INVENTORY MANAGEMENT

AND RISK POOLING

Prepared by

Jitesh Mohnot
CONTENTS OF THE TOPIC
Economic Lot size model
Single Period model with probabilistic demand
Multiple order opportunities
P & Q system
Safety stock
Variable lead times
Service level
Risk Pooling

Contd
CONTENTS OF THE TOPIC
Multifacility serial supply chain
Bull-Whip effect
Inventory classification
ABC
VED
FSN
Vendor Managed Inventory (VMI)
 Introduction and review

Inventory is one of the dominant cost

Manager have to maintain balance

between customer satisfaction and
minimium system cost and ensure that
correct inventory level should reach at
right place in right time
 Several forms of
inventory in supply
chain
Raw material
W.I.P
Finished product
inventory
 Why to hold Inventory
Unexpected change in customer
demand,
a) short P.L.C,
b) presence of similar products in
market
Uncertainty in the quantity and
quality of the supply, supplier
costs, and delivery time.
Lead time
Economies of scale offered by
transport companies.
 Key issues to explore
What to order?
When to order?
What is the relation between
forecast demand and optimum
order quantity,
Should the quantity demanded
be shorter, greater or equal to
forecasted demanded quantity?
 Inventory Policy: key
determinants
Customer demand & its variability
 ORDERING COST
Transportation cost
Product cost
Economies of scale
Larger the order quantity, smaller is the per unit size

HOLDING/CARRYING COST
Taxes
Insurance on inventories
Maintenance cost
Obsolescence cost
Changes in prices price prompts
Opportunity costs RoI on something else instead of
inventory
SINGLE STAGE Inventory control
We start by considering
inventory management in a
single supply - chain stage.
There are variety of techniques
depending on the characteristics
of that stage.
The Economic Lot Size
Model
(Ford Harris, 1915)
 ASSUMPTIONS

1.The firm knows with certainty

then annual usage of particular
item of inventory.
2.The rate at which firm uses
inventory is steady over time.
3.The orders placed to replenish
inventory stocks are received at
exactly that point in time when
inventories reach zero.
Some more assumptions
Demand is constant = D
 The Goal of the
model
We want to determine the optimal
number of units to order so that we
minimize the annual purchasing &
carrying cost while meeting all the
demand (i.e. without storage).
 EOQ
Economic Order
quantity
Economic order quantity
is the level of inventory that
minimizes total inventory
holding costs and ordering
costs. It is one of the oldest
classical production
scheduling models.
 Inventory level as a function of time

Zero inventory ordering

Order Size
property
Average
Inventory

Time

Saw toothed
inventory pattern
 We refer to the time between two successive
replenishments as a cycle time - T.
Thus, total inventory cost (TC) in a cycle of
length T is

K + hTQ/2 = TC

F.C is
charged
once per
Fixed cost = K
order
holding cost = h per
unit per day
Order units is fixed =
Q
Average inventory level
= Q/2
What will be total cost (TC) per unit
of time
 Since the inventory level changes
from Q to 0 during a cycle of length
T, and demand is constant at a rate
of D units per unit time, it must be
that Q=TD. Thus we can divide the
cost above by T, or , equivalently,
Q/D, to get the average total cost per
unit of time:

KD/Q + hQ/2
The simple model provides two important insights:
1. An optimum policy balances inventory holding cost per
unit time with setup cost per unit time. Indeed, setup cost
per unit time = KD/Q, while holding cost per unit time =
hQ/2.
Thus as one increase the order quantity Q, inventory
holding costs per unit of time increase while setup costs
per unit of time decrease.
The optimum order quantity is achieved at the point at
which inventory setup cost per unit of time (KD/Q)
equals inventory holding cost per unit of time
(hQ/2).That is

KD/Q = hQ/2

Q = 2kD/h
 2. Sensitivity analysis
b 0.5 0.8 0.9 1 1.1 1.2 1.5 2
Increas 25 2.5% 0.5% 0 0.4% 1.6% 8.9% 25%
e in %
cost

