Chapter- 2

Inventory Management and Risk

Pooling
 Inventory Management
• Introduction
• General motors in 1984:
Ø GM’s production and distribution network
Ø20,000 supplier plants
Ø133 parts plants
Ø31 assembly plants
Ø11,000 dealers
ØFreight transportation costs: $4.1 billion (60% for
material shipments)
ØGM inventory valued at $7.4 billion (70%WIP; Rest
Finished Vehicles)
v Response: Inventory Management in Supply Chain
Ø Most manufacturing organizations are networks of
manufacturing and distribution that produce raw
material, transform them in to intermediate finished
products and distribute the finished products to
customers
Ø Often multiple managers are responsible for
manufacturing, operations, logistics, material
distribution and transportation are responsible for
different parts of SC.
Ø This leads to difficulty in developing a coherent
inventory handling policy
Ø The average carrying cost of inventory across all
manufacturing industries in the US is 30 – 35 % of its
value
Ø What does that mean?
Ø Savings from reduced inventory results in increased
profit
Definitions
Ø Inventory – A physical resource that a firm holds
in stock with the intent of selling it or
transforming it in to a more valuable state
Ø Inventory system – A set of policies and controls
that monitors levels of inventory and determines
what levels should be maintained, when stock
should be replenished, and how large orders
should be
Types of Inventory
Ø Raw materials
Ø Purchased parts and supplies
Ø Work- in Process (partially completed) products
(WIP)
Ø Items being transported
Ø Tools and equipments
Inventory Costs
ØCarrying cost
üCost of holding an item in inventory
– Obsolescence
– Handling costs
– Occupancy costs
– Theft, security, damage, tax, insurance
ØOrdering cost
üCost of replenishing inventory
– Buyer time
– Transportation costs
– Receiving costs
– Unique other costs
vShortage cost – temporary or permanent loss of sales when
demand can not be met
Ø Goal of Inventory Management is:
…cont’d
• minimize cost of holding inventory
• maximize service to customer
• BOTH ARE CONFLICTING IN NATURE!
Ø Where do we hold inventory?
• Suppliers and manufacturers
• Warehouses and distribution centers
• Retailers
Ø Types of inventory: General classification
• WIP
• Raw materials
• Finished goods
 Reasons for Inventories
•Improve customer service
-Provides immediacy in product availability
•Encourage production, purchase, and transportation economies
-Allows for long production runs
-Takes advantage of price-quantity discounts
-Allows for transport economies from larger shipment sizes
•Act as a hedge against price changes
-Allows purchasing to take place under most favorable price
terms
•Protect against uncertainties in demand and lead times
-Provides a measure of safety to keep operations running when
demand levels and lead times cannot be known for sure
•Act as a hedge against contingencies
-Buffers against such events as strikes, fires, and disruptions in
supply
 Component of Inventory Decisions
Ø Cycle inventory
§ Average amount of inventory used to satisfy demand
between shipments
§ Depends on lot size
Ø Safety inventory
§ Inventory held in case demand exceeds expectations
§ Costs of carrying too much inventory versus cost of losing
sales
Ø Seasonal inventory
§ Inventory build up to counter predictable variability in
demand
§ Cost of carrying additional inventory versus cost of
flexibility production
 Overall trade – off
Ø Responsiveness (to customer needs) versus efficiency of
supply chain
v More inventory – greater responsiveness but greater
cost
v Less inventory – lower cost but lower responsiveness
 Value creation through Inventory handling
Remember this?
v Quality
ü Delivering right quality product to the customer
v Speed
ü Ensuring products are delivered in time
v Flexibility
ü Ability to take into account any variation in demand
up and down the supply chain
v Cost
ü Keeping the inventory handling cost as low as possible
q Factors Affecting Inventory Policy
§ Demand characteristics: known in advance or random

