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Chapter 2 MGMT notes

Inventory is one of the dominant costs. Effective inventory management in the supply chain
is to have the correct inventory at the right place at the right time to minimize system costs
while satisfying customer service requirements.

Inventory can appear in many places

- Raw material inventory
- Work in process inventory
- Finished product inventory

Each needs its own inventory control mechanism or approach.

Inventory is held due to:

1. Unexpected changes in customer demand. Customer demand has always been hard
to predict. Customer demand changes due to:
i) Short life cycle of an increasing number of products. This implies that historical
data about customer demand may not be available or may be quite limited
ii) Presence of many competing products in the marketplace. Proliferation of
products make it increasingly difficult to predict demand.
2. Presence in many situations of a significant uncertainty in the quantity and quality
of the supply, supplier costs and delivery times
3. Lead times. Even if there is no supply or demand. Need due to delivery lead times
4. Economies of scale offered by transportation companies that encourage firms to
transport large quantities of items and therefore hold large inventories


1) Customer demand, which may be known in advance or may be known in advance or
may be random.
2) Replenishment lead time, which may be known at the time the order is place or may be
3) The number of different products being considered. These products compete on budget
or space and hence the inventory policy of one product
4) Length of planning horizon
5) Cost, including order cost and inventory holding cost.
a) Typically, order cost consists of two components; the cost of the product and the
b) Inventory holding cost, or inventory carrying cost, consists of
i) State taxes, property taxes
ii) Maintenance costs
iii) Obsolescence cost, which derives from the risk that an item will lose some of its
value because of changes in the market
iv) Opportunity costs, which represent the return on investment that one would
receive had money been invested in something else.
6) Service level requirements,


Illustrates the trade-offs between ordering and storage cost. Consider a warehouse facing
constant demand for a single item. The warehouse orders from the supplier, who is
assumed to have an unlimited quantity of the product.
- Demand is constant at a rate of D items per day
- Order quantities are fixed at Q items per order; that is, each time the warehouse
places an order , it is for Q items
- A fixed cost, K, is incurred every time the warehouse places an order
- An inventory carrying cost, h, also referred to as a holding cost, is accrued per unit
held in inventory per day that the unit is held
- The lead time, the time that elapses between the placement of an order and its
receipt, is zero
- Initial inventory is zero
- The planning horizon is long ( infinite)

to find the optimal order policy that minimizes annual purchasing and carrying costs while
meeting all demand.

We refer to the time between two successive replenishments as a cycle time. Thus, total
inventory cost in a cycle of length T is

since the fixed costs is charged once per order and holding cost can be viewed as the
product of the per unit, per time holding cost, h; the average inventory level, Q/2 and the
length of the cycle, T
total cost per unit of time

Provides two important insights:

An optimal 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 (see
above figure). Thus, as one increases the order quanuty Q, inventory holding costs per unit
of time increase while setup costs per unit of time decrease. The optimal order quanityt 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)

Q 2

2 KD


1) Forecast is always wrong
2) The longer the forecast horizon, the worse the forecast
3) Aggregate forecasts are more accurate

It is more difficult to match supply and demand, and the second one implies that it is even
more difficult if one needs to predict customer demand for a long period of time..

The third principle suggest for instance, that while it is difficult to predict customer demand
for individual SKUs, it is much easier to predict demand across all SKUs, within one product


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 stokc in order to
meet demand. Using historical data, the firm can typically identify a variety of demand
scenarios and determine a likelihood or probability that each of these scenarios will occur.
This model is use to 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

Fixed production cost: $100,000
Variable production cost per unit: $80
During the summer season, selling price: $125 per unit
Salvage value: any swimsuit not sold during the summer season is sold to a discount store
for $20

Manufacturer produces 10,000 units while demand ends at 12,000 swimsuits
= 125(10,000) - 80(10,000) - 100,000
= $350,000

Manufacturer produces 10,000 units while demand ends at 8,000 swimsuits

= 125(8,000) + 20(2,000) - 80(10,000) - 100,000
= $140,000


Average profit as a function of production quantity

Compare marginal profit of selling an additional unit and marginal cost of not selling an
additional unit

Marginal profit/unit =
Selling Price - Variable Ordering (or, Production) Cost

Marginal cost/unit =
Variable Ordering (or, Production) Cost - Salvage Value

If Marginal Profit > Marginal Cost => Optimal Quantity > Average Demand
If Marginal Profit < Marginal Cost => Optimal Quantity < Average Demand


Average demand = 13,000 units.
Optimal production quantity = 12,000 units.