Explanation on
the next slide
 Total inventory cost is insensitive to order
quantities; that is , changes in order quantities
have a relatively small impact on annual setup
costs and inventory holding costs.
To illustrate this issue, consider a decision
maker that places an order quantity Q that is
a multiple b of the optimum order quantity Q*.
In other words, for a given b, the quantity is
Q= bQ*.
Thus b=1 implies that the decision maker
orders the EOQ. if b=1.20 or 0.80 the decision
maker orders 20% more or less then the
optimum order quantity
 Example.
Calculate EOQ, A Limited sells
2,25,000 unit of wrist watch per
annum. The unit cost per watch Rs
1000. the cost of placing an order is
Rs 500 , and carrying cost 10% .
Also find number of order to be
placed per year?
Multiple order opportunities
In some situations, demand is
random & manufacturer has a fixed
delivery lead time, so distributor has
to hold inventory.
Reasons for distributer to hold
inventory are:
To satisfy demand during lead time,
To protect against uncertainty of demand
To balance annual inventory holding and
annual fixed order costs.
But the question is when & how much to
order
 Policies that are adopted by
distributers
Continuous review policy
Inventory is reviewed continously, and an
order is placed when the inventory
reaches a particular level.
Periodical review policy
Inventory reviewed after some interval of
time.
 Continuous review policy
Provides more responsive inventory system
Assumptions .
Daily demand is random and follows a
normal distribution,
Every time an order is placed distributer
pays F.C,k,+V.C
Inventory holding cost is charged per item
per unit time,
Inventory level is continuously reviewed.
 Cont.
Chance of order lost,
The distributer specifies required
service level,(for ex. If distributor
want proportion of lead time in which
demand is met out of stock is 95%
.thus, the required service level is
95% in this case.
In this we use following information

AVG=average daily demand faced by the

distributer
STD=standard deviation of daily demand
faced by the distributer,
L=replenishment lead time from the
supplier to the distributor in days
h=cost of holding one unit of the product for
one day at the distributer
=service level. This implies that the
probability of stocking out is 1-
 Concept of Inventory
Position
The inventory position at any point in
time is the actual inventory at the
warehouse plus items ordered by the
distributor that have not yet arrived
minus items that are backordered.
 Policy adopted by the
distributor
For single period inventory model: In
this model when inventory was below
a certain level, we ordered enough to
raise the inventory up to another
higher level.
For continuous review model:In this
model,we employ a similar approach
known as(Q,R)policy-whenever
inventory level falls to a recorder
level R,place an order for Q unit.
 The reorder level R consist of two
components
1. Average Inventory
2. Safety Stock
 Average Inventory
The average inventory during lead time,which is
the product of average daily demand and the lead
time. This ensures that when the distributor
places an order, the system has enough inventory
to cover expected demand during lead time.
The average demand during lead time is exactly
L*AVG
(Where L=Replenishment lead time from the
supplier to the distributor in days,
AVG=Average daily demand faced by the
distributor)
 Safety Stock

The second component represent the safety stock,

which is the amount of inventory that the distributor
needs to keep at the warehouse and in the pipeline
to protect against deviation from average demand
durig lead time. The quantity is calculated as follows:
Z*STD*L
Where z is a constant, refered to as the safety factor.
This constant is associated with the service level.
Thus, the recorder level is equal to
L*AVG+Z*STD*l
 Service level and the Service
Factor,Z
Service level 90% 91% 92% 93% 94% 95% 96% 97%
98% 99% 99.9%
Z 1.29 1.34 1.41 1.48 1.56 1.65 1.75 1.88
2.05 2.33 3.08
The safety factor Z is chosen from
statistical tables to ensure that the
probability of stockouts during lead time is
exactly 1 . This implies that the
recorder level must satisfy:
Pr(demand during lead time
L*AVG+z*STD*l) =1-
The above table shown provides a list
of Z values for different values of the
service level
 Rajat

SAFETY STOCK
 WHAT IS SAFETY STOCK ?

Safety stock carried to

satisfy demand that
exceeds the amount
forecasted for a given
period.
 Reasons for safety stock
The main goal of safety stocks is
to absorb the variability of the
customer demand. Indeed, the
Production Planning is based on
a forecast, which is different form
the real demand. By absorbing
these variations, safety stock
improves the customer service
level.
 Factors that influence the
required level of safety stock
The appropriate level of safety stock is
determined by the following two
factors:

1 The uncertainty of both demand and

supply.

