Transportation

& Distribution Planning

Lecture-8
Inventory Strategy & Management

Instructor: Sayda Uzma Tahira

Contact Info: [email protected]

University of Central Punjab, Lahore

 Types of Inventories
•Pipeline
-Inventories in transit- Pipeline inventory refers to those
products that are in the company's shipping chain that have
yet to reach their ultimate destination. While the items are in
transit, they are still considered to be part of the shipper's
inventory if the recipient has yet to pay for them.
•Speculative
-Goods purchased in anticipation of price increases
•Regular/Cyclical/Seasonal
-Inventories held to meet normal operating needs
•Safety
-Extra stocks held in anticipation of demand and
lead time uncertainties
•Obsolete/Dead Stock
-Inventories that are of little or no value due to being
out of date, spoiled, damaged, etc. 9-2
 Inventory Management
Philosophies
•Pull
-Replenish inventory with order sizes based on specific needs
of each warehouse each warehouse
-Draws inventory into the stocking location
-Each stocking location is considered independent
-Maximizes local control of inventories
•Push
-Allocate supply to each warehouse on the basis of forecast
-Allocates production to stocking locations based on
overall demand
-Encourages economies of scale in production
•Just-in-time
-Attempts to synchronize stock flows so as to just
meet demand as it occurs
-Minimizes the need for inventory 9-3
Pull vs. Push Inventory Philosophies
PUSH - Allocate supply to each PULL - Replenish inventory with
warehouse based on the forecast order sizes based on specific needs
for each warehouse of each warehouse

Demand
forecast
Warehouse #1
Q1

A1

A2 Q2 Demand
Plant forecast
Warehouse #2
A3

Q3

A = Allocation quantity to each warehouse

Q = Requested replenishment quantity Demand
by each warehouse Warehouse #3 forecast
9-4
9-11
 Costs Relevant to Inventory
Management
•Carrying costs
-Cost for holding the inventory over time
-The primary cost is the cost of money tied up in
inventory, but also includes obsolescence,
insurance, personal property taxes, and storage
costs
-Typically, costs range from the cost of short term
capital to about 40%/year. The average is about
25%/year of the item value in inventory.

9-5
 Relevant Costs (Cont’d)

•Procurement costs
-Cost of preparing the order
-Cost of order transmission
-Cost of production setup if appropriate
-Cost of materials handling or processing at the
receiving dock
-Price of the goods

9-6
 Relevant Costs (Cont’d)

•Out-of-stock costs
-Lost sales cost
›Profit immediately foregone
›Future profits foregone through loss of goodwill
-Backorder cost
›Costs of extra order handling
›Additional transportation and handling costs
›Possibly additional setup costs
9-7
Inventory Management Objectives
Good inventory management is a careful balancing act
between stock availability and the cost of holding
inventory.
Customer Service, Inventory Holding costs
i.e., Stock Availability

•Service objectives
-Setting stocking levels so that there is only a
specified probability of running out of stock
•Cost objectives
-Balancing conflicting costs to find the most
economical replenishment quantities and timing
9-8
 Inventory Systems
 For a large enterprise such as Nike and
Oracle, managing inventory can be a
challenging task with thousands of products
located in thousands of locations all over the
world.
 The challenge magnifies when locations are
placed in different tiers or echelons of the
enterprise’s distribution channel.
 Broadly, there are two types of inventory
systems: - the single-echelon (or, single-tier)
inventory system and the multi-echelon (or,
multi-tier) inventory system. 9-9
 Single Echelon Inventory System
 A single-echelon inventory system is one wherein
a single Distribution Center (DC) acts as a central
repository between the supplier of the inventory
and the customer-facing outlets.
 In a single-echelon network, an individual material-
location combination is not affected by any other
material or location.
 If a business was selling products from a single
location, then it would be categorized as a single-
echelon system.
 The DC is under the control of a single enterprise.

