The Profitable Supply Chain: A Practitioners Guide

by Ramnath Ganesan
Apress 2015 (284 pages) Citation
ISBN:9781484205273

Providing a first-principles approach to understanding the drivers of todays successful supply chains, this book
offers numerous real-world examples and cases to clarify how this approach can be applied to specific situations,
along with spreadsheet functions when appropriate.
Recommend?

Table of Contents
The Profitable Supply ChainA Practitioner's Guide
Introduction
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 5
Chapter 6
Chapter 7
Chapter 8
Chapter 9
Appendix A
Appendix B
Index
List of Figures
List of Tables
List of Examples

Introduction
The increased importance of supply chain management (SCM) can be
attributed to globalization, the shift toward outsourced and offshore
manufacturing, and an increase in the number of products offered by a
company. These trends have provided companies with unprecedented
opportunities for growth, but at the risk of being driven out of business due to
inefficient sales and operating models.
An important message of this book is that it is all too easy to
make supply chain decisions that are detrimental to the performance of the
company, and you therefore need to carefully evaluate each situation to
protect against this possibility. The decision-making process is by no means
perfect in most companies, with poor judgment, risk aversion, fear, or habit
dictating actions. This book attempts to provide a rigorous approach toward
decision making, by providing quantitative models to evaluate situations and
procedures to implement actions. Quantitative models are important since factbased evaluations can offset emotion-based decisions.
In no way does this approach reduce the role of the individual. In fact, these
mathematical models are by no means perfect, and they make several
assumptions that can reduce accuracy for and relevance to a particular
situation. Therefore, it is important to leverage the strengths of both
approachesquantitative models that process data for several hundreds or
thousands of products and providing guidance and visibility to exceptions, and
the individual providing guidance when influences and factors are outside the
scope of the model.
Finally, this is a book about concepts regarding the use of information related
to demand and supply, and processes to implement change. It is the author's
anticipation that the discussions presented in this book will be valuable
to supply chain practitioners, and will provide you with several ideas to improve
the profitability of your company.

Chapter 1: Introduction
Overview
The importance of supply chain management (SCM) is undeniable. Companies
have invested a significant amount of time and money hiring personnel and
implementing expensive software systems to help realize improvements.
Although SCM is now offered as a course in many universities, the reality is that
the knowledge required by the practitioner has mainly been gathered tediously
on the job. The reason is that, unlike manufacturing and engineering, SCM is a
relatively new field that originated in the industry in the early 1990s; as a
result, it has not had the time to mature and become well understood.
Compounding the problem is that the term supply chain is now used in several
industries with differing interpretations. For example, a government
organization may view SCM as a form of procurement, while an electronics
manufacturer may view it as a process for aligning activities across
manufacturing, transportation, distribution, and order fulfillment. Universities
have only recently started offering supply chain courses. As a result, new
entrants to the field of SCM may be expected to have a better formal
understanding of supply chain concepts. The majority of established
practitioners, on the other hand, will not undergo retraining and may be
expected to retain widely differing views on the practices.
It is not just a matter of biding time, however, until the newly minted
practitioners have established their presence and disseminated a common
understanding of SCM. The problem goes deeper. First, there is disparity in the
course material across universities, the content being largely dictated by the
background of the teacher. Second, there is often an extreme focus on complex
mathematical methods (such as linear programming) rather than simple, easyto-use mathematical models. Third, the concepts and methods taught tend to
focus on a few simple, well-understood business cases and are not
comprehensive enough to enable the practitioner to deal with situations
encountered on a daily basis while operating a supply chain.
This book attempts to address these drawbacks by providing the practitioner
with (a) a process-oriented approach to implementing change, (b) simple

mathematical models that are easily understood, and (c) application of these
models to several real business situations to provide an understanding of their
pragmatic utility.
This chapter provides you with a background on some of the changes to the
business that have increased the importance of supply chain management, and
it shows you why traditional management approaches are not effective. The
structural changes are explained from a network and financial perspective,
followed by a discussion of the limitations of the current process framework
and systems. I then introduce an SCM process framework that I have
developed, based on my work with several leading manufacturers, to address
these limitations.

