Asset & Liabilities Management Chapter 3

7/29/2019 Asset & Liabilities Management Chapter 3

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Chapter 3

Inventory Management

In

Supply Chains


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Outline of the Presentation

Introduction to Inventory Management

The Effect of Demand Uncertainty

(s,S) Policy

Risk Pooling

Centralized vs. Decentralized Systems

Practical Issues in Inventory Management


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Inventory

Where do we hold inventory?Suppliers and manufacturers

warehouses and distribution centers

retailers

Types of InventoryWIP

raw materials

finished goods

Why do we hold inventory?Economies of scale

Uncertainty in supply and demand


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Goals:

Reduce Cost, Improve Service

By effectively managing inventory:

Xerox eliminated $700 million inventory from its

supply chain

Wal-Mart became the largest retail company utilizingefficient inventory management

GM has reduced parts inventory and transportation

costs by 26% annually


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Goals:

Reduce Cost, Improve Service

By not managing inventory successfully

In 1994, IBM continues to struggle with shortages in their

ThinkPad line (WSJ, Oct 7, 1994)

In 1993, Liz Claiborne said its unexpected earning decline is the

consequence of higher than anticipated excess inventory (WSJ,

July 15, 1993)

In 1993, Dell Computers predicts a loss; Stock plunges. Dell

acknowledged that the company was sharply off in its forecast of

demand, resulting in inventory write downs (WSJ, August 1993)


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Understanding Inventory

The inventory policy is affected by:

Demand Characteristics

Lead Time

Number of Products

Objectives

Service level

Minimize costs

Cost Structure


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Cost Structure

Order costs

Fixed

Variable

Holding CostsInsurance

Maintenance and Handling

Taxes

Opportunity Costs

Obsolescence


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EOQ: A Simple Model

Book Store Mug SalesDemand is constant, at 20 units a week

Fixed order cost of $12.00, no lead time

Holding cost of 25% of inventory valueannually

Mugs cost $1.00, sell for $5.00

QuestionHow many, when to order?


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EOQ: A View of Inventory

Time

Inventory

Order

Size

Note: No Stockouts

Order when no inventory

Order Size determines policy

Avg. Inven


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EOQ: Calculating Total Cost

Purchase Cost Constant

Holding Cost: (Avg. Inven) * (Holding Cost)

Ordering (Setup Cost):Number of Orders * Order Cost

Goal: Find the Order Quantity that

Minimizes These Costs:


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EOQ:Total Cost

Order Quantity

Annual Cost

Holding Cost

Total Cost Curve

Order (Setup) Cost

Optimal

Order Quantity (Q*)


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EOQ: Optimal Order Quantity

Optimal Quantity (Q):

So for our problem, the optimal quantity is

316

2 Annual Demand Ordering CostQ

Holding Cost


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EOQ: Important Observations

Tradeoffbetween set-up costs and holding costs

when determining order quantity. In fact, we

order so that these costs are equal per unit time

Total Cost is not particularly sensitive to the

optimal order quantityOrder

Qty

Cost

Increase

Order

Qty

Cost

Increase

50% 25% 110% 1%

80% 3% 120% 2%

90% 1% 150% 8%

100% 00.0% 200% 25%


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The Effect of

Demand Uncertainty

Most companies treat the world as if it were predictable:

Production and inventory planning are based on forecasts of

demand made far in advance of the selling season

Companies are aware of demand uncertainty when they create a

forecast, but they design their planning process as if the forecast

truly represents reality

Recent technological advances have increased the level of

demand uncertainty:

Short product life cyclesIncreasing product variety


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Demand Forecasts

The three principles of all forecasting techniques:

Forecasting is always wrong

The longer the forecast horizon the worst is the forecastAggregate forecasts are more accurate


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(s, S) Policies

For some starting inventory levels, it is better tonot start production

If we start, we always produce to the same level

Thus, we use an (s,S) policy. If the inventorylevel is below s, we produce up to S.

s is the reorder point, and Sis the order-up-to level

The difference between the two levels is driven bythe fixed costs associated with ordering,transportation, or manufacturing


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A Multi-Period Inventory Model

Often, there are multiple reorder opportunities

Consider a central distribution facility which orders from amanufacturer and delivers to retailers. The distributor

periodically places orders to replenish its inventory


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Case Study: Electronic

Component Distributor

Electronic Component Distributor

Parent company HQ in Japan with world-

wide manufacturingAll products manufactured by parent

company

One central warehouse in U.S.


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Supply Chain and Product Flow


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Demand Variability: Example 1

Product Demand

150

75

225

100

150

50

125

61

4853

104

45

0

50

100

150

200

250

Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar

Month

Demand

(000's)


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Demand Variability: Example 1

Histogram for Value of Orders Placed in a Week

0

5

10

15

20

25

$25

,000

$50,000

$75,

000

$100

,000

$125

,000

$150

,000

$175

,000

$200

,000

Value of Orders Placed in a Week

Frequency


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Reminder:

The Normal Distribution

0 10 20 30 40 50 60Average = 30

Standard Deviation = 5

Standard Deviation = 10


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The distributor holds inventory to:

Satisfy demand during lead time

Protect against demand uncertainty

Balance fixed costs and holding costs


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The Multi-Period Inventory Model

Normally distributed random demand

Fixed order cost plus a cost proportional to amount

ordered.

Inventory cost is charged per item per unit timeIf an order arrives and there is no inventory, the order is

lost

The distributor has a required service level. This is

expressed as the the likelihood that the distributor will notstock out during lead time.

Intuitively, what will a good policy look like?


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A View of (s, S) Policy

Time

InventoryL

evel

S

s

0

Lead

Time

Lead

Time

Inventory Position


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The (s,S) Policy

(s, S) Policy: Whenever the inventory position

drops below a certain level, s, we order to raise

the inventory position to level S.