Marginal profit = $45

Marginal cost = $60.

Thus, Marginal Cost > Marginal Profit

=> optimal production quantity < average demand


a distributor that faces random demand for a product, and meets that demand with product
ordered from a manufacturer. manufacturer cannot instantaneously satisfy orders placed by
the distributor: there is fixed lead time for delivery whenever the distributor places an
order. 3 reasons why the distributors holds inventory
To balance annual inventory holding costs and annual fixed order costs.
To satisfy demand occurring during lead time.
To protect against uncertainty in demand.
Continuous review policy
inventory is reviewed continuously
an order is placed when the inventory reaches a particular level or reorder
inventory can be continuously reviewed (computerized inventory systems are
Periodic review policy
inventory is reviewed at regular intervals
appropriate quantity is ordered after each review.
it is impossible or inconvenient to frequently review inventory and place
orders if necessary.


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

(Q,R) policy whenever inventory level falls to a reorder level R, place an order for Q units
What is the value of R?


Inventory level as a function of time in a (Q,R) policy

Inventory level before receiving an order = z STD L

Inventory level after receiving an order =


Average inventory = 2

Risk Pooling suggests that demand variability is reduced if one aggregates demand across
locations. This reduction in variability allows a decrease in safety stock and therefore
reduces average inventory. 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:


standard deviation measures the absolute variability of customer demands, the coefficient
of variation measures variability relative to average demand.

1) Centralizing inventory reduces both safety stock and average inventory in the system
2) The higher the coefficient of variation, the greater the benefit obtained from
centralized systems; that is, the greater the benefit from risk pooling
3) The benefits from pooling depend on the behavior of demand from one market
relative to demand from another.


Trade offs we need to consider:
Safety stock, safety decreases as a firm moves from a decentralized to a centralized system.
The amount of decrease a number of parameters

Service level when the centralized and decentralized systems have the same total safety
stock, the service level provided by the centralized system is higher
Overhead costs typically these costs are much greater in a decentralized system

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

1 Forecast is always wrong
2 The longer the forecast horizon, the worse the forecast
3 Aggregate forecasts are more accurate

Forecasting is a critical tool. Forecasts arent just for inventory decision making; decisions
about whether to enter a particular market at all, about whether to expand production
capacity, or about whether to implement a given promotional plan can all benefit from
effective forecasting
- Qualitative primarily subjective, rely on judgement (JUDGEMENT METHODS)
- Time series use historical demand only, best with stable demand
- Causal relationship between demand and some other factor
- Simulation imitate consumer choices that give rise to demand

Time series methods use a variety of past data to estimate future data,
Common time series methods
Moving average each forecast is the average of some number of previous demand points.
Select the number of points in the moving average so that the effect of irregularities in the
data is minimized

Exponential smoothing each forecast is a weighted average of the previous forecast and
the last demand point. This method is similar to the moving average, except that it is a
weighted average of all past data points.

Methods for data with trends the previous two approaches assume that there is no trend
in the data. If there is a trend, methods such as regression analysis and holts method are
more useful, as they specifically account for trends in the data. Regression analysis fits a
straight line to data points, while holts method combines the concept of exponential
smoothing with the ability to follow a linear trend in the data.

Methods for seasonal data a variety of techniques account for seasonal changes in
demand. For example, Seasonal decomposition methods remove the seasonal patterns
from the data and then apply the approaches listed above on these edited data. Similarly
winters method is a version of exponential smoothing that accounts for trends and
Judgment methods strive to assemble the opinions of a variety of experts in a systematic

Panels of experts can be assembled in order to reach a consensus. This approach assumes
that by communicating and openly sharing information. A superior forecast can be agreed
upon. These experts can be external experts or internal experts.

The Delphi method is a structured technique for reaching a consensus with a panel of
experts without gathering them in a single location. Indeed, the technique is designed to
eliminate the danger of one or a few strong willed individuals dominating the decision-
making process. Each member of the group of experts is surveyed for his or her opnion,
typically in writing. The opinions are compiled and summarized and each individual is given
the opportunity to change his or her opinion after seeing the summary. This process is
repeated until a consensus is achieved


- Forecasting module is core supply chain software
- Can be used to determine forecasting methods for the firm and by product
categories and markets
- Real time updates help firms respond quickly to changes in marketplace
- Facilitate demand planning