A Changing Supply Network and Cost Structure

Supply chains have been reshaped since the 1990s. The need to grow and
meet worldwide demand has driven many vertically integrated product
companies to outsource manufacturing and logistics functions and become
brand-oriented companies focused on product design and marketing. Even
companies that have not adopted outsourcing have expanded local
manufacturing operations to a network of factories in several continents. In
tandem, other market forces, including a larger customer base, varied
consumer preferences, and the need to innovate to stay ahead of the
competition have resulted in a marked increase in the number of products
offered by a company. For example, Nike states:
Our success depends on our ability to identify, originate and define product
trends as well as to anticipate, gauge and react to changing consumer
demands in a timely manner.
- 2010 Annual Report, Nike Inc.
Such a need is easily comprehended in consumer-oriented specialty products.
However, this trend is true in other industries as well, including electronics,
automotives, and consumer durables. Consider the example of Whirlpool, a
manufacturer of refrigerators and washing machines:
High consumer preference for our versatile brands has helped Whirlpool
Corporation strengthen our No. 1 position in Latin America. We drove ongoing
margin expansion in 2013 due to our impressive new product launches,
effective management of our resources and continued non-core appliance
growth. There were 50 major new products introduced in 2013.

- 2013 Annual Report, Whirlpool Appliances Inc.

Product proliferation increases the variability in demand for each product,
which, in turn, results in an increase in the inventory investment required to
stock shelves or fulfill customer orders. In addition, there is a higher level of
monetary risk the company faces due to this increased inventory position: If a
particular product falls out of favor and does not sell, the company has no
choice but to mark it down or declare the inventory scrap. Such write-offs are
expensive and have a significant impact on profits.
Companies are of course also becoming more and more global. Nike's revenues
from the US declined from 78% in 1990 to 41% in 2013. Such changes are
experienced by companies in all parts of the world; for example, Samsung
Electronics, a Korea-based company, saw domestic sales decline from 36% to
10% from 1998 to 2013. These globalization trends impact the supply chain in
many ways, including increased complexity from operating the business in
several countries. The many costs associated with importing goods into various
countries (such as import duties and tariffs), when combined with fluctuating
exchange rates and political influences, makes it hard to estimate margins.
Furthermore, the challenges in estimating local demand and competition
combine with extended shipping lead times to further increase
inventory costs and liabilities.
For a majority of companies, the complexities associated with bringing new
products to market in various parts of the world have been partly addressed by
outsourcing the design and manufacture of products to contract manufacturers.
One such company is Hewlett-Packard, a manufacturer of computers and
peripherals. The illustrative quote in Figure 1-1 from the company's annual
report clearly indicates the strategy that the company has adopted in order to
provide investors the enormous revenue growth from 1993 to 2013 (from
almost $21 billion in 1993 to $84 billion in 2013 for its computers and
peripherals business divisions).
Increased reliance upon outsourced manufacturing "We utilize a umber
of contract manufacturers ("CMs") and original design manufacturers ("ODMs")
around the world to manufacture HP-designed products. The use of CMs and
ODMs is intended to generate cost efficiencies and reduce time to market for
certain HPdesigned products."
- Hewlett-PackardAnnual Report 2007.
Open table as spreadsheet
(All numbers relative to revenue)

1993

2013

Machinery and equipment

29%

20%

U.S. revenue

46%

36%

(All numbers relative to revenue)

1993

2013

Cost of goods sold

57%

77%

Earnings

9%

11%

Revenue increase: 314% (2013 over 1993)

