Inventory Management - Cycle and Safety Inventory

Managing Economies of Scale
11 in a Supply Chain
Cycle Inventory
"Copyright © 2016 Pearson India Education Services Pvt. Ltd".

PowerPoint presentation
to accompany
Chopra, Meindl, and Kalra
Supply Chain Management, 6e
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Y S L E©A2016 I N G Education,Supply
R N Pearson Inc. Chain Management, 6e Sunil Chopra, Peter Meindl, Dharam Vir Kalra P E A11R– 1S O N
Learning Objectives
1. Balance the appropriate costs to choose the optimal
lot size and cycle inventory in a supply chain.

2. Understand the impact of quantity discounts on lot
size and cycle inventory.
3. Devise appropriate discounting schemes for a
supply chain.
4. Understand the impact of trade promotions on lot
size and cycle inventory.
5. Identify managerial levers that reduce lot size and
cycle inventory in a supply chain without increasing
cost.
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Role of Cycle Inventory
in a Supply Chain
• Lot or batch size is the quantity that a stage of a

supply chain either produces or purchases at a time
• Cycle inventory is the average inventory in a supply
chain due to either production or purchases in lot
sizes that are larger than those demanded by the
customer
Q: Quantity in a lot or batch size
D: Demand per unit time
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Inventory Profile

FIGURE 11-1
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in a Supply Chain

lot size Q
Cycle inventory = =
2 2
average inventory
Average flow time =
average flow rate
Average flow time cycle inventory Q

resulting from cycle = =
inventory demand 2D
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in a Supply Chain

lot size Q
Cycle inventory = =
2 2
For lot sizes of 1,000 and daily demand of 100
average inventory
Average
Average flow
flow time =
time
Qaverage1,000
flow= rate
resulting from cycle = = 5 days
inventory 2D 2´100
Average flow time cycle inventory Q
resulting from cycle = =
inventory demand 2D
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in a Supply Chain
• Lower cycle inventory has

– Shorter average flow time
– Lower working capital requirements
– Lower inventory holding costs
• Cycle inventory is held to
– Take advantage of economies of scale
– Reduce costs in the supply chain
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in a Supply Chain
• Average price paid per unit purchased is a key

cost in the lot-sizing decision
Material cost = C
• Fixed ordering cost includes all costs that do
not vary with the size of the order but are
incurred each time an order is placed
Fixed ordering cost = S
• Holding cost is the cost of carrying one unit in
inventory for a specified period of time
Holding cost = H = hC
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in a Supply Chain
• Following costs considered in lot sizing

decisions
Average price per unit purchased, $C/unit
Fixed ordering cost incurred per lot, $S/lot
Holding cost incurred per unit per year,

$H/unit/year = hC
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in a Supply Chain
• Primary role of cycle inventory is to allow

different stages to purchase product in lot sizes
that minimize the sum of material, ordering,
and holding costs
• Ideally, cycle inventory decisions should
consider costs across the entire supply chain
• In practice, each stage generally makes its own
supply chain decisions
• Increases total cycle inventory and total costs
in the supply chain
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Key Point

Cycle inventory exists in a supply chain
because different stages exploit
economies of scale to lower total cost. The
costs considered include material cost,
fixed ordering cost, and holding cost.
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in a Supply Chain
• Economies of scale exploited in three

typical situations
1. A fixed cost is incurred each time an order
is placed or produced
2. The supplier offers price discounts based
on the quantity purchased per lot
3. The supplier offers short-term price
discounts or holds trade promotions
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Estimating Cycle Inventory Related
Costs in Practice
• Inventory Holding Cost

– Cost of capital
E D
WACC = (R f + b ´ MRP) + Rb (1– t)
D+ E D+E
where
E = amount of equity
D = amount of debt
Rf = risk-free rate of return
b = the firm’s beta
MRP = market risk premium
Rb = rate at which the firm can borrow money
t = tax rate
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Costs in Practice
• Inventory Holding Cost

– Obsolescence cost
– Handling cost
– Occupancy cost
– Miscellaneous costs
• Theft, security, damage, tax, insurance
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Costs in Practice
• Ordering Cost

– Buyer time
– Transportation costs
– Receiving costs
– Other costs
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Economies of Scale
to Exploit Fixed Costs
• Lot sizing for a single product (EOQ)

