
scenarios will occur. Observe that given a specific inventory
policy, the firm can determine the profit associated with a
particular scenario. Thus, given a specific order quantity, the
firm can weight each scenario's profit by the likelihood
that it will occur and hence determine the average, or
expected, profit for a particular ordering quantity. It is thus
natural for the firm to order the quantity that maximizes the
average profit.
There are at least three reasons why the distributor
holds inventory:-
1- Satisfy demand occurring during lead time. Since
orders aren't met immediately, inventory must be
on hand to meet customer demand that is
realized between the time that the distributor
places an order and the time that the ordered
inventory arrives.
2- To protect against uncertainty in demand.
3- To balance annual inventory holding costs and
'annual fixed order costs. We have seen that
more frequent orders lead to lower inventory
levels and thus lower inventory holding costs,
but they also lead to higher annual fixed order
costs.
The specific inventory policy that the dis-
tributor should apply is not simple. To
manage inventory effectively, the distributor
needs to decide when and how much to
order. We distinguish between two types of
policies:
1-Continuous review policy:-
in which inventory is reviewed continuously, and
an order is placed when the inventory reaches a
particular level, or reorder point. This type of
policy is most appropriate when inventory can be
continuously reviewed- For example, when
computerized inventory systems are used .
We first consider a system in which inventory is continuously
reviewed. Such a review syslem typically provides a more
responsive inventory management strategy than the one
associated with a periodic review system (why?).
Daily demand is random and follows a normal
distribution. In other words, we assume that the
probabilistic forecast of daily demand follows the
famous bell-shaped curve. Note that we can completely
describe normal demand by its average and standard
deviation.
Every time the distributor places an order from the
manufacturer, the distributor pays a fixed cost, K, plus an
amount proportional to the quantity ordered.
Inventory holding cost is charged per
item per unit time.
Inventory level is continuously reviewed, and if an order is
placed, the order arrives after the appropriate lead time.
If a customer order arrives when there is no inventory on
hand to fill the order (i.e.,
when the distributor is stocked out), the order is lost.
The distributor specifies a required service level. The
service level is the probability of not stocking out during
lead time. For example, the distributor might want to
ensure that the proportion of lead times in which
demand is met out of stock is
95 percent. Thus, the required service level is 95 percent in this
case.
To characterize the inventory policy that the distributor
should use, we need the following information:
AVG = Average daily demand faced by the distributor
STD = Standard deviation of daily demand faced by the
distributor
L = Replenishment lead time from the supplier to the distributor
in days
h = Cost of holding one unit of the product for one day at the
distributor
a = service level. This implies that the probability of stocking out
is 1 - a.
2- PeriodicReview Policy :-
many real-life situations, the inventory level is reviewed
periodically at regular intervals, and an appropriate
quantity is ordered after each review. If these intervals
lire relatively short (for example, daily), it may make
sense to use a modified versionor the (Q, R) policy
presented above. Unfortunately, the (Q, R) policy can't
be directly implemented, since the inventory level may
fall below the reorder point when the warehouse places
an order. To overcome this problem, define two inventory
levels s und S, and during each inventory review.
Service Level Optimization :-
The objective of this inventory optimization is to
determine the optimal inventory policy given a specific
service level target. The question, of course, is how
the facility should decide on the appropriate level of
service. Sometimes this is determined by the
downstream customer. In other words, the retailer can
require the facility, for example, the supplier, to
maintain a Specific level of service and the supplier
will use that target to manage its own Inventory.
one possible strategy, used in retailing, to determine
service level for each SKU is to focus on maximizing
expected profit across all, or some, of their products.
That is, given a target service level across all products,
we determine service level for each SKU so as to
maximize expected profit. Everything else being equal,
service level will be higher for products with :-
- High profit margin .
- High volume.
- Low variability.
- Short lead time.
Risk Pooling :-
One of the most powerful tools used to address variability
in the supply chain is the concept of risk pooling. Risk
pooling suggests that demand variability is reduced if one
aggregates demand across locations. This is true since, as
we aggregate demand across different locations, it
becomes more likely that high demand from one
customer will be offset by low demand from another. This
reduction in variability allows a decrease in safety stock and
therefore reduces average inventory.To understand risk
pooling, it is essential to understand the concepts of
standard deviation and coefficient of variation of demand.
Standard deviation is a measure of how much demand
tends to vary around the average, and coefficient of variation
is the ratio of standard deviation to average demand.
The three critical points made about risk pooling :-
1- 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.
2- The higher the coefficient of variation, the greater the
benefit obtained from cen- trulized systems; that is, the
greater the benefit from risk pooling. This is explained
liS follows. Average inventory includes two
components: one proportional to uvcrage weekly
demand (Q ) 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, Ihe larger the impact of safety
stock on inventory reduction.
3- 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 cor-
relation between demand from the two markets
becomes more positive.
CENTRALIZED VERSUS DECENTRALIZED
SYSTEMS :-
The analysis in the previous section raises an important practical issue:
What are the made -offs that we need to consider in comparing
centralized distribution systems with centralized distribution 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 demand 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 demand 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 shorter.
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.
PRACTICAL ISSUES:-
1- Perform periodic inventory review.
2- Provide tight management of usage rates, lead
times, and safety stock.
3- Reduce safety stock levels.
4- Introduce or enhance cycle counting practice.
5- Follow ABC approach.
6- Shift more inventory or inventory ownership or
supplires.
7- Follow quantitative approaches.
FORECASTING:-
The three rule of forecasting are:-
1- The forecast always wrong.
2- The longer the forecast horizon, the worse the
forecast.
3- Aggregate forecasts are more accurate.