Figure 1-1: Illustration of Hewlett Packard's increased reliance on contract

manufacturing (revenues are for computers and peripherals business divisions
only)
This reliance on contract manufacturers has impacted the cost structure of the
company. And while the investment in machinery and equipment relative to
revenue has decreased, the cost of goods sold has significantly increased.
However, the earnings relative to revenue has remained the same, possibly
due to lower systems and administrative costs associated with divesting large
manufacturing facilities.
Outsourcing manufacturing activities to a contract manufacturer that operates
plants in countries with low-cost labor can result in reduced cost of goods that
have high labor content. This trend toward offshoring is highlighted in the
following excerpt from the annual report of a now-defunct furniture
manufacturer:
There has been a significant change in recent years in the manner by which we
bring products to market Where we have traditionally been a domestic
furniture manufacturer, we have shifted to a blended strategy, mixing domestic
production with products sourced from offshore.
An increasing percentage of our products are being sourced from
manufacturers located offshore, primarily in China, the Philippines, Indonesia,
and Vietnam. We design and engineer these products, and we have them
manufactured to our specifications by independent offshore manufacturers. We
have informal strategic alliances with several of the larger foreign
manufacturers whereby we have the ability to purchase, on a coordinated
basis, a significant portion of the foreign manufacturers' capacity, subject to
quality control and delivery standards. Two of these manufacturers
represented 20% and 12% of imported product during 2005 and three other
manufacturers represented in excess of 5% each.
- Furniture Brands International, Inc., 2005 Annual Report
Indeed, this offshoring to reduce manufacturing costssss is a trend seen in
other industries as well, including apparel, building materials, electronics,
pharmaceuticals, and telecommunications. However, if the company is utilizing
broadly available technologies or commodity-based products, then costof

goods may increase, because the company is forced to share margins with the
contract manufacturer. In such cases, the company's role becomes more of a
distributor for overseas markets.
Figure 1-2 captures some of the ways in which supply chains have changed
over the years. The dominant link in the traditional supply chain (with in-house,
near-shore manufacturing) is the company's manufacturing plant. In many
cases, the company may not be required to operate separate distribution
centers. That's because a portion of the plant may be utilized for storing the
produced materials, and the company can ship material directly from the plant
to the distributor with facilities in various regions. In turn, the distributor would
receive orders from the retailer and ship material to the retailer's distribution
centers or directly to the retail stores.

Figure 1-2: Structure of supply chain with in-house, near-shore manufacturing

vs. outsourced, off-shore manufacturing
In contrast, the off-shore and often outsourced supply chain is different in many
ways: The manufacturing plant is now owned by the contract manufacturer,
and the company negotiates capacity contracts spanning several months or
quarters and issues purchase orders for the production and delivery
of materials. Since the company has divested its manufacturing facility, it is

now necessary to operate distribution centers to receive material from the

contract manufacturer and hold buffer inventory. The company may choose to
operate the distribution centers or utilize the facilities of a third-party logistics
provider (3PL). While distributors remain one channel for distribution of
products, the channel focus has often shifted to direct sales to large retailers
and online sales to consumers.
The overall trend has been to reduce the assets required to deliver products,
with reliance on contract manufacturers for production, third-party logistics
providers for holding inventory, transportation providers for overseas and
inland movement of goods, and web stores in lieu of a physical presence. This
shift to a virtual supply chain has far-reaching impact on the flow of goods and
information, and the importance of inventory as a buffer between the various
parties.
In addition, outsourcing affects the cost structure in one other significant way:
It reduces fixed costs and increases variable costs. This results in very different
outcomes when the company experiences variability in demand or supply. This
change is better understood via an example. Table 1-1summarizes costs for a
manufacturing plant that produces goods worth $10 million on a cost-basis. For
simplicity, the plant is assumed to produce only one type of product. In the
example, 65% of the entire cost is fixed, while the variable cost is 35%.
Table 1-1: Sample Cost Data for In-House Manufacturing
Open table as spreadsheet
Cost Categories
Details
Units produced (per month)
100,000
Material cost (delivered, per unit)
$
25.00
Labor costs (per month)
Contract labor
$ 2,500,000
Supervision
$ 500,000
Administration
$ 500,000
Total labor
$ 3,500,000
Shipping cost (per unit)
$
10.00
Maintenance and repair (per month)
$ 2,000,000
Utilities, rent, other (per month)
$ 1,000,000
Cost, per unit
Fixed cost
$
65.00
Variable cost
$
35.00
Total cost
$
100.00
Contrast this situation with an outsourced manufacturing situation shown
in Table 1-2. Because the company sources this product from a contract
manufacturer, the contract would typically include a commitment to purchase a
certain volume of product at a certain unit price over a particular time period