D =
Annual demand of the product
S =
Fixed cost incurred per order
C =
Cost per unit
h =
Holding cost per year as a fraction of product
cost
• Basic assumptions
– Demand is steady at D units per unit time
– No shortages are allowed
– Replenishment lead time is fixed
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Economies of Scale
to Exploit Fixed Costs
• Minimize

– Annual material cost
– Annual ordering cost
– Annual holding cost
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Lot Sizing for a Single Product
Annual material cost = CD

D
Number of orders per year =
Q
æ Dö
Annual ordering cost = ç ÷ S
èQø
æQ ö æQö
Annual holding cost = ç ÷ H = ç ÷ hC
è2ø è2ø
æ Dö æQ ö
Total annual cost, TC = CD + ç ÷ S + ç ÷ hC
èQø è2ø
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FIGURE 11-2
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• The economic order quantity (EOQ)

2DS
Optimal lot size, Q* =
hC
• The optimal ordering frequency
D DhC
n* = =
Q* 2S
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EOQ Example

Annual demand, D = 1,000 x 12 = 12,000 units
Order cost per lot, S = $4,000
Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2
2 ´12,000 ´ 4,000
Optimal order size = Q* = = 980
0.2 ´ 500
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EOQ Example

Q * 980
Cycle inventory = = = 490
2 2
D
Number of orders per year = = 12.24
Q*
D æ Q *ö
Annual ordering and holding cost = S +ç ÷ hC = $97,980
Q* è 2 ø
Q* 490
Average flow time = = = 0.041= 0.49 month
2D 12,000
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Key Point

Total ordering and holding costs are
relatively stable around the economic
order quantity. A firm is often better
served by ordering a convenient lot size
close to the EOQ rather than the precise
EOQ.
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Key Point

If demand increases by a factor of k, the
optimal lot size increases by a factor of k.
The number of orders placed per year
should also increase by a factor of k .
Flow time attributed to cycle inventory
should decrease by a factor of k .
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EOQ Example

Lot size reduced to Q = 200 units
D æQ ö
Annual inventory-related costs = S + ç ÷ hC = $250,000
Q è2ø
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Lot Size and Ordering Cost
• If the lot size Q* = 200, how much should

the ordering cost be reduced?
Desired lot size, Q* = 200
Annual demand, D = 1,000 × 12 = 12,000 units
Unit cost per computer, C = $500
Holding cost per year as a fraction of inventory value, h = 0.2
hC(Q*)2 0.2 ´ 500 ´ 2002

S= = = $166.7
2D 2´12,000
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Key Point

To reduce the optimal lot size by a factor
of k, the fixed order cost S must be
reduced by a factor of k2.
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Production Lot Sizing
• The entire lot does not arrive at the same time
• Production occurs at a specified rate P

• Inventory builds up at a rate of P – D
2DS
QP =
(1– D / P)hC
Annual setup cost Annual holding cost

æ Dö æQP ö
ç P ÷S (1– D / P) ç ÷ hC
èQ ø è 2 ø
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Lot Sizing with Capacity Constraint
• If order size is constrained to K units

and Q > K,
– Compare the cost of ordering K units and the EOQ

– Optimal order size is the minimum of EOQ and
capacity K
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Aggregating Multiple Products
in a Single Order
• Savings in transportation costs

– Reduces fixed cost for each product
– Lot size for each product can be reduced
– Cycle inventory is reduced
• Single delivery from multiple suppliers or
single truck delivering to multiple retailers
• Receiving and loading costs reduced
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Key Point

Aggregating replenishment across
products, retailers, or suppliers in a single
order allows for a reduction in lot size for
individual products because fixed ordering
and transportation costs are now spread
across multiple products, retailers, or
suppliers.
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Lot Sizing with Multiple
Products or Customers
• Ordering, transportation, and receiving

costs grow with the variety of products or
pickup points
• Lot sizes and ordering policy that minimize
total cost
Di: Annual demand for product i
S: Order cost incurred each time an order is placed,
independent of the variety of products in the order
si: Additional order cost incurred if product i is included
in the order
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Lot Sizing with Multiple
Products or Customers
• Three approaches

1. Each product manager orders his or her model
independently
2. The product managers jointly order every
product in each lot
3. Product managers order jointly but not every
order contains every product; that is, each lot
contains a selected subset of the products
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Multiple Products Ordered and
Delivered Independently
Demand

