Introduction to inventory management

And risk pooling

Inventory management :-

- in many industries supply chains, inventory is one of the dominant costs. For many managers , supply chain management is sysnonymous with reducing inventory levels in the supply chain. The goal of effective inventory management in the supply chain is to have the correct inventory at the right place at right time to minimize system costs while satisfying customer service requirements .

- Inventory can appear in many places in supply chain,and in serval forms:-

1- Raw material inventory.

2- work-in-process(WIP) inventory.

3- Finished product inventory.

Each of these needs its own inventory control mechanism or approach.

Types of Inventory How Inventory is Used:-

Anticipation or seasonal inventory.

Safety stock: buffer demand fluctuations.

Lot-size or cycle stock: take advantage of quantity discounts or purchasing efficiencies.

Pipeline or transportation inventory.

Speculative or hedge inventory protects against some future event, e.g. labor strike.

Maintenance, repair, and operating (MRO) inventories.

Objectives of Inventory Management:-

Provide acceptable level of customer service (on-time delivery).

Allow cost-efficient operations.

Minimize inventory investment.

Relevant Inventory Costs :-

Item Cost : Cost per item plus any other direct costs associated with getting the item to the plant.

Holding Cost : Capital, storage, and risk cost typically stated as a % of the unit value.

Ordering Cost : Fixed, constant dollar amount incurred for each order placed.

Shortage Cost : Loss of customer goodwill, back order handling, and lost sales .

EOQ Total Cost ( Economic Order Quantity)

Economic Order Quantity

EOQ Assumptions:

Demand is known & constant - no safety stock is required

Lead time is known & constant

No quantity discounts are available

Ordering (or setup) costs are constant

All demand is satisfied (no shortages)

The order quantity arrives in a single shipment

EOQ: Total Cost Equation:-

TCEOQ=(DQ S)+(Q2 H )WhereTC= total annual costD= annual demandQ=quantity to be orderedH=annual holding costS= ordering or setup cost

Role of Inventory in Services:

• Decoupling inventories.

• Seasonal inventories.

• Speculative inventories.

• Cyclical inventories.

• In-transit inventories.

• Safety stocks.

considerations in Inventory Systems:-

• Type of customer demand.

• Planning time horizon .

• Replenishment lead time .

• Constraints and relevant costs .

The Effect of Demand Uncertainty:-

The previous model illustrates the trade-offs between setup costs and inventory holding costs. It ignores, however, issues such as demand uncertainty and forecasting. hulced, many companies treat the world as if it were predictable, making production IIlId inventory decisions based on forecasts of the demand made far in advance of the

:a'lling season. Although these companies are aware of demand uncertainty when they I'f'l'ale a forecast, they design their planning processes as if the initial forecast was an urcurate representation of reality. In this case, one needs to remember the following principles of all forecasts:-

1- The forecast is always wrong .2- The longer the forecast horizon,

the worse the forecast.3- Aggregate forecasts are more accurate.

Single Period Models:-

To better understand the impact of demand uncertainty, we consider aseries of increasingly detailed and complex situations. To start, we consider a product that has a short lifecycle and hence the firm has only one ordering opportunity. Thus, before demand occurs, the firm must decide how much to stock in order to meet demand. If the firm stocks too much, it will be stuck with excess inventory it has to dispose of. If the firm stocks too little, it will forgo some sales, and thus some profits.Using historical data, the firm can typically identify a variety of demand scenariosand determine a likelihood or probability that each of these scenarios will occur. Observe that given a specific inventory policy, the firm can determine the profit associated with a particular scenario. Thus, given a specific order quantity, the firm can weight each scenario's profit by the likelihood that it will occur and hence determine the average, or expected, profit for a particular ordering quantity. It is thus natural for the firm to order the quantity that maximizes the average profit.

There are at least three reasons why the distributor holds inventory:-

1- Satisfy demand occurring during lead time. Since orders aren't met immediately, inventory must be on hand to meet customer demand that is realized between the time that the distributor places an order and the time that the ordered inventory arrives.

2- To protect against uncertainty in demand.3- To balance annual inventory holding costs and

'annual fixed order costs. We have seen that more frequent orders lead to lower inventory levels and thus lower inventory holding costs, but they also lead to higher annual fixed order costs.

The specific inventory policy that the dis- tributor should apply is not simple. To manage inventory effectively, the distributor needs to decide when and how much to order. We distinguish between two types of policies:

1-Continuous review policy:-

in which inventory is reviewed continuously, and an order is placed when the inventory reaches a particular level, or reorder point. This type of policy is most appropriate when inventory can be continuously reviewed For example, when computerized inventory systems are used .

We first consider a system in which inventory is continuously reviewed. Such a review syslem typically provides a more responsive inventory management strategy than the one associated with a periodic review system (why?).

• Daily demand is random and follows a normal distribution. In other words, we assume that the probabilistic forecast of daily demand follows the famous bell-shaped curve. Note that we can completely describe normal demand by its average and standard deviation.

• Every time the distributor places an order from the manufacturer, the distributor pays a fixed cost, K, plus an amount proportional to the quantity ordered.