(such as per quarter or per year). Since the goods produced by the contract
manufacturer needs to be shipped to the company's distribution centers,
additional transportation and warehousing costs needs to be incorporated.
Additionally, since the company does not operate a manufacturing plant, there
are no operating assets, maintenance and repair, or utilities to be paid.
Table 1-2: Sample Cost Data for Outsourced Manufacturing
Open table as spreadsheet
Cost Categories
Details
Units produced (per month)
100,000
Material cost (delivered, per unit)
$
70.00
Warehousing cost (per unit, per month)
$
15.00
Transportation cost (per unit)
$
10.00
Administrative cost (per month)
$ 500,000
Total cost, per unit
Fixed cost
$
5.00
Variable cost
$
95.00
Total cost
$ 100.00
Comparing the cost summaries in Table 1-1 and Table 1-2, you can see several
differences. The first is that fixed costs have been greatly reduced with
outsourced manufacturing. These costs have been converted to
variable costs since payments are made on a per-unit basis to the contract
manufacturer and the third-party warehouse logistics provider. Since the
total cost remains $100 per unit, it would appear that there is no difference
between the two cases on a cost basis. Indeed, if the company were able to
realize sales as targeted, then the two situations would provide identical
margins. If, however, the company experiences variability in demand and price,
then the two situations have very different outcomes on a cost basis, as shown
in Table 1-3.
Table 1-3: Margin Sensitivity to Changes in Demand and Price
Open table as spreadsheet
Situation
High Fixed Cost
High Variable Cost
Revenue target
$ 15,000,000
$ 15,000,000
Volume (units)
100,000
100,000
Price
$
150.00
$
150.00
Fixed cost
$ 6,500,000
$
500,000
Unit variable cost
$
35.00
$
95.00
Variable cost
$ 3,500,000
$ 9,500,000
Gross margin
$ 5,000,000
$ 5,000,000
Gross margin %
33.33%
33.33%
Scenario: Sales are light, therefore price is decreased by 10% to achieve

Table 1-3: Margin Sensitivity to Changes in Demand and Price

Open table as spreadsheet
Situation
revenue target.
Price
$
140.00
$
140.00
Units sold
107,143
107,143
Revenue
$ 15,000,000
$ 15,000,000
Total cost
$ 10,250,000
$ 10,678,571
Gross margin
$ 4,750,000
$ 4,321,429
Gross margin %
31.67%
28.81%
In the example, a price rebate situation is analyzed. The company experiences
demand variability and is not on track to sell the projected volume at the
planned price (i.e., 100,000 units at $150 per unit). In order to meet the
revenue target, the price is reduced by $10, which boosts sales and allows the
company to meet its revenue target. However, the resulting impact on margins
is very different for the two situations. In the in-house manufacturing situation
with high fixed costs, the margin erosion is only 1% (from 33% to 32%);
however, in the outsourced manufacturing situation with high variablecosts,
margin erosion is 4%. The lower margin erosion in the former case is due to the
fixed cost being spread over additional sales units, thus reducing unit costs by
a greater value for the in-house manufacturing situation. The outsourced
manufacturing situation behaves poorly since unitcosts are maintained at the
original level ($95 per unit) even though price is reduced. If unit costs were to
be proportionally reduced, then margin erosion could be contained; however,
such cost reductions are often hard to enforce since supply commitments and
purchase prices are typically made several months prior to demand due to
longer lead times associated with contract manufacturing and ocean
transportation.
Conversely, if a price reduction was not initiated and demand were to come in
below the target value, the in-house manufacturing situation would result in
higher margin erosion because fixed costs are distributed over fewer units. As a
result, the predominant behavior in the in-house manufacturing situation is to
plan production for the plant (usually for a two- or three-month horizon) and
then maximize sales, relying on price rebates if necessary. However, this
management approach will perform adversely in the outsourced manufacturing
situation due to the markedly different cost structure.
The difference is exacerbated if business variability is high. Figure 13 examines demand variability for two industriesconsumer durables and
computers and electronicsmeasured by new orders for manufacturers, as
tracked by the U.S. Census Bureau. The data reveals that the computer
industry exhibits more variability than the consumer durables, as can be
expected due to the shorter product lifecycles associated with computer

