INVENTORY MANAGEMENT AND RISK POOLING by YUSUF MAHOMED

Inventory Management, Supply Contracts, Risk Pooling and VMI David Simchi-Levi Philip Kaminsky Edith Simchi-Levi

Outline of the Presentation  

Introduction to Inventory Management The Effect of Demand Uncertainty    

(s,S) Policy Periodic Review Policy Forecasting Supply Contracts

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Risk Pooling Centralized vs. Decentralized Systems Vendor Managed Inventory (VMI)

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Practical Issues in Inventory Management

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Sources: plants vendors ports

Regional Warehouses: stocking points

Field Warehouses: stocking points

Customers, demand centers sinks

Supply

Inventory & warehousing costs Production/ purchase costs 1-3

Transportation costs Inventory & warehousing costs

Transportation costs

Inventory 

Where do we hold inventory?   

Suppliers and manufacturers warehouses and distribution centers retailers

What is Inventory? Those stocks or items used to support production (raw materials and work-in-process items), supporting activities (maintenance, repair, and operating supplies) and customer service (finished goods and spare parts) (Cox & Blackstone, 2002)



Why do we hold inventory? Reasons: Economies of scale offered by transportation companies (Large Qs)  Uncertainty in supply and demand, supplier costs & delivery times  Lead Time, Capacity limitations, Capacity limitations  -Unexpected changes in customer demand: i.e. (a) Short life cycle of an increasing number on products (b) Presence of many competing products in the market place 

1-4

What is the role of Inventory - Types? Cycle Stock: components or products that are received in bulk by a downstream partner, gradually used up, and then replenished again in bulk by the upstream partner. 2. Safety Stock: extra inventory that companies hold to protect themselves against uncertainties in either demand or replenishment time. 3. Anticipation Inventory: inventory that is held in anticipation of customer demand. 4. Hedge inventory: a form of inventory buildup to buffer against some event that may not happen. Hedge inventory planning involves speculation related to potential labour strikes, price increases, unsettled governments, and events that could severely impair the companyâ&#x20AC;&#x2122;s strategic initiatives. 5. Transportation inventory: inventory that is moving from one link in the supply chain to another 6. Smoothing Inventories: inventories used to smooth out difference between upstream production levels an downstream demand. 1.

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Role of Inventory in the Supply Chain Improve Matching of Supply and Demand Improved Forecasting Reduce Material Flow Time Reduce Waiting Time Reduce Buffer Inventory

Economies of Scale

Supply / Demand Variability

Seasonal Variability

Cycle Inventory

Safety Inventory

Seasonal Inventory

Figure Error! No text of

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Goals: Reduce Cost, Improve Service 

By effectively managing inventory: 

Wal-Mart became the largest retail company utilizing efficient inventory management

Inventory Driver Uncertainty in supply or demand

Impact Safety stock and Hedge inventory

Mismatch between downstream Cycle stock partner’s demand and most efficient production or shipment volumes for upstream partner Mismatch between downstream demand level and upstream production capacity

Smoothing inventory

Mismatch between timing of customer demand and supply chain lead times

Anticipation inventory Transportation inventory

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Understanding Inventory 

The inventory policy is affected by: 1. Demand Characteristics (amount of variability in customer demand) 2. Replenishment Lead Time (may be known at the time of the order placed or may be uncertain. 3. Number of Products (these products compete on budget or space) 4. Objectives  Service level requirements (accepted level of service must be specified by management)  Minimize costs 5. Cost Structure – Divided into two: • Order costs= cost of product and transportation cost • Holding cost= state taxes, insurance, maintenance, obsolescence, etc 6. The Length of planning horizon

EOQ: A View of Inventory*

Inventory

Note: • No Stockouts • Order when no inventory • Order Size determines policy

Order Size Avg. Inven 1-9

A. Simple Model Inventory Control 1.

Economic Lot Size Model

•

Warehouse facing constant demand for a single item.