DL = 12,000/yr, DM = 1,200/yr, DH = 120/yr
Common order cost
S = $4,000
Product-specific order cost
sL = $1,000, sM = $1,000, sH = $1,000
Holding cost
h = 0.2
Unit cost
CL = $500, CM = $500, CH = $500
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Multiple Products Ordered and
Delivered Independently
Litepro Medpro Heavypro

Demand per year 12,000 1,200 120
Fixed cost/order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Cycle inventory 548 173 55
Annual holding cost $54,772 $17,321 $5,477
Order frequency 11.0/year 3.5/year 1.1/year
Annual ordering cost $54,772 $17,321 $5,477
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual cost $109,544 $34,642 $10,954
TABLE 11-1
Total annual cost = $155,140
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Lots Ordered and Delivered Jointly
S* = S + sL + sM + sH Annual order cost = S * n

DL hC L DM hCM DH hC H
Annual holding cost = + +
2n 2n 2n
DL hC L DM hCM DH hC H
Total annual cost = + + +S*n
2n 2n 2n
å
k
DL hC L + DM hCM + DH hC H Di hCi
n* = n* = i=1
2S * 2S *
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Products Ordered and Delivered
Jointly

S* = S + sA + sB + sC = $7,000 per order
12,000 ´100 +1,200 ´100 +120 ´100

n* = = 9.75
2 ´ 7,000
Annual order cost = 9.75 x 7,000 = $68,250
Annual ordering
and holding cost = $61,512 + $6,151 + $615 + $68,250
= $136,528
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Products Ordered and Delivered
Jointly

Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 9.75/year 9.75/year 9.75/year
Optimal order size (D/n∗) 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Annual holding cost $61,512 $6,151 $615
TABLE 11-2
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Aggregation with Capacity
Constraint
• W.W. Grainger example

Demand per product, Di = 10,000
Holding cost, h = 0.2
Unit cost per product, Ci = $50
Common order cost, S = $500
Supplier-specific order cost, si = $100
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Constraint

S* = S + s1 + s2 + s3 + s4 = $900 per order
å
4
D1hC1 4 ´10,000 ´ 0.2 ´ 50
n* = i=1
= = 14.91
2S * 2 ´ 900
900
Annual order cost = 14.91´ = $3,355
4
Annual holding hCiQ 671

= = 0.2 ´ 50 ´ = $3,355
cost per supplier 2 2
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Constraint

Total required capacity per truck = 4 x 671 = 2,684 units
Truck capacity = 2,500 units
Order quantity from each supplier = 2,500/4 = 625
Order frequency increased to 10,000/625 = 16
Annual order cost per supplier increases to $3,600
Annual holding cost per supplier decreases to $3,125
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for a Selected Subset
Step 1: Identify the most frequently ordered

product assuming each product is
ordered independently
hCi Di
ni =
2(S + si )
Step 2: For all products i ≠ i*, evaluate the
ordering frequency
hCi Di
ni =
2si
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Step 3: For all i ≠ i*, evaluate the frequency of

product i relative to the most frequently
ordered product i* to be mi
mi = éên ni ùú
Step 4: Recalculate the ordering frequency of the

most frequently ordered product i* to be n
å
l
hCi mi D
n= i=1
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R N Pearson Inc.
(
2 S + å si / mi
Chain Management, 6e
l
i=1 )
Sunil Chopra, Peter Meindl, Dharam Vir Kalra P E A11R– 43S O N

Step 5: Evaluate an order frequency of ni = n/mi and
the total cost of such an ordering policy
læD ö l
TC = nS + å ni si + åç i ÷ hC1
i=1 i-1 è 2ni ø
Tailored aggregation – higher-demand products

ordered more frequently and lower-demand
products ordered less frequently
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Ordered and Delivered Jointly –
Frequency Varies by Order
• Applying Step 1

hC L DL
nL = = 11.0
2(S + sL )
Thus
n = 11.0
hCM DM
nM = = 3.5
2(S + sM )
hC H DH
nL = = 1.1
2(S + sH )
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• Applying Step 2

hCM DM hC H DH
nM = = 7.7 and nH = = 2.4
2sM 2sH
• Applying Step 3
é n ù é11.0 ù é n ù é11.0 ù
mM = ê ú = ê ú = 2 and mH = ê ú = ê ú= 5
ê nM ú ê 7.7 ú ê nH ú ê 2.4 ú
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• Applying Step 4