products. Additionally, the inherent variability has remained at a high level for
over two decades in both industries. Wise supply chain managers therefore
review new order data for their own and other industries and note a similar
trend in variability. Several reasons contribute to the variability, including
frequent new product launches, product proliferation, increased competition,
and rapidly changing customer preferences.

Figure 1-3: Demand variability of new ordersfor consumer durables and

computer industries.($ Million). Source: U.S. Census Bureau
Given the changing cost structure and dynamic business environment faced by
most companies, the natural question is how management practices should
change. Are the company's current processes ready to handle these changes?
Are the systems in place appropriate for the dealing with this extended and
increasingly virtual supply chain? Are the people in the company schooled to
think in a different way? Each of these areas is examined in detail in the
following sections of this chapter.

The Process Framework: MPC vs. SCM

The historical focus on manufacturing efficiency needs to change in order to
manage a network of companies responsible for timely supply, production, and
distribution. Practitioners have typically been trained to rely on
the manufacturing planning and control (MPC) process framework to manage
the business. This section describes the MPC process, lists some of the
drawbacks with this approach, and specifies the SCM process framework that
addresses these drawbacks.
The MPC framework, shown in Figure 1-4, supports activities related to the
production of sub-assemblies and finished goods and the procurement of raw
materials. These steps are briefly described below. [1]

Figure 1-4: The manufacturing planning and control (MPC) process framework
The main steps for managing the flow of material and use of resources are
demand management, production planning, master production scheduling,
rough cut capacity planning, and materials requirements planning.
Demand management encompasses forecasting customer and product
demand, order entry, and order processing.
Production planning specifies the manufacturing plan that will support the
specified demand, frequently expressed as output in financial units such as
dollars. When it is not possible for the factories to produce a sufficient amount
of goods to meet demand, the production plan provides a basis for
understanding the extent of the shortfall, and how scarce material or capacity
should be best utilized. Therefore, one of the main goals of production planning
is to match demand with supply, and provide a framework for optimizing
resource utilization. The production plan is often expressed in monthly periods
and can span several quarters, depending on the lead time required to
manufacture goods.
Master production scheduling (MPS) is the detailed version of the production
plan, expressed in production units for each product, usually for an 8- to 13week time horizon. While converting the monthly production plan into weekly
schedules, the MPS considers guidelines related to setup times and production
batch sizes, which helps reduce costs and create a feasible schedule.
When appropriate, the MPS is modified based on rough cut capacity
planning(RCCP), which checks for capacity shortfalls and bottlenecks. The
calculations for this are based on setups and time taken to perform various
production tasks. When a capacity shortfall is encountered, the production
schedule is modified to best meet the production plan. However, if capacity
shortfalls are severe and it is not possible to meet the plan for the entire
month, then the financial impact of the shortfall (in terms of variance from the
production plan) is computed and made available to management for decision
making.

