McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2
InventoryManagementand Risk Pooling
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2.1 IntroductionWhy Is Inventory Important?
Distribution and inventory (logistics) costs are quite substantial
Total U.S. Manufacturing Inventories ($m): 1992-01-31: $m 808,773 1996-08-31: $m 1,000,774 2006-05-31: $m 1,324,108
Inventory-Sales Ratio (U.S. Manufacturers): 1992-01-01: 1.56 2006-05-01: 1.25
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GM’s production and distribution network 20,000 supplier plants 133 parts plants 31 assembly plants 11,000 dealers
Freight transportation costs: $4.1 billion (60% for material shipments)
GM inventory valued at $7.4 billion (70%WIP; Rest Finished Vehicles)
Decision tool to reduce: combined corporate cost of inventory and transportation.
26% annual cost reduction by adjusting: Shipment sizes (inventory policy) Routes (transportation strategy)
Why Is Inventory Important?
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Why Is Inventory Required?
Uncertainty in customer demandShorter product life cyclesMore competing products
Uncertainty in suppliesQuality/Quantity/Costs/Delivery Times
Delivery lead times Incentives for larger shipments
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Holding the right amount at the right time is difficult!
Dell Computer’s was sharply off in its forecast of demand, resulting in inventory write-downs 1993 stock plunge
Liz Claiborne’s higher-than-anticipated excess inventories 1993 unexpected earnings decline,
IBM’s ineffective inventory management 1994 shortages in the ThinkPad line
Cisco’s declining sales 2001 $ 2.25B excess inventory charge
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Inventory Management-Demand Forecasts
Uncertain demand makes demand forecast critical for inventory related decisions:What to order?When to order?How much is the optimal order quantity?
Approach includes a set of techniquesINVENTORY POLICY!!
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Supply Chain Factors in Inventory Policy
Estimation of customer demand Replenishment lead time The number of different products being considered The length of the planning horizon Costs
Order cost: Product cost Transportation cost
Inventory holding cost, or inventory carrying cost: State taxes, property taxes, and insurance on inventories Maintenance costs Obsolescence cost Opportunity costs
Service level requirements
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2.2 Single Stage Inventory Control
Single supply chain stage Variety of techniques
Economic Lot Size Model Demand Uncertainty Single Period Models Initial Inventory Multiple Order Opportunities Continuous Review Policy Variable Lead Times Periodic Review Policy Service Level Optimization
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EOQ: Costs
FIGURE 2-4: Economic lot size model: total cost per unit time
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Demand Uncertainty
The forecast is always wrong It is difficult to match supply and demand
The longer the forecast horizon, the worse the forecast It is even more difficult if one needs to predict
customer demand for a long period of time Aggregate forecasts are more accurate.
More difficult to predict customer demand for individual SKUs
Much easier to predict demand across all SKUs within one product family
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Single Period Models
Short lifecycle productsOne ordering opportunity onlyOrder quantity to be decided before
demand occurs
Order Quantity > Demand => Dispose excess inventory
Order Quantity < Demand => Lose sales/profits
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Single Period Models Using historical data
identify a variety of demand scenarios determine probability each of these scenarios will occur
Given a specific inventory policy determine the profit associated with a particular scenario given a specific order quantity
weight each scenario’s profit by the likelihood that it will occur determine the average, or expected, profit for a particular ordering
quantity.
Order the quantity that maximizes the average profit.
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ObservationsThe optimal order quantity is not necessarily
equal to forecast, or average, demand. As the order quantity increases, average
profit typically increases until the production quantity reaches a certain value, after which the average profit starts decreasing.
Risk/Reward trade-off: As we increase the production quantity, both risk and reward increases.
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What If the Manufacturer Has an Initial Inventory?
Trade-off between:Using on-hand inventory to meet demand and
avoid paying fixed production cost: need sufficient inventory stock
Paying the fixed cost of production and not have as much inventory
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Multiple Order OpportunitiesREASONS To balance annual inventory holding costs and annual fixed order
costs. To satisfy demand occurring during lead time. To protect against uncertainty in demand.
TWO POLICIES Continuous review policy
inventory is reviewed continuously an order is placed when the inventory reaches a particular level or reorder point. inventory can be continuously reviewed (computerized inventory systems are
used)
Periodic review policy inventory is reviewed at regular intervals appropriate quantity is ordered after each review. it is impossible or inconvenient to frequently review inventory and place orders if
necessary.