2 The desired level of product availbility.

 Uncertainty of demand and
supply
As the uncertainty of supply or demand
grows, the required level of safety stocks
increases.
- Consider the sale of Palm personal digital
assistants at B&M Office Supplies.
When a new Palm model is introduced, demand is
highly uncertain. B&M thus carries a much higher
level of safety stock relative to demand.
As the markets reaction to the new model
becomes clearer, uncertainty is reduced and
demand is easier to predict.
 As the desired level of product
availability increses, the required
level of safety stock also increases. If
B&M targets a higher level of product
availability for the new Palm model,
it must carry a higher level of safety
stock for that model.
 Desired level of product
availability
Measuring product availability
Product availability reflects a
firms
ability to fill a customer order out
of available stock. A stockout
results if a customer order arrives
when product is not available.
 Some of the important measures
1> Product fill rate (fr) it is the
fraction of product demand is satisfied
from product in stock. Fill rate should be
measured over specified amounts of
demand rather than time.
Thus, it is more appropriate to measure fill
rate over every milion units of demand
rather than every month. Fill rate is
equivalent to the probability that product
demand is supplied from available stock.
 EXAMPLE
Assume that B&M provides Palms to
90% of its customers from stock,
with the remaining 10% lost to a
neighboring competitor because of a
lack of available stock.
In this case B&M achieves a fill rate
of 90%.
 2> ORDER FILL RATE It is the
fraction of orders that are filled from
available stock. Order fill rate should
also be measured over a specified
number of orders rather than time.
In a multiproduct scenario, an order
is filled from stock only if all products
in the order can be supplied from the
available stock.
 EXAMPLE
Assume that a customer may order a
palm along with a calculator. The
order is filled from stock only if both
the palm and the calculator are
available through the store.
Order fill rates tend to be lower than
product fill rates because all products
must be in stock for an order to be
filled.
 3> CYCLE SERVICE LEVEL (CSL)- It is the
fraction of replenishment cycle that ends
with all the customer demand being met.
A replenishment cycle is the interval
between two successive replenishment
deliveries. The CSL is equal to the
probability of not having a stockout in a
replenishment cycle.
CSL should be mesured over a specified
number of replenishment cycles.
 EXAMPLE
If the manager at B&M manages
stock such
that the store does not run out of
stock in 6 out of 10 replenishment
cycles, the store achieves a CSL of
60%. Observe that a CSL of 60%
typically results in a much higher fill
rate.
 Replenishment Policies
A replenishment policy consists of
decisions regarding when to reorder and
how much to reorder. These decisions
determine the cycle and safety stocks
along with the product fill rate (fr) and
Cycle Service Level.
It may take any of several forms. We will
conisder two types:
1. Continuous review
2. Periodic review.
 Continuous review
Stock is contineously tracked and an
order for a lot size Q is placed when the
stock declines to the reorder point (ROP).
Ex.- the store manager at B&M who
continuously tracks the stock of Palms. He
orders 600 Palms when the stock drops
below 400.
In this case, the size of the order does not
change from one order to the next.
 Periodic review
Stock status is checked at regular periodic
intervals and an order is placed to raise
the stock level to a specified threshold
Ex- Consider the purchase of film at B&M. the
store manager does not track film stock
continuously. Every Saturday , employees check
film stock and the manager orders enough so
that the available stock and the size of the order
total equals 1,000 films. In this case the time
between orders is fixed.
 Evaluating Safety Inventory Given
an Inventory Policy
Assume that weekly demand for MOUSE at
B&M Computer World is normally distributed ,
with a mean of 2,500 and a standard deviation
of 500. the manufacturer takes two weeks to
fill an order placed by the B&M manager.
The store manager currently orders 10,000
Mouse when the stock on hand drops to 6,000.
Evaluate the safety stock carried by B&M and
the avarage stock carried by B&M. Also
evaluate the averge time spent by a Mouse at
B&M.
 Solution
Under this replenishment policy,we have
Average demand per week,D = 2,500
Standard deviation of weekly demand, D
= 500
Average lead time for replenishment , L =
2 weeks
Reorder point (ROP) = 6,000
Average lot size,Q = 10,000
Safety stock = Reorder Point Expected
demand during lead time
= 6000 5000 = 1000
B&M thus carries a safety stock of 1000 mouses
cycle stock = avg. lot size / 2
= 10000/2 = 5000
Avg. stock = cycle stock + safety stock
5000 + 1000 = 6000
B&M thus carries an avg. of 6000 mouse in
stock.
To determine average time spent by
Mouse at B&M
Average flow time = avg. stock /
throughput
=
6000/2500 = 2.4 weeks