n = 11.47
• Applying Step 5
nL = 11.47 / yr nM = 11.47 / 2 = 5.74 / yr
nH = 11.47 / 5 = 2.29 / yr
Annual order cost Total annual cost
nS + nL sL + nM sM + nH sH = $65,383.5 $130,767
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Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 11.47/year 5.74/year 2.29/year
Optimal order size (D/n∗) 1,046 209 52
Cycle inventory 523 104.5 26
Annual holding cost $52,307 $10,461 $2,615
TABLE 11-3
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Key Point
A key to reducing cycle inventory is the reduction

of lot size. A key to reducing lot size without
increasing costs is reducing the fixed cost
associated with each lot. This may be achieved
by reducing the fixed cost itself or by aggregating
lots across multiple products, customers, or
suppliers. When aggregating across multiple
products, customers, or suppliers, simple
aggregation is effective when product-specific
order costs are small, and tailored aggregation is
best if product-specific order costs are large.
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Managing Multiechelon
Cycle Inventory
• Multiechelon supply chains have multiple stages

with possibly many players at each stage
• Lack of coordination in lot sizing decisions across
the supply chain results in high costs and more
cycle inventory than required
• The goal is to decrease total costs by
coordinating orders across the supply chain
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Managing Multiechelon
Cycle Inventory

FIGURE 11-6
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12
Managing Uncertainty
in a Supply Chain
Safety Inventory
Learning Objectives
1. Describe different measures of product

availability
2. Understand the role of safety inventory in a
supply chain
3. Identify factors that influence the required
level of safety inventory
4. Utilize available managerial levers to lower
safety inventory without hurting product
availability
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The Role of Safety Inventory

FIGURE 12-1
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• Three key questions

1. What is the appropriate level of product
availability?
2. How much safety inventory is needed for the
desired level of product availability?
3. What actions can be taken to reduce safety
inventory without hurting product availability?
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The Level of Safety Inventory
• Determined by two factors

– The uncertainty of both demand and supply
– The desired level of product availability
• Measuring Demand Uncertainty
D = Average demand per period
sD = Standard deviation of demand (forecast error) per
period
Lead time (L) is the gap between when an order is placed
and when it is received
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Evaluating Demand Distribution
Over L Periods

L L
DL = å Di sL = å i + 2å rijs is j
s 2
i=1 i=1 i> j
DL = DL s L = Ls D
The coefficient of variation
cv = s / m
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Measuring Product Availability
1. Product fill rate (fr)

– Fraction of product demand satisfied from
product in inventory
2. Order fill rate
– Fraction of orders filled from available inventory
3. Cycle service level (CSL)
– Fraction of replenishment cycles that end with
all customer demand being met
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Measuring Product Availability
1. Product fill rate (fr)

– Fraction of product demand satisfied from
product in inventory
replenishment
2. Order fill rate cycle – the interval
between two successive replenishment
– Fraction of orders filled from available inventory
deliveries
3. Cycle service level (CSL)
– Fraction of replenishment cycles that end with
all customer demand being met
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Replenishment Policies
1. Continuous review

– Inventory is continuously tracked
– Order for a lot size Q is placed when the inventory
declines to the reorder point (ROP)
2. Periodic review
– Inventory status is checked at regular periodic
intervals
– Order is placed to raise the inventory level to a
specified threshold
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Determining the Appropriate Level
of Safety Inventory
• Evaluating Safety Inventory Given a

Replenishment Policy
Expected demand during lead time = D x L

Safety inventory, ss = ROP – D x L
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of Safety Inventory
Average demand per week, D = 2,500

Standard deviation of weekly demand, sD = 500
Average lead time for replenishment, L = 2 weeks
Reorder point, ROP = 6,000
Average lot size, Q = 10,000
Safety inventory, ss = ROP – DL = 6,000 – 5,000 = 1,000

Cycle inventory = Q/2 = 10,0002 = 5,000
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of Safety Inventory

Average inventory = cycle inventory + safety inventory
= 5,000 + 1,000 = 6,000
Average flow time = average inventory/throughput

= 6,000/2,500 = 2.4 weeks
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of Safety Inventory
• Evaluating Cycle Service Level Given a

CSL = Prob(ddlt of L weeks ≤ ROP)