9-10
 Multi-Echelon Inventory System
 A multi-echelon inventory system is one that
relies heavily on layers of suppliers distributed
across multiple distribution centers and that is
based on outsourced manufacturing.
 In such a system, new inventory shipments are first
stored at a central or regional distribution center
(RDC).
 These central facilities are the internal suppliers to
the customer-facing outlets, also called forward
distribution centers (DCs).
 For example, Nike’s distribution network consists of 7
RDCs and more than 300,000 DCs; and these DCs
serve end customers. Here, the DC and RDC both
are under the control of a single enterprise – Nike,
9-11
Inc.
9-12
 Multi-Echelon Inventories
Control the entire channel inventory levels, not just a
single echelon.
How much stock here when
retailers also carry stock?
Warehouse
echelon
ad- R1

End customer demand

le
e tail LT R d1 , sd1
R e,
Warehouse tim
lead-time, LTw R2
S W
d 2 , sd 2
Supplier Warehouse

R3
d 3 , sd 3
Retailer

9-13
 Multi-Echelon Inventories (Cont’d)
Example
An item has the following cost characteristics. Item
values are CR=$10/unit and CW=$5/unit. Carrying cost
is I = 20%/year. Ordering costs are SR=$40/order and
SW=$75/order. Lead times are LTR=0.25 month and
LTW=0.5 months. In-stock probability for retailers and
warehouses is 90%. Monthly demand statistics are:

Monthly Std. dev.,

avg., units units
Retailer 1 202.5 16.8
Retailer 2 100.5 15.6
Retailer 3 302.5 18.0
Combined 605.5 29.14
9-14
 Multi-Echelon Inventories (Cont’d)
Solution
Based on reorder point inventory control, the retailers’
inventory statistics are
The retailer 1 order quantity is
2DR1SR
Q1   2(202.5x12)(40)  311.80or 312 units
ICR 0.20(10)
ROP1  d1xLTR  zsd1 LTR  202.5(.25) 1.28(16.8) .25
 61.38or61 units
The average inventory AIL is
Q
AIL1  1  zsd1 LTR
2
 311.8 1.28(16.8) 0.25
2
166.65. or 167 units 9-15
 Multi-Echelon Inventories (Cont’d)
Solution
Based on reorder point inventory control, the retailers’
inventory statistics are
Retailer 1 Retailer 2 Retailer 3
Reorder qty, Q 312 220 381
Reorder point, ROP 61 35 87
Avg. inv., AIL 167 120 202

The warehouse echelon order quantity is

2DW SW
QW   2(605.5x12)(75)  1,043.98, or 1,044 units
ICW 0.20(5)
ROPW  dW xLTW  zsW LTW  605.5(.5) 1.28(29.14) .5
 329.124 units
9-16
 Multi-Echelon Inventories (Cont’d)
The warehouse echelon inventory is
Q
AILW  W  zsW LTW
2
1,043.98 1.28(29.14) 0.5
2
 551.32. or 551 units
The average warehouse inventory is the warehouse
echelon inventory less the retailers’ inventory, or 551
– 167 –120 – 202 = 62 units.
Rule When the total warehouse inventory (sum of
retailers’ inventory, inventory at the warehouse and on
order, and retailers’ orders less any inventory committed
to customers drops below 329.124 units, order 1,044
units. 9-17
 Risk Pooling
 Risk pooling is a statistical concept that suggests
that demand variability is reduced if one can
aggregate demand, for example, across locations,
across products or even across time.
 This is a statistical concept that suggests that
aggregation reduces variability and uncertainty.
 For example, if demand is aggregated 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.
9-18
 Advantages of Risk Pooling
 More consolidated the inventory, the easier it
is to manage overall and the less risk of
obsolescence.
 Less variability in demand the less safety
stock is required to buffer against fluctuations.
 By centralizing a product in one location, you
can take advantage of the aggregated
demand.
 The more consolidated the products and the
warehouses are, the cheaper the
transportation costs as shipments can be sent
in larger batches.
9-19
 Inventory Consolidation
(“Risk Pooling”)
Illustration of risk pooling

Suppose there is a product stocked in two warehouses.

