Chapter 12 ALKO

The goal of this case is to get students to understand that the value of
centralization of inventory is affected by the coefficient of variation as well as the
correlation of demand. High coefficient of variation products with low correlation
provide the biggest gains from centralization while low coefficient of variation
products with high correlations provide the least value from centralization. The
results for this case are obtained using the accompanying spreadsheet Chapter12Alko.
Status Quo Calculations
The worksheet Demand & Costs evaluates the inventory and transportation costs
for the status quo where each region is served by a local DC. Each region follows a
periodic review policy where an order is placed every 6 days with a replenishment
lead time of 5 days. Given a reorder interval of 6 days, the batch size is 6 days of
demand. The safety inventory in each location (for each product) is calculated using
Equation 12.18. The cycle inventory and safety inventories are evaluated in Cells
C43:G48. They are converted into days of demand in Cells K43:O48. It is interesting
to get the class to observe that the days of safety inventory held is proportional to
the coefficient of variation calculated in Cell C25:G27. The total cost of the status
quo is evaluated in Cell H67 to be $960,326.
Impact of Centralization
The worksheet Central vs. Local details the inventory and financial impact of
centralizing all inventory in an NDC. The mean and standard deviation of centralized
demand is obtained in Cells J16:J21 using Equation 12.13. This is used to evaluate
the cycle and safety inventory (using Equation 12.18) in Cells J35:J40. The costs
from centralizing each part type is obtained in Cells J56:J58 with the total cost in Cell
J59 of $755,164 for the case when demand across all regions is independent. The
net savings from centralization are shown in Cell J60. Tables from row 64 to row 114
show the impact of different cycle service levels and correlation coefficient on the
net savings from centralization.
Observe that as the correlation coefficient increases, the benefit of centralization
declines. As the cycle service level increases, the benefit of centralization grows.
Cells K56:K58 show the marginal savings for each part type. Observe that the
marginal savings from part type 1 (low coefficient of variation) are the lowest while
the marginal savings from part type 7 (high coefficient of variation) are the highest.
This suggests that we should look at options where only some of the products are
centralized. This is because centralization requires the building of a new NDC and
the size of the new NDC is affected by the parts centralized. Centralizing all parts in
an NDC requires an NDC capable of handling about 700K units per year at a cost of

about $1.1 million (from Figure 12-8). This translates to a net investment of
$850,000 because we save $50,000 per DC that is closed.

Centralize only Parts 3 & 7

The worksheet Option 1.0 shows all calculations for the case where parts of type 1
are decentralized while parts of type 3 and 7 are centralized at the NDC. Cell H68
shows the total operating cost of such a system to be $765,064 for the case where
all demands are independent. This option thus results in a net savings of $195,262.
The NDC to be built, however, is now much smaller and requires a smaller
investment. The total units shipped through the NDC in this case are 358,759
requiring an NDC investment of only about $650,000. Clearly the return on
investment in this case is higher than if all products are centralized.
Centralize only Parts 7
The worksheet Option 1.0a shows all calculations for the case where parts of type 1
and 3 are decentralized while parts of type 7 are centralized at the NDC. Cell H68
shows the total operating cost of such a system to be $828,921 for the case where
all demands are independent. This option thus results in a net savings of $131,405.
The NDC to be built, however, is now much smaller and requires a smaller
investment. The total units shipped through the NDC in this case are 165,820
requiring an NDC investment of only about $300,000.
Centralize Parts 3 & 7 and Combine Regions 4 and 5
The worksheet Option 2 shows all calculations for the case where parts of type 1 are
decentralized (regions 4 and 5 are combined) while parts of type 3 and 7 are
centralized at the NDC. We make the assumption that transportation costs do not
change into region 5. Cell H68 shows the total operating cost of such a system to be
$751,714 for the case where all demands are independent. This option thus results
in a net savings of $208,612.
Summary of Results
These results are summarized in worksheet Summary for the case where demand
across all regions is independent.

Any positive correlation will reduce the benefit of centralization.