•

Assumption – page33

Goal: To find the optimal order policy that minimizes annual purchasing and carrying costs while meeting all demand (without shortages) Orders should be received at the warehouse precisely when the inventory level drops to Zero. (or Zero Inventory Ordering Property) NB: As one increases the order quantity, Q, inventory holding costs per unit of time increase while setup costs per unit of time decrease. NB: Changes in order quantities have a relatively small impact on annual setup costs and inventory holding costs (i.e. Total inventory cost is insensitive to order quantities) Calculations and Formula – page 34

2. The Effect of Demand Uncertainty 

Most companies treat the world as if it were predictable:  



Production and inventory planning are based on forecasts of demand made far in advance of the selling season Companies are aware of demand uncertainty when they create a forecast, but they design their planning process as if the forecast truly represents reality

Recent technological advances have increased the level of demand uncertainty:  

Short product life cycles Increasing product variety

Demand Forecast The three principles of all forecasting techniques: 1.

Forecasting is always wrong

- Implies that it is difficult to match supply and demand 2. The longer the forecast horizon the worst is the forecast -

Implies that it is even more difficult if one needs to predict customer demand for a long period of time (12 to 18 months)

3. Aggregate forecasts are more accurate -

suggests that while it is difficult to predict customer demand for individual SKUs

It is much easier to predict demand across all skills within one product family

This principle is an example of Risk Pooling

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Key Insights from this Model    

The optimal order quantity is not necessarily equal to average forecast demand The optimal quantity depends on the relationship between marginal profit and marginal cost As order quantity increases, average profit first increases and then decreases As production quantity increases, risk increases. In other words, the probability of large gains and of large losses increases

Supply Contracts

Fixed Production Cost =$100,000 Variable Production Cost=$35

Wholesale Price =$80 Selling Price=$125 Salvage Value=$20 Manufacturer

Manufacturer DC

Retail DC

Stores 1-14 ÂŠ 2003 Simchi-Levi, Kaminsky, Simchi-Levi

Supply Contracts Supply Contracts - Buyer and Supplier many agree on: • Pricing and volume discounts • Minimum and maximum purchase quantities • Delivery lead times • Product or material quality • Product return policies (Reverse Purchasing) Note: Retailer makes a purchasing decision to optimise his own profit, and the manufacturer reacts to decisions made by the retailer = refer to = Sequential Supply Chain (In SC each party determines its own course of action independent of the other parties) == rather the Global Optimisation.

Types of Contracts Buy-back contracts – the seller agrees to buy back unsold goods from the buyer for some agreed-upon price Revenue Sharing contracts – the buyer shares some of its revenue with seller, in return for a discount on the wholesale price. (Retailer can convince the manufacturer to reduce the wholesale price, with incentive by retailer to order more) Quantity-Flexibility contracts – contracts in which the supplier provides full refund for returned (unsold) items as long as the number of returns in no larger than a certain quantity. Note: Q-flexibility contracts give full refund for a portion of the returned items – where buy-back contracts provide partial refund for all returned items. Sales Rebate contracts – provide a direct incentive to the retailer to increase sales by means of a rebate paid by the supplier for any item sold above a certain quantity. Global Optimisation – allow buyers and suppliers to share the risk and potential benefits

Supply Contracts: Key Insights 



Effective supply contracts allow supply chain partners to replace sequential optimization by global optimization Buy Back and Revenue Sharing contracts achieve this objective through risk sharing

4. Initial Inventory    

Suppose that one of the jacket designs is a model produced last year. Some inventory is left from last year Assume the same demand pattern as before If only old inventory is sold, no setup cost

One in which the firm already has some inventory of the product on hand, perhaps inventory left over from the previous season.

(s, S) Policies       

For some starting inventory levels, it is better to not start production If we start, we always produce to the same level Thus, we use an (s,S) policy. If the inventory level is below s, we produce up to S. It is also known as min max policy s is the reorder point, and S is the order-up-to level Always order enough to raise inventory to the target inventory level The difference between the two levels is driven by the fixed costs associated with ordering (no fixed cost), transportation, or manufacturing 1-19 © 2003 Simchi-Levi, Kaminsky, Simchi-Levi

5. A Multi-Period Inventory Model ď ˝

Often, there are multiple reorder opportunities

ď ˝

Consider a central distribution facility which orders from a manufacturer and delivers to retailers. The distributor periodically places orders to replenish its inventory

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Reminder: The Normal Distribution

Standard Deviation = 5 Standard Deviation = 10

Average = 30 0

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The DC holds inventory to:  Satisfy

demand during lead time  Protect against demand uncertainty  Balance fixed costs and holding costs

The Multi-Period Continuous Review Inventory Model     

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Normally distributed random demand Fixed order cost plus a cost proportional to amount ordered. Inventory cost is charged per item per unit time If an order arrives and there is no inventory, the order is lost The distributor has a required service level. This is expressed as the the likelihood that the distributor will not stock out during lead time. Intuitively, how will this effect our policy?