The replenishment quantities are determined by the
economic order quantity formula. The replenishment
lead-time is 0.5 months, the cost for a replenishment
order is $50, the inventory carrying cost is 2% per
month, and the item value is $75 per unit. The
probability of an out of stock during the lead-time period
is 2.5%. The demand is normally distributed with
typical demand over six months as follows. At in-stock
probability of 97 % Z=1.96

9-20
 Risk Pooling (Cont’d)
Combined
Demand Demand Demand in a
in Whse in Whse Central
Month A B Whse
1 35 67 102
2 62 83 145
3 46 71 117
4 25 62 87
5 37 55 92
6 43 66 109
Avg. (D) 41.33 67.33 108.66
6
Std. Dev. (sd) 11.38 8.58 19.07

Estimate the average inventory levels for two-

warehouse and one-warehouse supply channels.
9-21
 Risk Pooling (Cont’d)
Regular stock

2DS
RS  Q  IC
2 2
2(41.33)(50)
0.02(75)
RSA   52.49  26.25 units
2 2
2(67.33)(50)
0.02(75)
RSB   67.00  33.50 units
2 2
Regular stock in system is
R S s  R S A  R S B  2 6 . 2 5  3 3 . 5 0  5 9 . 7 5 u n it s
9-22
 Risk Pooling (Cont’d)
Regular stock if item is entirely in one warehouse

2(108.66)(50)
0 .02(75)
RSC   85 .11  42 .56 units
2 2
Safety stock
SS  z(sd ) LT

SSA  1.96(11.38) 0.5  15.77 units

SSB  1.96(8.58) 0.5  11.89 units
System safety stock in 2 warehouses
S S A  S S B  1 5 . 7 7  1 1 . 8 9  2 7 . 6 6 u n it s
9-23
 Risk Pooling (Cont’d)
Safety stock in 1 warehouse
S S c  1 .9 6 ( 1 9 .0 7 ) 0 .5  2 6 .4 3 u n its

Total inventory
Two
AIL = Regular stock + Safety stock warehouses

AIL = 59.75 + 27.66 = 87.41 units

In a one-warehouse channel
AIL = 42.56 + 26.43 = 68.99 units
Conclusion There is a reduction in the average
inventory level of an item as the number of stocking
points in the supply channel is decreased. In this
example, both regular stock and safety stock decline.
9-24
9-77
 Virtual Inventories
•Stockouts are filled from other stocking locations in
the distribution network
• Customers assigned to a primary stocking location
• Backup locations are usually determined by
“zoning” rules
• Expectation is that lower system-wide inventories
can be achieved while maintaining or improving
stock availability levels
• Total distribution costs should be lower to support
the cross filling of customer demand

9-25
 Cross Filling Among 2
Stocking Locations
Stock Stock
location A
assignment
location B

assignment
Primary

Primary
Secondary
assignment
Demand 1 Demand 2
Virtual Inventories 9-26
 Regular Stock in 2 Locations
•Meaning of regular stock Stock Stock

•How it varies with:

location A location B

assignment

assignment
Primary

Primary
Demand dispersion Secondary
assignment

Demand 1 Demand 2
Method of stock control
Fill rate

Virtual Inventories
9-27
9-82
 Stock Control Methods
and Regular Stock
If control is EOQ-based, average inventory level (AIL) is
EOQ
formula 
0.5

2S D




AIL  Q  IC
 
   kD0.5
2 2
AIL is a function of
demand with
If stock-to-demand control exponents ranging
from 0.5 to 1.0
A IL  k D 1 .0
Virtual Inventories
9-28
 Observation about
Regular Stock
A system of multiple stocking locations
will carry its maximum regular stock
when demand is balanced among them

Virtual Inventories
9-29
 Fill Rate and Regular Stock
Cross filling increases regular stock as lower fill rates
are specified

Example

•2 locations
•Demand is dispersed 50 and 150
•Fill rate is 90%
•Stocking policy is D0.5 with k=1