§ Lead time

§ Number of different products stored in the

warehouse

§ Economies of scale offered by supplier & transport

§ Length of planning horizon

§ Service level desired

 Design of Inventory Management systems: Macro Issues
Ø Need for Finished Goods Inventory
§ Need to satisfy internal or external customers?
§ Can some one else in the value chain carry the inventory?
Ø Ownership of Inventories
§ Proper accountability to minimize losses
Ø Specific contents of inventories
§ Knowing your inventory – visibility
Ø Location of inventories
§ Placing inventory at the right place for quick order
Ø Tracking
§ Locating where your inventory is to eliminate uncertainty and
timely delivery
 …cont’d
Ø Order quantity
§ Economic Order Quantity (EOQ)

Ø Order Timing
§ Reorder Point
 Supply chain management and Uncertainty
(Bullwhip effect)
Ø Bullwhip effect
§demand information is distorted as it moves away from the end
use customer
§higher safety stock inventories are stored to compensate
Ø Inventory and back-order levels fluctuate considerably across the
supply chain even when customer demand doesn't vary
Ø The variability worsens as we travel up the supply chain
 How to count Bullwhip Effect?
Ø JIT
- Difficult to implement – cost
Ø AGILITY- quickly respond to customer and market demands
- A key characteristic of an agile organization is flexible.
Agility should not be confused with leanness. Lean is about
doing more with less
Can your company be lean and agile at the same time?
Achieving Agility
§ Market sensitivity
§ Virtual supply chain
§ Process integration
§ Networking
 Inventory related issues
i. lack of information sharing
Ø An effective supply chain performance is measured
based on different nodes joint performance
Ø Often each node performs its task independently
without keeping in mind the impact of its activity will
have on the overall supply chain network
Ø e.g. Indiana based company based started cutting
inventory at manufacturing level. Therefore its final
assembly unit and point of distribution had to keep
inventory high to meet customer needs
Ø Therefore companies need to develop a metrics in which
entire supply chain performance is measured based on
the overall performance
 …cont’d
ii. Inadequate Definition of a Customer Service
Ø Ideally a Supply chain performance must be measured
based on its responsiveness to customers. Customer
expect their products to be delivered in time
Ø A dealer’s order normally involves multiple orders. E.gg a
PC dealer may order printer’s, computers and software in
one order. The dealer is then selling these stocks to
customers, supplier can ship these products separately
without adversely effecting dealers business
Ø A customer who is ordering items online may demand all
products to be delivered as a single shipment
 …cont’d
iii. Inefficient information systems
Ø The database of different sites in a supply chain that
informs of environment, inventory, future production
plans should be inter linked
Ø Delay in information would make it possible to make
short production cycles leading to gross errors in
inventory forecast errors
Ø E.g. Northern California base PC manufacturer developed a
production plan. It depends on information about inventory status
that was collected from databases at a number of sites and
functions. This forced the manufacturer to plan on monthly basis
resulting in longer planning cycles which caused forecast errors.
Manufacturing ends up building wrong products leading to high
inventory
 …cont’d
iv. Ignoring the Impact of Uncertainty
Ø There are many sources of uncertainty in a supply chain
§ Supplier lead time
§ Quality of incoming material
§ Manufacturing process time
§ Customer demand etc.
Ø To reduce the impact of uncertainty a SC Manger should
first understand the sources of these uncertainties and
magnitude of their impact. It is easier said than done.
Ø Consequently companies may over stock and
understock others. They can miscalculate lead times for
material movement along the SC and invest in wrong
resources for performance improvement
Ø Emphasis of JIT is to closely monitor the performance
 …cont’d
v. Product–Process Design without SC Consideration
Ø Many new approaches to product process design been
introduced. Products can be manufactured and assembled
at a fast rate but implications of supply chain inventory are
usually ignored or poorly understood. The saving that is
made through improved production process design could
be lost.
Ø Similarly product introduction in to a market, without
proper supply chain planning can create problems like
product unavailability, excessively long delivery lead times
and unnecessary expediting costs etc.
Ø A US computer company made printers for worldwide distribution.
The printers have a few country specific components such as power
supply and owners manual. The US factory produces to meet
demand forecasts but by the time printers reach regional
 Deterministic and Stochastic Models
Ø If demand and lead time are known (constant), they are
called deterministic models
Ø If they are treated as random (unknown), they are called
stochastic
Ø Each random variable can have a probability distribution
Ø Attention is focused on the distribution of demand
during the lead time
Deterministic inventory models: Economic Lot Size Model

(Economic Order Quantity (EOQ))

Ø One of the important problems in inventory control is to balance
the costs of holding inventories (holding costs) with the costs of
placing orders for inventory replenishment (ordering costs).