A View of (s, S) Policy

Inventory Level

Inventory Position

Lead Time

s 0 Time

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The (s,S) Policy 



(s, S) Policy: Whenever the inventory position drops below a certain level, s, we order to raise the inventory position to level S. The reorder point is a function of:    

The Lead Time Average demand Demand variability Service level

Periodic Review  Suppose

the distributor places orders every month  What policy should the distributor use?  What about the fixed cost?

Base-Stock Policy r

Inventory Level

Base-stock Level

L Inventory Position

0 Time 1-27 ÂŠ 2003 Simchi-Levi, Kaminsky, Simchi-Levi

Periodic Review Policy  

Each review echelon, inventory position is raised to the base-stock level. The base-stock level includes two components: 



Average demand during r+L days (the time until the next order arrives): (r+L)*AVG Safety stock during that time: z*STD* √r+L

Risk Pooling ď ˝

Consider these two systems:

Warehouse One

Market One

Warehouse Two

Market Two

Supplier

Market One Supplier

Warehouse Market Two

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What is Risk Pooling? RP – suggests that demand variability is reduced if one aggregates demand across locations. RP is to redesign the SC, the production process, or the product to either reduce the uncertainty the firm faces or hedge uncertainty so that the firm is in a better position to mitigate the consequence of uncertainty. - Inventory aggregation (Inv.Agg), also called Risk Pooling - In.Agg is one of the most efficient ways to reduce the level of safety stocks thereby reducing inventory across supply chain. - It becomes 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 -

Std deviation – a measure of how much demand tends to vary around the average. (measures the absolute variability of customer demands) Coefficient of variation – the ratio of std deviation to average demand. (measures variability relative to average demand) 1-30 © 2003 Simchi-Levi, Kaminsky, Simchi-Levi

- Safety stock is a major contributor towards inventory holding costs for a SC ---- thereby reducing operational efficiency - SCs retain safety stocks as insurance to avoid the risk of stockouts due to: 1) Uncertainties in customer demand, and 2) Replenishment lead time Two extreme scenarios in a SC to meet retailer demands: • Each retailer is supplied by its own dedicated warehouse • All retailers are supplied by a centralised warehouse Impacts of RP/Inv.Agg. on various SC metrics: 1) Safety stock decreases with aggregation. (The amount varies depending on the extend of correlation among the retailer demands) 2) Overhead costs for maintaining warehouses decreases with risk pooling 3) SC becomes less responsive because lead time increase due to centralisation 4) Under risk pooling, inbound transportation costs to warehouses decrease due to economies of scale – but outbound transportation costs increase due to increased distances between the warehouses and the retailers 1-31 © 2003 Simchi-Levi, Kaminsky, Simchi-Levi

Types of Risk Pooling Location Pooling – is very effective at reducing inventory but moves inventory away from customers. 2. Product pooling – with a universal design is also quite useful but might limit functionality of the products offered. 3. Consolidated distribution – is not as good as location pooling at reducing inventory, but it keeps inventory near customers (Lead time pooling) 4. Delayed differentiation – addresses that limitation but probably requires redesigning the product/process and may introduce a slight delay to fulfill demand. (Lead time pooling). It is an ideal strategy when: • Customers demand many versions, that is, variety is important • There is less uncertainty with respect to total demand that there is for individual versions • Variety is created late in the production process • Variety can be added quickly and cheaply • The components needed to create variety are inexpensive relative to generic components 5. Capacity Pooling – can increase sales and capacity utilisation but requires flexible capacity, which is probably not free and may be quite expensive. 1.

Six important features of RP on the distribution network structure: The number of locations in the pooling group 2. The replenishment lead time from the central warehouse 3. The demand process, 4. The timing (before or after demand is observed) and consequent purpose of transshipment (preventive or emergency) 5. The reparability of stocked items 6. The measure of performance (cost or service level) There are two inventory anomaly : (Inventory increase (rather than decrease) incurred by inventory pooling) 1. Full substitution:- a circumstance in which consumers demonstrate neutral preference of two alternative products. - All demand types can be pooled into a single demand type 2. Partial substitution:- only a fraction of customers switch to an alternative product 1.