Virtual Inventories
9-30
 Example (Cont’d)
No cross filling Cross filling

Location A Location B Location A Location B

Demand 1 50 0 45a 5b
Demand 2 0 150 15 135
Total 50 150 60 140
Regular stock 7.1 12.2 7.7 11.8
System inv. 19.3 19.5
a50x.90=45
b[50x(1-0.90)]x0.905
Regular stock increases
with cross filling
Virtual Inventories
9-31
9-87
 Safety Stock in 2 Locations Stock Stock
locationA
locationA locationB
locationB

assignment

assignment
Primary
•Meaning of safety stock

Primary
Secondary

•Safety stock depends on

assignment

Demand 1 Demand 2

Demand dispersion (variance is proportional

to (demand)
Fill rate
Observation
A system of multiple stocking
locations will carry its minimum
safety stock when demand is
balanced among them
Virtual Inventories
9-32
9-89
 Safety Stock in 2 Locations
Example

•2 locations
•Weekly demand is (50, 150) and standard
deviation is (5, 15)
•Lead time is 1 week
•Fill rate (FR) is 95%
•z is 1.65 for 95% stocking level (demand normally
distributed)
•Inventory control is EOQ based i.e. D0.5 with k=1
Virtual Inventories 9-33
 Safety Stock for 2 Locations
No cross filling Cross filling

Location A Location B Location A Location B

Std. Dev. 1 5 0 4.7500 0.2375
Std. Dev. 2 0 15 0.7125 14.2500
Combined 5 15 5.4 14.3
Safety stock 8.3 24.8 7.9 23.5
System inv. 33.1 31.4

Safety stock decreases

with cross filling

Virtual Inventories SS  z(sd ) LT

9-34
9-92
 Turnover Ratio
A n n u a l s a le s
T u rn o v e r ra ti o 
A v e ra g e i n v e n to ry
A fruit grower stocks its dried fruit products in 12 warehouses
around the country. What is the turnover ratio for the
distribution system?

Ware- Annual Average Ware- Annual Average

house warehouse inventory house warehouse inventory
no. throughput, $ level, $ no. throughput, $ level, $
1 21,136,032 2,217,790 7 43,105,917 6,542,079
2 16,174,988 2,196,364 8 47,136,632 5,722,640
3 78,559,012 9,510,027 9 24,745,328 2,641,138
4 17,102,486 2,085,246 10 57,789,509 6,403,076
5 88,228,672 11,443,489 11 16,483,970 1,991,016
6 40,884,400 5,293,539 12 26,368,290 2,719,330
Totals 425,295,236 43,701,344

$425,295,236
TO ratio   9.7 $ are at cost
$43,701,344 9-35
 A table entry is the proportion of the

Areas under area under the curve from a z of 0 to a

positive value of z. To find the area
from a z of 0 to a negative z, subtract the
tabled value from 1.

Standardized z
0.0
0.1
.00
0.5000
0.5398
.01
0.5040
0.5438
.02
0.5080
0.5478
.03
0.5120
0.5517
.04
0.5160
0.5557
.05
0.5199
0.5596
.06
0.5239
0.5636
.07
0.5279
0.5675
.08
0.5319
0.5714
.09
0.5359
0.5753

Normal 0.2
0.3
0.4
0.5793
0.6179
0.6554
0.5832
0.6217
0.6591
0.5871
0.6255
0.6628
0.5910
0.6293
0.6664
0.5948
0.6331
0.6700
0.5987
0.6368
0.6736
0.6026
0.6406
0.6772
0.6064
0.6443
0.6808
0.6103
0.6480
0.6844
0.6141
0.6517
0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224

Distribution 0.6
0.7
0.8
0.9
0.7257
0.7580
0.7881
0.8159
0.7291
0.7611
0.7910
0.8186
0.7324
0.7642
0.7939
0.8212
0.7357
0.7673
0.7967
0.8238
0.7389
0.7704
0.7995
0.8264
0.7422
0.7734
0.8023
0.8289
0.7454
0.7764
0.8051
0.8315
0.7486
0.7794
0.8078
0.8340
0.7517
0.7823
0.8106
0.8365
0.7549
0.7852
0.8133
0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997 9-36
9-104
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998
Unit Normal
Loss
Integrals

9-37
9-105