• Inventory holding cost is charged per item per unit time.

• Inventory level is continuously reviewed, and if an order is placed, the order arrives after the appropriate lead time.•If a customer order arrives when there is no inventory on hand to fill the order (i.e.,

when the distributor is stocked out), the order is lost.

• The distributor specifies a required service level. The service level is the probability of not stocking out during lead time. For example, the distributor might want to ensure that the proportion of lead times in which demand is met out of stock is

95 percent. Thus, the required service level is 95 percent in this case.

To characterize the inventory policy that the distributor should use, we need the following information:

AVG = Average daily demand faced by the distributor

STD = Standard deviation of daily demand faced by the distributor

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 distributor

a = service level. This implies that the probability of stocking out is 1 - a.

2- PeriodicReview Policy :-

many real-life situations, the inventory level is reviewed periodically at regular intervals, and an appropriate quantity is ordered after each review. If these intervals lire relatively short (for example, daily), it may make sense to use a modified versionor the (Q, R) policy presented above. Unfortunately, the (Q, R) policy can't be directly implemented, since the inventory level may fall below the reorder point when the warehouse places an order. To overcome this problem, define two inventory levels s und S, and during each inventory review.

Service Level Optimization :-

The objective of this inventory optimization is to determine the optimal inventory policy given a specific service level target. The question, of course, is how the facility should decide on the appropriate level of service. Sometimes this is determined by the downstream customer. In other words, 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.

one possible strategy, used in retailing, to determine service level for each SKU is to focus on maximizing expected profit across all, or some, of their products. That is, given a target service level across all products, we 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 margin .- High volume.- Low variability.- Short lead time.

Risk Pooling :-

One of the most powerful tools used to address variability in the 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 from one customer will be offset by low demand from another. This reduction in variability allows a decrease in safety stock and therefore reduces average inventory.To understand risk pooling, it is essential to understand the concepts of standard deviation and coefficient of variation of demand. Standard deviation is a measure of how much demand tends to vary around the average, and coefficient of variation is the ratio of standard deviation to average demand.

The three critical points made about risk pooling :-

1- Centralizing inventory reduces both safety stock and average inventory in the system. Intuitively this is explained as follows. In a centralized distribution system, whenever demand from one market area is higher than average while demand in another market area is lower than average, items in the warehouse that were originally allocated for one market can be reallocated to the other. The process of reallocating inventory is not possible in a decentralized distribution system where different warehouses serve different markets.

2- The higher the coefficient of variation, the greater the benefit obtained from cen trulized systems; that is, the greater the benefit from risk pooling. This is explained liS follows. Average inventory includes two components: one proportional to uvcrage weekly demand (Q ) and the other proportional to the standard deviation of weekly demand (safety stock). Since reduction in average inventory is achieved mainly through a reduction in safety stock, the higher the coefficient of variation, Ihe larger the impact of safety stock on inventory reduction.

3- The benefits from risk pooling depend on the behavior of demand from one market relative to demand from another. We say that demand from two markets is positively correlated if it is very likely that whenever demand from one market is greater then average, demand from the other market is also greater than average.

Similarly, when demand from one market is smaller than average, so is demand from the other. Intuitively, the benefit from risk pooling decreases as the cor relation between demand from the two markets becomes more positive.

CENTRALIZED VERSUS DECENTRALIZED SYSTEMS :-

The analysis in the previous section raises an important practical issue: What are the made -offs that we need to consider in comparing centralized distribution systems with centralized distribution systems:-

Safety stock: Clearly, safety stock decreases as a firm moves from a decentralized to a centralized system. The amount of decrease depends on a number of parameters, including the coefficient of variation and the correlation between the demand from the different markets.

Service level : When the centralized and decentralized systems have the same total safety stock, the service level provided by the centralized system is higher. As before, the magnitude of the increase in service level depends on the coefficient of variation and the correlation between the demand from the different markets.

Overhead costs : Typically, these costs are much greater in a decentralized system because there are fewer economies of scale.

Customer lead time : . Since the warehouses are much closer to the customers in a decentralized system, response time is much shorter.

Transportation costs : The impact on transportation costs depends on the specifics of the situation. On one hand, as we increase the number of warehouses, outbound transportation costs-the costs incurred for delivering the items from the warehouses to the customers-decrease because warehouses are much closer to the market areas. On the other hand, inbound transportation costs-the costs of shipping the products from the supply and manufacturing facilities to the warehouses-increase. Thus, the net impact on total transportation cost is not immediately clear.

PRACTICAL ISSUES:-

1- Perform periodic inventory review.2- Provide tight management of usage rates, lead

times, and safety stock.3- Reduce safety stock levels. 4- Introduce or enhance cycle counting practice. 5- Follow ABC approach. 6- Shift more inventory or inventory ownership or

supplires.7- Follow quantitative approaches.

FORECASTING:-

The three rule of forecasting are:-

1- The forecast always wrong.2- The longer the forecast horizon, the worse the

forecast.3- Aggregate forecasts are more accurate.