Each Mouse thus spends an average

of 2.4 weeks at B&M.
VARIABLE LEAD TIME
In many cases, the assumption that
delivery lead time to warehouse is fixed
and known in advance does not
necessarily hold. In many practical
situations , the lead time to the
warehouse may be random or unknown
in advance.
In these cases we
R= AVG*AVGL + z calculate
AVGL*STD +lead time
AVG*STD
Where AVG*AVGL represents average
demand during lead time .
 Periodic Review Policy
In real life situation , the inventory level is
reviewed periodically at regular intervals and
an example appropriate quantity is ordered
after each review. If these intervals are
relatively short or are more than required it
makes sense to modify the version of the
periodic review policy .
Also most important is that , if there is larger
time between the successive reviews of
inventory , it makes sense to order after an
inventory level review.
Inventory level as a function of time in a periodic review
policy
 Ritu

SERVICE
. LEVEL
 .INTRODUCTION
Service level is used in
supply chain management and in
inventory management to measure
the performance of inventory system.

.Objective of this inventory

optimization is to determine the
optimal inventory policy given a
specific service level target.
 SERVICE
LEVEL
Sometimes this is determined by the
downstream customer.

The retailer can require the facility, for

example, the supplier, to maintain a specific
level of service and the supplier will use that
target to manage its own inventory.

The facility has the flexibility to choose the

appropriate level of service.
*The lower the inventory level, the higher
the impact of a unit of inventory on
service level and hence on expected profit.

*Everything else being equal, service level

will be higher for product with:-
* High profit margin
* High volume
*Low variability
*Short lead time
 Risk Pooling
One of the most important tools to address
variability in supply chain is the concept of
risk pooling.
Risk pooling suggests that demand
variability is reduced if one aggregates
demand across locations.
This is true since, as we aggregate demand
across different locations, it becomes more
likely that high demand by one customer
will be offset by low demand from another.
 Practical Issues
Perform periodic inventory review
Provide tight management of usage rates, lead times
and safety stock
Reduce safety level stock
Introduce cycle counting practice
Follow ABC approach
Shift more inventory to suppliers
Follow quantitative approaches

Inventory turnover ratio = Annual sales/Avg inventory

level
Inventory classification
 ABC approach
Class A high revenue 70 to 80 % of
sales
20 % of inventory SKUs
High frequency periodic review
Class B 15 % of annual sales
Periodic review
Class C 5 % of sales
If expensive hold no inventory
If inexpensive keep high inventory
 FSN analysis
Fast Moving
Slow Moving
Non Moving
 ABC + FSN
Case of Amazon.com
Amazon distinguishes between 2
types of inventory for books & other
products like DVDs

1. Fast moving High volume inventory

stored
2. Slow moving Low volume no
inventory stored
 VED classification
Vital products (eg life saving drugs)
Essential
Desirable
Bull Whip effect
 Supply Chain Management and Uncertainty
Inventory and back-order levels fluctuate considerably
across the supply chain even when customer demand
doesnt vary
The variability worsens as we travel up the supply
chain
Multi-
Forecasting doesnt help!
Wholesale
tier Manufacture Retailer Consume
Supplier Distributor
s r s s rs

Sales
Sales
Sales

Sales

Time Time Time

Time

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Bullwhip Effect
Factors Contributing to the Bullwhip

Demand forecasting practices

Min-max inventory management (reorder points to
bring inventory up to predicted levels)
Lead time
Longer lead times lead to greater variability in
estimates of average demand, thus increasing
variability and safety stock costs
Batch ordering
Peaks and valleys in orders
Fixed ordering costs
Impact of transportation costs (e.g., fuel costs)
Sales quotas
Price fluctuations
Promotion and discount policies
Lack of centralized information

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Taming the Bullwhip

Four critical methods for reducing the Bullwhip effect:

Reduce uncertainty in the supply chain
Centralize demand information
Keep each stage of the supply chain provided with up-to-date
customer demand information
More frequent planning (continuous real-time planning the
goal)
Reduce variability in the supply chain
Every-day-low-price strategies for stable demand patterns
Reduce lead times
Use cross-docking to reduce order lead times
Use EDI techniques to reduce information lead times
Eliminate the bullwhip through strategic partnerships
Vendor-managed inventory (VMI)
Collaborative planning, forecasting and replenishment (CPFR)

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