The reorder point is a function of:

The Lead Time

Average demand

Demand variabilityService level


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Notation

AVG = average daily demand

STD = standard deviation of daily demand

LT = replenishment lead time in days

h = holding cost of one unit for one day

SL = service level (for example, 95%). This implies that

the probability of stocking out is 100%-SL (for example,

5%)

Also, the Inventory Position at any time is the actualinventory plus items already ordered, but not yet delivered.


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Analysis

The reorder point has two components:

To account for average demand during lead time:

LT AVG

To account for deviations from average (we call this safety stock)

where z is chosen from statistical tables to ensure that the

probability of stockouts during leadtime is100%-SL.

dSafety Stock z LT


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Example

The distributor has historically observed weekly demandof:

AVG = 44.6 STD = 32.1Replenishment lead time is 2 weeks, and desired service

level SL = 97%Average demand during lead time is:

44.6 2 = 89.2

Safety Stock is:

1.88

32.1

2 = 85.3Reorder point is thus 175, or about 3.9 weeks of supply atwarehouse and in the pipeline


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Model Two:

Fixed Costs

In addition to previous costs, a fixed cost K is paid every

time an order is placed.

We have seen that this motivates an (s,S) policy, where

reorder point and order quantity are different.

The reorder point will be the same as the previous model,

in order to meet meet the service requirement:What about the order up to level?

( )( ) ( )( )S LT Avg z Avg LT


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Model Two:

The Order-Up-To Level

We have used the EOQ model to balance fixed, variable

costs:

If there was no variability in demand, we would order Qwhen inventory level was at LT AVG. Why?

There is variability, so we need safety stock

The total order-up-to level is:

2 ( )K AvgQ

h

( )( )z Avg LT

{ ,( )( )} ( )( )S Max Q LT Avg z Avg LT


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Model Two: Example

Consider the previous example, but with the followingadditional info:

fixed cost of $4500 when an order is placed

$250 product cost

holding cost 18% of product

Weekly holding cost:h = (.18 250) / 52 = 0.87

Order quantity

Order-up-to level:s + Q = 85 + 679 = 765

(2)(4500)(44.6)6790.87Q


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Market Two

Risk Pooling

Consider these two systems:

Supplier

Warehouse One

Warehouse Two

Market One

Market Two

Supplier Warehouse

Market One


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Risk Pooling

For the same service level, which system will

require more inventory? Why?

For the same total inventory level, which system

will have better service? Why?

What are the factors that affect these answers?


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Risk Pooling Example

Compare the two systems:

two products

maintain 97% service level

$60 order cost

$.27 weekly holding cost

$1.05 transportation cost per unit in decentralized

system, $1.10 in centralized system

1 week lead time


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Week 1 2 3 4 5 6 7 8

Prod A,

Market 1

33 45 37 38 55 30 18 58

Prod A,

Market 2

46 35 41 40 26 48 18 55

Prod B,

Market 1

0 2 3 0 0 1 3 0

Product B,

Market 2

2 4 0 0 3 1 0 0


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Warehouse Product AVG STD CV

Market 1 A 39.3 13.2 .34

Market 2 A 38.6 12.0 .31

Market 1 B 1.125 1.36 1.21

Market 2 B 1.25 1.58 1.26


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Warehouse Product AVG STD CV s S Avg.

Inven.

%

Dec.

Market 1 A 39.3 13.2 .34 65 158 91

Market 2 A 38.6 12.0 .31 62 154 88

Market 1 B 1.125 1.36 1.21 4 26 15

Market 2 B 1.25 1.58 1.26 5 27 15

Cent. A 77.9 20.7 .27 118 226 132 26%

Cent B 2.375 1.9 .81 6 37 20 33%

Ri k P li


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Risk Pooling:

Important Observations

Centralizing inventory control reduces both safety

stock and average inventory level for the same

service level.

This works best for

High coefficient of variation, which reduces required

safety stock.

Negatively correlated demand. Why?

What other kinds of risk pooling will we see?

Ri k P li


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Risk Pooling:

Types of Risk Pooling

Risk Pooling Across Markets

Risk Pooling Across Products

Risk Pooling Across Time

Daily order up to quantity is: LT AVG + z AVG LT

10 1211 13 14 15

Demands

Orders


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To Centralize or not to Centralize

What is the effect on:

Safety stock?

Service level?Overhead?

Lead time?

Transportation Costs?


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Supplier

Warehouse

Retailers

Centralized Systems


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Decentralized System

Supplier

Warehouses

Retailers


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Centralized Distribution Systems

Question: How much inventory should management keep

at each location?

A good strategy:

The retailer raises inventory to level Sr each period

The supplier raises the sum of inventory in the retailer

and supplier warehouses and in transit to Ss

If there is not enough inventory in the warehouse to

meet all demands from retailers, it is allocated so thatthe service level at each of the retailers will be equal.


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Inventory Management: Best Practice

Periodic inventory review policy (59%)

Tight management of usage rates, leadtimes and safety stock (46%)

ABC approach (37%)

Reduced safety stock levels (34%)

Shift more inventory, or inventoryownership, to suppliers (31%)

Quantitative approaches (33%)


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Industry Upper

Quartile

Median Lower

QuartileDairy Products 34.4 19.3 9.2

Electronic Component 9.8 5.7 3.7

Electronic Computers 9.4 5.3 3.5Books: publishing 9.8 2.4 1.3

Household audio &video equipment

6.2 3.4 2.3

Household electrical

appliances

8.0 5.0 3.8

Industrial chemical 10.3 6.6 4.4

Inventory Turn Over Ratios

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