Ø The EOQ approach is designed to achieve such a balance.

Ø The EOQ approach is based on the following assumptions:
• Inventory is consumed at a constant rate.
• Costs do not vary overtime.
• Lead Time is known and constant.
• Order costs, holding costs and unit price are constant.
• Holding costs are proportional to value of stocks held, similarly, order
cost varies proportionately with price.
The Inventory Cycle
 Stochastic inventory models:
Lot size - Reorder Point (Q, R) Systems
Ø In the simple EOQ model, demand is known and fixed.
However, often demand is random. The lot size-reorder
point (Q, R) systems allow random demand.
Ø There are two decision variables in a (Q, R) system
§ Order quantity, Q and
§ Reorder point, R
Ø The Q, R policy is as follows
§ When the level of on-hand inventory hits reorder point,
R place an order with lot size Q.
Ø In the simple EOQ model, R is the demand during the lead
time
Ø However, in presence of random demand, R usually
includes a safety stock, in addition to the expected
demand during the lead time. So,
Ø Reorder point, R= lead-time demand + safety stock
Ø In the simple EOQ model, only holding cost and ordering
costs are considered.
Ø In presence of random demand, the demand may
sometimes be too high and exceed the inventory on hand.
The result is stock-out
Ø For each unit of shortage, a penalty cost p is charged.
Penalty cost = p per unit
• The goal of a lot size-reorder point system is to find Q and
R so that the total annual holding cost, ordering cost and
stock-out cost is minimized
 Safety stock and Service Level
Ø Safety stock determines the chance of a stockout during
lead time
Ø The complement of this chance is called the service level
Ø Service level is defined as the probability of not incurring
a stockout during any one lead time
Ø The higher the probability inventory will be on hand, the
more likely customer demand will be met
Ø Service level of 90% means there is a 0.90 probability that
demand will be met during lead time and 0.10 probability
of stock out
 Forecasting Models
Ø Qualitative or judgmental methods
§ Delphi method
§ It is a process of gaining consensus from a
group of experts while maintaining their
anonymity.
§ It is forecasting techniques applied to subjective
nature demand values.
§ It is useful when there is no historical data from
which to develop statistical models and when
managers inside the firm have no experience.
§ Several knowledgeable persons are asked to
provide estimates of demand or forecasts of
possible advances of technology.
Ø Nominal Group Method
§ Like the Delphi Method, the Nominal Group
Method also involves a panel of experts.
§ However, the major difference between the two
is that while under the Delphi Technique, experts
are not allowed to discuss among themselves,
for assessing the questions, under the Nominal
Group Method, experts are given the opportunity
to discuss among themselves.
 Risk Pooling
Consider these two systems:

Warehouse one Market one

Supplier

Warehouse two Market two

Market one

Supplier Warehouse
Market two

Questions:
Q1: For the same service level, which system will require more inventory?
Q2: For the same total inventory level, which system will have better service?
 What is Risk Pooling?
Ø The idea behind risk pooling is redesign the supply
chain, the production process, or the product to either
reduce the uncertainty the firm faces or to hedge
uncertainty so that the firm is in a better position to
mitigate the consequence of uncertainty.

• Location pooling

• Product pooling

• Lead time pooling

• Capacity pooling
 Advantages/Disadvantages
Advantages Disadvantages
Location pooling • Reduce demand variability • Creates distance
• Reduce expected inventory between inventory and
investment needed to achieve a customers
target service level
Product pooling • Reduction in demand variability • Potentially degrades
• Better performance in terms of product functionality
matching supply and demand
Lead time pooling • Decrease lead time • Extra costs of operating
• Keep inventory closer to distribution center
customer • Additional
• Reduce inventory investment transportation cost

Capacity pooling • Accommodate demand • Large costs to have

uncertainty flexibility
Thank You!