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Three critical points to Risk Pooling Centralised inventory saves safety stock and average inventory in the system. 2. The higher the coefficient of variation, the greater the benefit obtained from centralised systems, that is, the greater the benefit from risk pooling 3. The benefits from the risk pooling depend directly on the relative market behaviour. It is explained as follows: 1.

If we compare two markets and when demand from both markets are more or less than the average demand, we say that the demands from the market are positively correlated. Thus the benefits derived from risk pooling decreases as the correlation between demands from the two markets becomes more positive. NB: The benefit from risk pooling decreases as the correlation between demand from the two markets becomes more positive. NB: The coefficient variation should be higher

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Risk Pooling   

For the same service level, which system will require more inventory? Why? For the same total inventory level, which system will have better service? Why? What are the factors that affect these answers?

Risk Pooling: Important Observations  

Centralizing inventory control reduces both safety stock and average inventory level for the same service level. This works best for  



High coefficient of variation, which increases required safety stock. Negatively correlated demand. Why?

What other kinds of risk pooling will we see?

Risk Pooling: Types of Risk Pooling*   

Risk Pooling Across Markets Risk Pooling Across Products Risk Pooling Across Time 

Daily order up to quantity is: 

LT×AVG + z × AVG × √LT

Orders 10 1-37

Centralized system vs Decentralized system What is the effect on: 1. Safety stock= safety stock decreases as a firm moves from a decentralised to centralised. (Depends on coefficient of variation and the correlation between the demand from the different markets) 2. Service level = centralised system provides higher service level with both systems having same total of safety stock. 3. Overhead = costs are much greater in a decentralised system because there are fewer economies of scale. 4. Lead time = since the warehouses are much closer to the customers in a decentralised system, response time is much shorter 5. Transportation Costs = depends on the specifics of the situation

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Centralized Systems* Supplier

Warehouse ď ˝

Centralized Decision Retailers

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Centralized Distribution Systems*  

Question: How much inventory should management keep at each location? A good strategy:  The retailer raises inventory to level S r each period 

The supplier raises the sum of inventory in the retailer and supplier warehouses and in transit to Ss



If there is not enough inventory in the warehouse to meet all demands from retailers, it is allocated so that the service level at each of the retailers will be equal.

Inventory Management: Best Practice      

Periodic inventory reviews Tight management of usage rates, lead times and safety stock ABC approach Reduced safety stock levels Shift more inventory, or inventory ownership, to suppliers Quantitative approaches

Factors that Drive Reduction in Inventory      

Top management emphasis on inventory reduction (19%) Reduce the Number of SKUs in the warehouse (10%) Improved forecasting (7%) Use of sophisticated inventory management software (6%) Coordination among supply chain members (6%) Others

Forecasting   

Recall the three rules Nevertheless, forecast is critical General Overview:    

Judgment methods Market research methods Time Series methods Causal methods

Judgment Methods    

Assemble the opinion of experts Sales-force composite combines salespeople’s estimates Panels of experts – internal, external, both Delphi method   

Each member surveyed Opinions are compiled Each member is given the opportunity to change his opinion

Market Research Methods  

Particularly valuable for developing forecasts of newly introduced products Market testing   



Focus groups assembled. Responses tested. Extrapolations to rest of market made.

Market surveys  

Data gathered from potential customers Interviews, phone-surveys, written surveys, etc.

Time Series Methods  

Past data is used to estimate future data Examples include   

Moving averages – average of some previous demand points. Exponential Smoothing – more recent points receive more weight Methods for data with trends:  



Methods for data with seasonality  

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Regression analysis – fits line to data Holt’s method – combines exponential smoothing concepts with the ability to follow a trend Seasonal decomposition methods (seasonal patterns removed) Winter’s method: advanced approach based on exponential smoothing

Complex methods (not clear that these work better)

Causal Methods  

Forecasts are generated based on data other than the data being predicted Examples include:     

Inflation rates GNP Unemployment rates Weather Sales of other products

Selecting the Appropriate Approach: 

What is the purpose of the forecast? 



What are the dynamics of the system being forecast?  

 

Is it sensitive to economic data? Is it seasonal? Trending?

How important is the past in estimating the future? Different approaches may be appropriate for different stages of the product lifecycle:   



Gross or detailed estimates?

