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Chapter 2
Inventory Management and Risk Pooling
Background of case and intent Overview of business What does data tell you about Specialty? How much inventory might you expect? What opportunities are there for Custom? Wrap up
McGraw-Hill/Irwin
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Custom Products
Rapid growth, 1/3 of total sales ($133 MM) One customer per product Very high margins High service level 3 plants, co-located with R&D center Each product produced at a single plant
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Specialty Products
Rapid growth, 2/3 of total sales ($267 MM) 6 product families 3 plants, each producing 2 product families 130 customers, 120 products Few big customers Highly volatile demand High service level
Consultant Recommendation
Drop low volume products Improve forecasts Consolidate warehouses
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7 products:
High volume (2) is not very volatile Low volume (5) is very volatile
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Cycle stock
8 504 1232 49 9 28 18 1848
Saf. stock
26 510 990 185 23 160 92 1986
E[I]
34 1014 2222 234 32 188 110 3834
Act. Inv.
72 740 1875 604 55 388 190 3824
Assume base stock model with periodic review Review period = r = ? Lead time = L = ?
E [I ] = r
+ z r + L
Assumes r = 1; L=0.25; and z = 1.8 Cycle stock = r /2
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Wrap Up
Realistic diagnostic exercise In real life: not as clean, more data and more considerations Yet simple models and principles can provide valuable guidance
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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.
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Uncertainty in supplies
Quality/Quantity/Costs/Delivery Times
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Assumptions
D items per day: Constant demand rate Q items per order: Order quantities are fixed, i.e., each time the warehouse places an order, it is for Q items. K, fixed setup cost, incurred every time the warehouse places an order. h, inventory carrying cost accrued per unit held in inventory per day that the unit is held (also known as, holding cost) Lead time = 0 (the time that elapses between the placement of an order and its receipt) Initial inventory = 0 Planning horizon is long (infinite).
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Deriving EOQ
Total cost at every cycle:
K + hTQ 2
Average inventory holding cost in a cycle: Q/2 Cycle time T =Q/D Average total cost per unit time: KD + hQ Q 2
Q* = 2 KD h
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EOQ: Costs
Sensitivity Analysis
Total inventory cost relatively insensitive to order quantities Actual order quantity: Q Q is a multiple b of the optimal order quantity Q*. For a given b, the quantity ordered is Q = bQ*
b Increase in cost .5 25% .8 2.5% .9 0.5% 1 0 1.1 .4% 1.2 1.6% 1.5 8.9% 2 25%
FIGURE 2-4: Economic lot size model: total cost per unit time
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Additional Information
Fixed production cost: $100,000 Variable production cost per unit: $80. During the summer season, selling price: $125 per unit. Salvage value: Any swimsuit not sold during the summer season is sold to a discount store for $20.
Two Scenarios
Manufacturer produces 10,000 units while demand ends at 12,000 swimsuits Profit = 125(10,000) - 80(10,000) - 100,000 = $350,000 Manufacturer produces 10,000 units while demand ends at 8,000 swimsuits Profit = 125(8,000) + 20(2,000) - 80(10,000) - 100,000 = $140,000
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Risk-Reward Tradeoffs
Optimal production quantity maximizes average profit is about 12,000 Producing 9,000 units or producing 16,000 units will lead to about the same average profit of $294,000. If we had to choose between producing 9,000 units and 16,000 units, which one should we choose?
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Risk-Reward Tradeoffs
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Risk-Reward Tradeoffs
Production Quantity = 9000 units
Profit is:
either $200,000 with probability of about 11 % or $305,000 with probability of about 89 %
Observations
The 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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1.29
1.34
1.41
1.48
1.56
1.65
1.75
1.88
2.05
2.33
3.08
z is chosen from statistical tables to ensure that the probability of stockouts during lead time is exactly 1 -
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Inventory level before receiving an order = z STD L Inventory level after receiving an order = Q + z STD L Average Inventory =
Q 2
+ z STD L
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Average monthly demand = 191.17 Standard deviation of monthly demand = 66.53 Average weekly demand = Average Monthly Demand/4.3 Standard deviation of weekly demand = Monthly standard deviation/4.3
Value
44.58
86.20
176
Q=
Order Quantity =
Q =
2 K AVG h
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(s,S) policy
Calculate the Q and R values as if this were a continuous review model Set s equal to R Set S equal to R+Q.
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Average demand = 44.58 x 5 = 222.9 Safety stock = 1.9 32.8 5 Base-stock level = 223 + 136 = 359 Average inventory level = 344.58 + 1.9 32.08 5 = 203.17 2 Distributor keeps 5 (= 203.17/44.58) weeks of supply.
Facility may have the flexibility to choose the appropriate level of service
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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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FIGURE 2-11: Service level inventory versus inventory level as a function of lead time
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 margin high volume low variability short lead time
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Demand Variation
Standard deviation measures how much demand tends to vary around the average
Gives an absolute measure of the variability
New Idea
Replace the 2 warehouses with a single warehouse (located some suitable place) and try to implement the same service level 97 % Delivery lead times may increase But may decrease total inventory investment considerably.
Week Massachusetts New Jersey Total 1 33 46 79
Historical Data
PRODUCT A
2 45 35 80 3 37 41 78 4 38 40 78 5 55 26 81 6 30 48 78 7 18 18 36 8 58 55 113
PRODUCT B
Week Massachusetts New Jersey Total 1 0 2 2 2 3 4 6 3 3 3 3 4 0 0 0 5 0 3 3 6 1 1 2 7 3 0 3 8 0 0 0
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Inventory Levels
Product Average Demand During Lead Time 39.3 1.125 38.6 1.25 77.9 2.375 Safety Stock Reorder Point Q
65 4 62 5 118 6
132 25 31 24 186 33
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Savings in Inventory
Average inventory for Product A:
At NJ warehouse is about 88 units At MA warehouse is about 91 units In the centralized warehouse is about 132 units Average inventory reduced by about 36 percent
Critical Points
The higher the coefficient of variation, the greater the benefit from risk pooling The higher the variability, the higher the safety stocks kept by the warehouses. The variability of the demand aggregated by the single warehouse is lower The benefits from risk pooling depend on the behavior of the demand from one market relative to demand from another risk pooling benefits are higher in situations where demands observed at warehouses are negatively correlated
Reallocation of items from one market to another easily accomplished in centralized systems. Not possible to do in decentralized systems where they serve different markets
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Echelon Inventory
AVG = average demand at the retailer STD = standard deviation of demand at the retailer Reorder point R = Le AVG + z STD Le
FIGURE 2-13: A serial supply chain
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45 45 45 45
1.2 .9 .8 .7
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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.
22.7 6.3
7.0 3.9
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Utility of Forecasting
Part of the available tools for a manager Despite difficulties with forecasts, it can be used for a variety of decisions Number of techniques allow prudent use of forecasts as needed
Techniques
Judgment Methods
Sales-force composite Experts panel Delphi method
Trends
Regression Holts method
Seasonal patterns Seasonal decomposition Trend + Seasonality Winters Method Causal Methods
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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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