The master production schedule is converted into raw

material supply requirements using material requirements planning (MRP). MRP
uses a bill of material to connect finished goods to sub-assemblies and raw
materials, and a specific time phasing logic (based on production lead times) to
convert production requirements into supplies. Finally, shop-floor scheduling
and purchasing use the output of MRP for creating detailed production
schedules and purchase orders, respectively.
Each of the process steps of the MPC framework is executed according to a
schedule: demand management and production planning are typically
performed at the beginning of each month, while master production
scheduling, capacity planning, and material requirements planning are
performed at the beginning of each week. The remaining activities are
performed on a daily basis or prior to each shift.
The process flow shown in Figure 1-4 is illustrative of a "pull" process, in which
demand drives supply activities such as production and purchasing. If a
demand forecast drives supplies, then the production activities are classified
as build-to-forecast; if actual customer orders drive supplies, then production
is build-to-order. While a build-to-order supply chain has less risk, it is typically
not feasible to operate entirely in this mode due to long lead times associated
with certain manufacturing or purchasing activities. Therefore, most companies
operate as build-to-order for activities closer to the customer (such as final
assembly and packaging) and build-to-forecast for longer lead time activities.
Conversely, a company that commits to a certain level of production and
subsequently aligns demand based on this plan is classified as a
"push"supply chain. Examples include mining, oil extraction, and the recycling
industries. In each of these cases, there is a commitment for a certain level of
production over an extended period of time (ranging from several quarters to
several years). During this time period, the companies need to "find" the
demand for the produced volume. If there is a significant mismatch between
market supply and demand, production volume changes can be initiated only
at the end of the commitment period. For such a push supply chain, the
process framework would look different since supplies are the driving factor.
Therefore, demand management is driven by the production schedule.
Additionally, the demand management process mainly deals with the allocation
of the production schedule to specific customer accounts and orders.
Similar to MPC for manufacturing organizations, warehouse management
systems (WMS) help manage the distribution section of the supply chain,
providing functionality for tracking inventory, entering sales orders, placing
purchase orders, and receiving and shipping goods.
Companies have found that the MPC framework does not provide adequate
support for the new business environment. A few of the issues include:

Lack of support for scale and globalization. Businesses have grown from
a single factory to multiple factories distributed across the world and
distribution networks consisting of central and regional warehouses in
several continents. The traditional MPC framework is oriented to the
management of a single facility and is not well-equipped to deal with this
network of suppliers, factories, distribution centers, and customers. As a
result, coordination of material and capacity across these different
facilities needs to be performed outside the scope of MPC.

Lack of support for the outsourced environment. The outsourcing of

manufacturing operations to other companies has required increased
formality and structure between the different functions. What used to be
operations under the same roof have now been transferred to different
companies, often in different continents. MPC provides limited support
for the increasingly collaborative relationships required to operate in this
environment.

Inadequate treatment of variability. The MPC framework has limited

treatment of demand uncertainty and supply variability. When lead times
were of the order of two or three weeks and demand was localized, ad
hoc procedures and simple rules sufficed since the costimpact was
limited. However, global markets, a proliferation of products, and
increasing lead times have increased variability and stressed the MPC
framework.

Inadequate treatment of network optimization. Since the MPC framework

focuses mainly on a single plant, it does not provide guidance regarding
optimal placement of manufacturing and distribution facilities. These
analyses are performed outside the framework, and the results of the
analysis in the form of material routings and costs are provided as inputs
to MPC. The current business environment requires that companies reevaluate and reconfigure the network on a more frequent basis, due to
higher fuel prices, expansion into new markets, or an increase in the
number of facilities due to mergers and acquisitions. Lack of support for
this important function is a significant drawback of the MPC framework.

Limited analysis of variable costs. While demand management and

production planning are expressed in financial terms, the remaining MPC
functions are completed using production units. Since several important
decisions are taken during capacity planning and MRP, there is no
visibility to the impact of these actions on profits. This approach may
have been justifiable when fixed costs were high and estimating costs for
specific activities were not clear or subject to error. However, as
variable costs have increased, it has become important, and increasingly
feasible, to estimate cost impact and to include these considerations in
the decision-making process.