CSL = F(ROP, DL, sL) = NORMDIST(ROP, DL, sL, 1)
(ddlt = demand during lead time)
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of Safety Inventory
Q = 10,000, ROP = 6,000, L = 2 weeks

D = 2,500/week, sD = 500
DL = D ´ L = 2 ´ 2,500 = 5,000
s L = Ls D = 2 ´ 500 = 707
CSL = F(ROP, DL, sL) = NORMDIST(ROP, DL, sL, 1)

= NORMDIST(6,000, 5,000, 707, 1) = 0.92
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of Safety Inventory
• Evaluating Required Safety Inventory

Given a Desired Cycle Service Level
Desired cycle service level = CSL

Mean demand during lead time = DL
Standard deviation of demand during lead time = σL
Probability(demand during lead time ≤ DL + ss) = CSL
• Identify safety inventory ss so that
F(DL + ss, DL, sL) = CSL
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of Safety Inventory

DL + ss = F –1(CSL,DL ,s L ) = NORMINV (CSL,DL ,s L )
or
ss = F –1(CSL,DL ,s L ) – DL = NORMINV (CSL,DL ,s L ) – DL
ss = FS–1(CSL) ´ s L = FS–1(CSL) ´ Ls D
= NORMSINV (CSL) ´ Ls D
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of Safety Inventory

D = 2,500/week, sD = 500, CSL = 0.9, L = 2 weeks
DL = DL = 2 ´ 2,500 = 5,000
s L = Ls D = 2 ´ 500 = 707
ss = Fs–1(CSL) ´ s L = NORMSINV (CSL) ´ s L

= NORMSINV (0.90) ´ 707 = 906
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Evaluating Fill Rate Given a
• Expected shortage per replenishment cycle

(ESC) is the average units of demand that
are not satisfied from inventory in stock per
replenishment cycle
• Product fill rate
fr = 1 – ESC/Q = (Q – ESC)/Q
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ò
¥
ESC = (x – ROP) f (x) dx
x=ROP
é æ ss öù æ ss ö
ESC = –ss ê1– Fs ç ÷ú + s L f s ç ÷
êë è s L øúû ès L ø
ESC = –ss[1– NORMDIST(ss / s L ,0,1,1)]

+s L NORMDIST(ss / s L ,0,1,0)
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Lot size, Q = 10,000

Average demand during lead time, DL = 5,000
Standard deviation of demand during lead time, sL = 707
Safety inventory, ss = ROP – DL = 6,000 – 5,000 = 1,000
ESC = –1,000[1– NORMDIST(1,000 / 707,0,1,1)]

+707NORMDIST(1,000 / 707,0,1,0) = 25
fr = (Q – ESC)/Q = 110,000 – 252/10,000 = 0.9975
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FIGURE 12-2
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Key Point

Both fill rate and cycle service level
increase as the safety inventory is
increased. For the same safety inventory,
an increase in lot size increases the fill rate
but not the cycle service level.
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Evaluating Safety Inventory Given
Desired Fill Rate

• Expected shortage per replenishment cycle is
ESC = (1 – fr)Q
• No equation for ss
• Try values or use GOALSEEK in Excel
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Desired Fill Rate

Desired fill rate, fr = 0.975
Lot size, Q = 10,000 boxes
Standard deviation of ddlt, s L = 2 ´ 500 = 707
ESC = (1 – fr)Q = (1 – 0.975)10,000 = 250
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Desired Fill Rate

ESC = 250 = –ss ê1– Fs ç ÷ú + s L f s ç ÷
êë è s L øúû ès L ø
= –ss ê1– Fs ç ÷ú + 707 f s ç ÷
ë è 707 øû è 707 ø
250 = –ss[1– NORMDIST(ss / 707,0,1,1)]

+707NORMDIST(ss / 707,0,1,0)
• Use GOALSEEK to find safety inventory ss = 67 boxes
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Desired Fill Rate

FIGURE 12-3
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Impact of Desired Product Availability
and Uncertainty
• As desired product availability goes up the

required safety inventory increases
Fill Rate Safety Inventory

97.5% 67
98.0% 183
98.5% 321
99.0% 499
99.5% 767
TABLE 12-1
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Key Point

The required safety inventory grows
rapidly with an increase in the desired
product availability.
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Key Point

