McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2 Inventory Management and Risk Pooling.

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