Testing and intro: market research methods, judgment methods Rapid growth: time series methods Mature: time series, causal methods (particularly for long-range planning)

It is typically effective to combine approaches.

Vendor Managed Inventory (Pioneered in the early 1980s by firms such as Wal-Mart and Proctor & Gamble, researchers have attempted to determine how this policy delivers benefits to participants)

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What is Vendor Managed Inventory (VMI)? 

 



VMI:- is a SC system whereby a supplier (often a manufacturer) assumes responsibility for maintaining inventory levels and determining order quantities for its customers (often distributors or retailers) (Dong , Xu and Dresner, 2007) VMI, also known as consignment inventory VMI-consignment:- is an arrangement whereby the owners of goods, the “consignor”, delivers its goods to another party, the “consignee”, for use or for sale by the consignee, with the proceeds to the sale being remitted to the consignor only after the actual use/sale. VMI program – involves a supplier which monitors inventory levels at its customer’s warehouses and assumes responsibility for replenishing that inventory to achieve specified targets through the use of highly automated electronic messaging systems. The supplier makes the replenishment decision, rather than waiting for the customer to reorder the product.

Dong and Xu (2002) suggest anecdotal evidence that: A consignee may enjoy reductions in holding costs and some operational costs plus cash flow benefits, while a consignor needs to bear the burden (of inventory carrying and demand forecasting) but probably gain chances to improve other production and marketing efficiency. • Buyer company appears to be the ‘leader” in this relationship: - Specifies order quantity according to its own cost characteristics - Determines purchase prices for certain amounts of products provided by the supplier. • Supplier has no choice but accepts the prices. • VMI allows the companies to cut total inventory-related costs and thus provides a strong incentive for both firms to integrate their inventory systems. • The supplier’s profit and the buyer’s purchase price are headed towards opposite directions. • The buyer’s profit level will always be increased after VMI • The supplier’s profit could be decreased even with a higher purchase price offered by the buyer to compensate the increased costs due to VMI. 1-51 © 2003 Simchi-Levi, Kaminsky, Simchi-Levi

What are the effects of VMI on SC inventories? VMI leads to a reduction in inventories mainly resulting from more:  Frequent inventory review, Shorter order intervals and Frequent deliveries Information sharing enhances the ability of the supplier to use downstream demand information from several buyers to coordinate shipments It means: VMI suppliers are able to deliver to their customers at higher frequencies without increasing transportation costs. Caution by Grocery products Retailers: VMI could impair visibility in the supply chain by transferring decision making authority to suppliers. Retailers say: “The farther you go up the supply chain, the harder it is to see what’s going on” (Bruce and Ireland, 2002) Other Drawbacks: 1) Higher delivery frequencies, 2) Inadequate forecasting capabilities by vendors, 3) Inefficient coordination in promotions planning under VMI. 1-52 © 2003 Simchi-Levi, Kaminsky, Simchi-Levi

Why Buyers adopt the VMI? When it has a large degree of cooperation with its supplier 2. When it faces a low degree of uncertainty in its operations 3. When the supplierâ&#x20AC;&#x2122;s industry is characterised by a high degree of competitiveness. What are the elements of VMI? 1) Sharing information (demand and inventory) between members of the SC 2) A buyer must work with its supplier to set sound inventory management goals, liability levels, and risk-sharing parameters 3) VMI should be viewed as a SCM technology, often adopted in conjunction with other SCM components, such as EDI 4) Key success factors include representation of every interest advanced by each firm and the sponsorship and support by top management in both companies. 5) The goals of both partners must be transparent and shared 6) Entrench collaborative relationship that is built on trust and mutual benefit 1.

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Factors associated with VMI adoption: 1)

Buyer’s market competitiveness

Question: Can greater competitiveness in the buyer’s market associated with a higher degree of adoption of VMI? 2) Supplier’s market competitiveness Question: Can greater competitiveness in the supplier’s market associated with a higher degree of adoption of VMI? 3) Product demand uncertainty Question: Can greater product demand uncertainty in the buyer’s market associated with a higher degree of adoption of VMI? 4) Buyer operational uncertainty Question: Can greater levels of buyer operational uncertainty associated with a lower degree of adoption of VMI? 5) Buyer-supplier cooperation Question: Can greater levels of buyer-supplier cooperation associated with a greater degree of adoption of VMI?