In conclusion, while MPC continues to be a useful framework for managing the

individual plant, a new approach is required for managing the
entiresupply chain. SCM emerged toward the beginning of the 1990s to address
some of these drawbacks. Unlike MPC, there is little standardization in the
specification of the SCM process, and it had achieved a good deal of adoption
by companies before being offered as part of the management sciences
curriculum in business schools. You are likely to see different representations of
SCM across manufacturing companies and software vendors. A common
illustration of SCM is shown in Figure 1-5.

Figure 1-5: The supply chain management (SCM) process framework

The SCM framework consists of several processes: inventory planning, network
planning, demand planning, supply planning, and sales and operations
planning(S&OP). This framework directly addresses several of the issues
present in MPC:

Network planning reduces costs by optimizing the placement of facilities

and flow of goods, considering transportation, warehousing, and
manufacturing costs.

Inventory planning calculates optimal customer service levels, inventory

levels, and cash budgets considering uncertainty in demand, variability
in supply, as well as costs for holding inventory and for missing demand.

Supply planning utilizes these targets to plan production and purchases

for the entire network of distribution centers and manufacturing plants.
Thus, it addresses the single-facility limitation of MPC.

S&OP is a cross-functional process for reviewing and reacting to demand

and supply imbalances. This process involves executives and
stakeholders and addresses the inwardly focused nature of MPC.

Demand collaboration and supply collaboration explicitly include

partners (retailers, contract manufacturers, and strategic suppliers) into
the information-sharing process.

As with MPC, the supply chain management framework divides the processes
into planning and execution categories. This distinction is important since the
nature of activities differ between the two: While execution processes tend to
be transactional and numerous, planning activities are performed less
frequently, are more analytical, and often involve upper management. Demand
planning, supply planning, and S&OP are usually performed on a monthly basis.
Inventory planning may be performed on a monthly or quarterly basis,
depending on the extent to which the demand plan fluctuates month-to-month.
Network planning may be a quarterly or even an annual activity.
Figure 1-6 illustrates the various uses of these processes by different
departments within a company. There are several processesnetwork
planning, inventory planning, and S&OPthat involve all departments. Indeed,
as SCM continues to evolve, additional stakeholders are included; the
involvement of finance in the cross-functional processes has become standard.
In addition, the engineering department may also be included for network and
inventory planning, since product design features such as modularity and
component commonality can significantly supply chainperformance. This is one
of the key features of supply chain managementit explicitly considers the
impact of actions of one part of the company on another, involves all parties
impacted, and allows for decisions to be made that are beneficial not just for a
department, but for the company as a whole.

Figure 1-6: Relevance of supply chain processes to different departments of a

company
[1]

For more details, see Thomas E. Vollman, William L. Berry, D. Clay Whybark,
and F. Robert Jacobs, Manufacturing Planning, and Control Systems, 5th ed.
(New York: McGraw-Hill, 1997).
Supply Chain Systems

The use of software applications in SCM is extensive, mainly due to the growing
scale of businesses, the adverse impact of process variances, and the need to
stay competitive in an increasingly digital environment. An example of system
layout for SCM is shown in Figure 1-7; these systems are segmented based on
enterprise vs. collaborative systems, as well as centralized vs. site
deployments. Planning and business intelligence systems are usually deployed
in a centralized fashion, so that operations can be viewed across sites and
synergies and cross-site decisions can be taken. Systems for communication
and collaboration have gained in importance due to the need to quickly
communicate new and important information to partners, and electronic data
interchange (EDI) networks are being augmented with web-based collaborative
systems that allow partners to analyze the data and make changes.

Figure 1-7: Systems layout for supply chain management

Some of the key differences between traditional MPC and supply chain systems
are the following:

Site vs. corporate deployment. Manufacturing planning and control

systems are deployed to specific manufacturing plants (i.e.,
decentralized deployment). For example, for a company with five plants,
five different instances of the MPC systems, one for each plant, must be
installed. Similarly, warehouse management systems are deployed to
specific distribution centers. In contrast, supply chainsystems are
deployed at a corporate level (i.e., centralized deployment). This
centralized deployment allows for activities to be coordinated across
plants and distribution centers, providing the company the opportunity
to optimize operations across facilities. However, centralized
deployments come with their own challenges, such as the effort required
to synchronize the collection of data across multiple facilities.