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Optimal inventory policy assumes a specific service level target.
What is the appropriate level of service? May be determined by the downstream
customerRetailer may require the supplier, to maintain a
specific service levelSupplier will use that target to manage its own
inventoryFacility may have the flexibility to choose the
appropriate level of service
Service Level Optimization
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Trade-Offs
Everything else being equal:the higher the service level, the higher the
inventory level. for the same inventory level, the longer the
lead time to the facility, the lower the level of service provided by the facility.
the lower the inventory level, the higher the impact of a unit of inventory on service level and hence on expected profit
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Retail Strategy
Given a target service level across all products 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 marginhigh volumelow variabilityshort lead time
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Target inventory level = 95% across all products.
Service level > 99% for many products with high profit margin, high volume and low variability.
Service level < 95% for products with low profit margin, low volume and high variability.
Profit Optimization and Service Level
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2.3 Risk Pooling
Demand variability is reduced if one aggregates demand across locations.
More likely that high demand from one customer will be offset by low demand from another.
Reduction in variability allows a decrease in safety stock and therefore reduces average inventory.
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Demand Variation
Standard deviation measures how much demand tends to vary around the averageGives an absolute measure of the variability
Coefficient of variation is the ratio of standard deviation to average demandGives a relative measure of the variability,
relative to the average demand
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2.4 Centralized vs. Decentralized Systems
Safety stock: lower with centralization Service level: higher service level for the same
inventory investment with centralization Overhead costs: higher in decentralized system Customer lead time: response times lower in the
decentralized system Transportation costs: not clear. Consider
outbound and inbound costs.
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Inventory decisions are given by a single decision maker whose objective is to minimize the system-wide cost
The decision maker has access to inventory information at each of the retailers and at the warehouse
Echelons and echelon inventoryEchelon inventory at any stage or level of the system
equals the inventory on hand at the echelon, plus all downstream inventory (downstream means closer to the customer)
2.5 Managing Inventory in the Supply Chain
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Echelon Inventory
FIGURE 2-13: A serial supply chain
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More than One Facility at Each Stage
Echelon inventory at the warehouse is the inventory at the warehouse, plus all of the inventory in transit to and in stock at each of the retailers.
Similarly, the 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 minus all items that are backordered.
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Warehouse Echelon Inventory
FIGURE 2-14: The warehouse echelon inventory
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2.6 Practical Issues Periodic inventory review. Tight management of usage rates, lead times, and
safety stock. Reduce safety stock levels. Introduce or enhance cycle counting practice. ABC approach. Shift more inventory or inventory ownership to
suppliers. Quantitative approaches. FOCUS: not reducing costs but reducing inventory levels. Significant effort in industry to increase inventory turnover
LevelInventoryAverage
SalesAnnualRatioTurnoverInventory
__
___
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Inventory Turnover Ratios for Different Manufacturers
Industry Upper quartile Median Lower quartile
Electronic components and accessories
8.1 4.9 3.3
Electronic computers 22.7 7.0 2.7
Household audio and video equipment
6.3 3.9 2.5
Paper Mills 11.7 8.0 5.5
Industrial chemicals 14.1 6.4 4.2
Bakery products 39.7 23.0 12.6
Books: Publishing and printing
7.2 2.8 1.5
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2.7 Forecasting
RULES OF FORECASTING The forecast is always wrong. The longer the forecast horizon, the
worse the forecast. Aggregate forecasts are more accurate.
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Utility of Forecasting
Part of the available tools for a managerDespite difficulties with forecasts, it can be
used for a variety of decisionsNumber of techniques allow prudent use
of forecasts as needed
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Techniques Judgment Methods
Sales-force composite Experts panel Delphi method
Market research/survey Time Series
Moving Averages Exponential Smoothing
Trends Regression Holt’s method
Seasonal patterns – Seasonal decomposition Trend + Seasonality – Winter’s Method Causal Methods
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The Most Appropriate Technique(s)
Purpose of the forecastHow will the forecast be used?Dynamics of system for which forecast will
be madeHow accurate is the past history in
predicting the future?
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SUMMARY
Matching supply with demand a major challenge Forecast demand is always wrong Longer the forecast horizon, less accurate the
forecast Aggregate demand more accurate than
disaggregated demand Need the most appropriate technique Need the most appropriate inventory policy
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