The required safety inventory increases
with an increase in the lead time and the
uncertainty of periodic demand.
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Impact of Desired Product Availability
and Uncertainty
• Goal is to reduce the level of safety

inventory required in a way that does not
adversely affect product availability
1. Reduce the supplier lead time L
2. Reduce the underlying uncertainty of
demand (represented by sD)
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Benefits of Reducing Lead Time
D = 2,500/week, sD = 800, CSL = 0.95

ss = NORMSINV (CSL) ´ Ls D
= NORMSINV (.95) ´ 9 ´ 800 = 3,948
• If lead time is reduced to one week

ss = NORMSINV (.95) ´ 1´ 800 = 1,316
• If standard deviation is reduced to 400

ss = NORMSINV (.95) ´ 9 ´ 400 = 1,974
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Impact of Supply Uncertainty
on Safety Inventory
• We incorporate supply uncertainty by

assuming that lead time is uncertain
D: Average demand per period

sD: Standard deviation of demand per period
L: Average lead time for replenishment
sL: Standard deviation of lead time
DL = DL s L = Ls D2 + D2 sL2
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Impact of Lead Time Uncertainty
on Safety Inventory
Average demand per period, D = 2,500

Standard deviation of demand per period, sD = 500
Average lead time for replenishment, L = 7 days
Standard deviation of lead time, sL = 7 days
Mean ddlt, DL = DL = 2,500 x 7 = 17,500
Standard deviation of ddlt s L = Ls D2 + D2 sL2

= 7 ´ 5002 + 2,5002 ´ 72
= 17,500
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Impact of Lead Time Uncertainty
on Safety Inventory
• Required safety inventory

ss = FS–1(CSL) ´ s L = NORMSINV (CSL) ´ s L
= NORMSINV (0.90) ´17,500
TABLE 12-2 = 22,491 tablets
sL sL ss (units) ss (days)
6 15,058 19,298 7.72
5 12,570 16,109 6.44
4 10,087 12,927 5.17
3 7,616 9,760 3.90
2 5,172 6,628 2.65
1 2,828 3,625 1.45
0 1,323 1,695 0.68
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Key Point

A reduction in supply uncertainty can help
to dramatically reduce the required safety
inventory without hurting product
availability.
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Impact of Aggregation
on Safety Inventory
• How does aggregation affect forecast

accuracy and safety inventories
Di: Mean weekly demand in region i, i = 1,…, k
si: Standard deviation of weekly demand in region i, i =
1,…, k
rij: Correlation of weekly demand for regions i, j,
1≤i≠j≤k
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on Safety Inventory
k
= å FS–1(CSL) ´ L ´ s i
Total safety inventory

in decentralized option i=1
k
D = å Di ; ( ) = ås i2 + 2å rijs is j ;
C k C
var D
i=1
i=1 i> j
s DC = var DC ( )
DC = kD s DC = ks 2 + k ( k – 1) rs 2
Simplified to s DC = ks D
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on Safety Inventory

k
= å FS–1(CSL) ´ L ´ s DC
Require safety inventory
on aggregation i=1
Holding – cost savings on

aggregation per unit sold
FS–1(CSL) ´ L ´ H æk ö
= ´ ççås i – s D ÷÷
C
DC è i=1 ø
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on Safety Inventory
•

The safety inventory savings on aggregation increase
with the desired cycle service level CSL
• The safety inventory savings on aggregation increase
with the replenishment lead time L
with the holding cost H
with the coefficient of variation of demand (sD/D)
• The safety inventory savings on aggregation decrease as
the correlation coefficients increase
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Impact of Correlation on
Value of Aggregation
Standard deviation of weekly demand, sD = 5;

Replenishment, L = 2 weeks; Decentralized CSL = 0.9
Total required
safety inventory, ss = k ´ Fs–1(CSL) ´ L ´ s D
= 4 ´ Fs–1(0.9) ´ 2 ´ 5
= 4 ´ NORMSINV (0.9) ´ 2 ´ 5 = 36.25 cars
Aggregate r = 0
Standard deviation of
weekly demand at central outlet, s DC = 4 ´ 5 = 10
ss = Fs–1(0.9) ´ L ´ s DC = NORMSINV (0.9) ´ 2 ´10 = 18.12

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Disaggregate Aggregate
r Safety Inventory Safety Inventory
0 36.25 18.12
0.2 36.25 22.93
0.4 36.25 26.88
0.6 36.25 30.33
0.8 36.25 33.42
1.0 36.25 36.25
TABLE 12-3
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on Safety Inventory
• The Square-Root Law

FIGURE 12-4
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• Two possible disadvantages to

aggregation
1. Increase in response time to customer
order
2. Increase in transportation cost to
customer
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Trade-offs of Physical Centralization
• Use four regional or one national distribution center

D = 1,000/week, sD = 300, L = 4 weeks, CSL = 0.95
• Four regional centers
Total required
safety inventory, ss = 4 ´ Fs–1(CSL) ´ L ´ s D
= 4 ´ NORMSINV (0.95) ´ 4 ´ 300 = 3,948
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Trade-offs of Physical Centralization
• One national distribution center, r = 0

Standard deviation
of weekly demand, s DC = 4 ´ 300 = 600
ss = Fs–1(0.95) ´ L ´ s DC
= NORMSINV (0.95) ´ 4 ´ 600 = 1,974
Decrease in holding costs = (3,948 – 1,974) $1,000 x 0.2

= $394,765
Decrease in facility costs = $150,000
Increase in transportation = 52 x 1,000 x (13 – 10)
= $624,000
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Information Centralization
• Online systems that allow customers or

stores to locate stock
• Improves product availability without
adding to inventories
• Reduces the amount of safety inventory
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Specialization
• Inventory is carried at multiple locations

• Should all products should be stocked at every
location?
– Required level of safety inventory
– Affected by coefficient of variation of demand
– Low demand, slow-moving items, typically have a high
coefficient of variation
– High demand, fast-moving items, typically have a low
coefficient of variation
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Impact of Coefficient of Variation on
Value of Aggregation TABLE 12-4
Motors Cleaner
Inventory is stocked in each store

Mean weekly demand per store 20 1,000
Standard deviation 40 100
Coefficient of variation 2.0 0.1
Safety inventory per store 132 329
Total safety inventory 211,200 526,400
Value of safety inventory $105,600,000 $15,792,000
Inventory is aggregated at the DC
Mean weekly aggregate demand 32,000 1,600,000
Standard deviation of aggregate demand 1,600 4,000
Coefficient of variation 0.05 0.0025
Aggregate safety inventory 5,264 13,159
Value of safety inventory $2,632,000 $394,770
Savings
Total inventory saving on aggregation $102,968,000 $15,397,230
Total holding cost saving on aggregation $25,742,000 $3,849,308
Holding cost saving per unit sold $15.47 $0.046
Savings as a percentage of product cost 3.09% 0.15%
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Key Point

The higher the coefficient of variation of
an item, the greater is the reduction in
safety inventories as a result of
centralization.
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R N Pearson Inc. Chain Management, 6e Sunil Chopra, Peter Meindl, Dharam Vir Kalra P E A11R– 100
SON
Specialization

Item Type Centralized Inventories Decentralized Inventories
Fast Moving Predictable Customer willing to pay Low cost
{Low Value} premium?
Slow Moving Low cost Customer willing to pay
Unpredictable {High Value} premium?
FIGURE 12-5
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SON
Product Substitution
• The use of one product to satisfy

demand for a different product
1. Manufacturer-driven substitution
• Allows aggregation of demand
• Reduce safety inventories
• Influenced by the cost differential, correlation
of demand
2. Customer-driven substitution
• Allows aggregation of safety inventory
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SON
Key Point

Manufacturer-driven substitution
increases overall profitability for the
manufacturer by allowing some
aggregation of demand, which reduces the
inventory requirements for the same level
of availability.
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SON
Key Point

Recognition of customer-driven
substitution and joint management of
inventories across substitutable products
allows a supply chain to reduce the
required safety inventory while ensuring a
high level of product availability.
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SON
Component Commonality
• Without common components

– Uncertainty of demand for a component is the
same as for the finished product
– Results in high levels of safety inventory
• With common components
– Demand for a component is an aggregation of the
demand for the finished products
– Component demand is more predictable
– Component inventories are reduced
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SON
Value of Component Commonality
27 servers, 3 components, 3 x 27 = 81 distinct components

Monthly demand = 5,000
Standard deviation = 3,000
Replenishment lead time = 1 month
CSL = 0.95
Total safety inventory

required = 81´ NORMSINV (0.95) ´ 1´ 3,000
= 399,699 units
Safety inventory per
common component = NORMSINV (0.95) ´ 1´ 9 ´ 3,000
= 14,804 units
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SON

With component commonality
• Nine distinct components
Total safety inventory required = 9 ´14,804 = 133,236
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SON

Number of Finished Safety Marginal Reduction Total Reduction in
Products per Component Inventory in Safety Inventory Safety Inventory
1 399,699
2 282,630 117,069 117,069
3 230,766 51,864 168,933
4 199,849 30,917 199,850
5 178,751 21,098 220,948
6 163,176 15,575 236,523
7 151,072 12,104 248,627
8 141,315 9,757 258,384
9 133,233 8,082 266,466
TABLE 12-5
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SON
Key Point

Component commonality decreases the
safety inventory required. The marginal
benefit, however, decreases with
increasing commonality.
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SON
Impact of Replenishment Policies on
Safety Inventory
• Continuous Review Policies

Mean demand during lead time, DL = D ´ L

Standard deviation of demand during lead time, s L = Ls D
ss = FS–1(CSL) ´ s L = NORMSINV (CSL) ´ Ls D ,ROP = DL + ss
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SON
Safety Inventory
• Periodic Review Policies

– Lot size determined by prespecified order-up-to
level (OUL)
T: Review interval
CSL: Desired cycle service level
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SON
Safety Inventory

Probability(demand during L + T ≤ OUL) = CSL
Mean demand during T + L periods, DT +L = (T + L)D

Std dev demand during T + L periods, s T +L = T + Ls D
OUL = DT +L + ss
ss = FS–1(CSL) ´ s D+L = NORMSINV (CSL) ´ s T +L
Average lot size, Q = DT = D ´T
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SON
Safety Inventory

FIGURE 12-6
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SON
Evaluation Safety Inventory for a
Periodic Review Policy
D = 2,500, sD = 500, L = 2 weeks, T = 4 weeks

Mean demand during T + L periods, DT +L = (T + L)D
= (2 + 4)2,500 = 15,000
Std dev demand during T + L periods, s T +L = T + Ls D
= ( )
4 + 2 500 = 1,225
ss = FS–1(CSL) ´ s D+L = NORMSINV (CSL) ´ s T +L

= NORMSINV (0.90) ´1,225 = 1,570 boxes
OUL = DT +L + ss = 15,000 +1,570 = 16,570

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SON
Key Point

Periodic review replenishment policies
require more safety inventory than
continuous review policies for the same
lead time and level of product availability.
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SON
Managing Safety Inventory in a
Multiechelon Supply Chain
• In multiechelon supply chains stages often do not

know demand and supply distributions
• Inventory between a stage and the final customer is
called the echelon inventory
• Reorder points and order-up-to levels at any stage
should be based on echelon inventory
• Decisions must be made about the level of safety
inventory carried at different stages
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SON
The Role of IT in
Inventory Management
• IT systems can help

– Improve inventory visibility
– Coordination in the supply chain
– Track inventory (RFID)
• Value tightly linked to the accuracy of the
inventory information
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SON
Estimating and Managing Safety
Inventory in Practice

1. Account for the fact that supply chain
demand is lumpy
2. Adjust inventory policies if demand is
seasonal
3. Use simulation to test inventory policies
4. Start with a pilot
5. Monitor service levels
6. Focus on reducing safety inventories
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SON
• Safety inventory is carried to satisfy demand

that exceeds the amount forecasted
– Raising the level of safety inventory increases
product availability and thus the margin captured
from customer purchases
– Raising the level of safety inventory increases
inventory holding costs
A L W ACopyright
SON

Inventory Management - Cycle and Safety Inventory

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Managing Economies of Scale

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Average flow time cycle inventory Q

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Average price per unit purchased, $C/unit

Fixed ordering cost incurred per lot, $S/lot

Holding cost incurred per unit per year,

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• The economic order quantity (EOQ)

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• The optimal ordering frequency

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hC(Q*)2 0.2 ´ 500 ´ 2002

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Annual setup cost Annual holding cost

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– Compare the cost of ordering K units and the EOQ

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S* = S + sL + sM + sH Annual order cost = S * n

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12,000 ´100 +1,200 ´100 +120 ´100

Annual order cost = 9.75 x 7,000 = $68,250

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Annual holding hCiQ 671

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Step 4: Recalculate the ordering frequency of the

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Tailored aggregation – higher-demand products

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