Desktop vs. server deployment. The traditional desktop deployment of

production planning systems has changed over time to server
deployments. This has allowed for plans to be shared between people
and better support cross-functional workflows. Servers also provide
greater computational power, which is required for supporting increased
scale due to product proliferation and multi-site supply chains.
Additionally, for companies providing supply chain systems, server-based
systems are far easier to maintain and manage.

Batch vs. real-time data collection. The prevalence of bar codes or Radio
Frequency Identification (RFID) tags on shipments has resulted in the
collection of a significant volume of data related to in-transit and onhand inventory. Since this data can be used in the demand
andsupply planning processes to obtain a real-time view of inventory and
make better decisions, real-time (or near real-time) data collection has
become an integral part of the supply chain systems design.

Manual vs. automated workflows. The prevalence of server-based

systems and high-bandwidth networks has enabled automation with
respect to data transfers between systems and partners. Workflows have
also become automated, and review and approval steps for various
decisions are now completed within the system, without having to
documents and emails. As a result, it is rely on cumbersome common for
a workflow system to be an integral part of the system landscape.

Proprietary vs. open networks. The traditional method of using Electronic

Data Interchange (EDI) to communicate with suppliers and customers
continues to be used by most companies. However, the inflexibility of
EDI combined with the need to communicate additional information has
resulted in the creation of communication networks that use the Internet
as the transport mechanism, and data models tuned to supporting a
collaborative exchange.

Proprietary vs. industry standards. As companies begin to collaborate

with several partners, the need for an industry standard became
apparent. For example, consider a manufacturer collaborating with a
dozen retailers; if each retailer communicates purchase forecasts and
orders in a proprietary format, the manufacturer is forced to
accommodate and stay abreast with all these formats, which increases
the cost of doing business. This has been the main driver for standards
such as RosettaNet for the electronics industry and Collaborative
Planning, Forecasting, and Replenishment (CPFR) for the retail industry.
These standards define a data model for exchanging information as well
as recommended workflows for timing the exchanges.

As the Internet continues to evolve, network bandwidth continues to become

more readily available, and new devices for ready access of information are

invented, the supply chain systems landscape will continue to evolve to take
advantage of these capabilities. The chapter on the
evolving supplychain (Chapter 8) covers some of the changes that are
forthcoming.
The Supply Chain Organization
Traditionally, supply chain management has not been a separate department
within the company, but a set of processes performed by personnel from other
departments such as manufacturing and procurement. However, this is
changing as large- and mid-sized companies have realized that the costbenefits
that can be achieved by focusing on supply chain efficiency are significant. This
has resulted in the creation of a dedicated organization with ownership of the
cross-functional processes and supply chain systems.
The role of the person performing these planning functions, referred to as "the
analyst," is essential to ensuring that each step is being executed in the best
possible manner. In large companies, several people may be required to
perform the different functions, but it is important for skills and a common
understanding to be shared. Often, the role is filled by an individual from
manufacturing, distribution, or procurement. While in-depth knowledge of a
particular discipline is important, the requirements of a supply chain analyst
are much broader, as described in Table 1-4. Not only does the analyst require
an understanding of the different disciplines in the company, but she also
needs to be aware of the financial situation and management methods. Finally,
in order to be successful, the analyst needs to be able to effectively
communicate issues, actions, and results to the company's executives.
Table 1-4: Breadth of Knowledge Required by
the Supply Chain Analyst
Open table as spreadsheet
Area
Specifics
Disciplines
Purchasing processes, suppliers contracts and relations
Manufacturing processes and capacity positions
Distribution processes, storage and transportation
capacity
Marketing processes, pricing and promotion strategies
Finance
Material prices, contract manufacturing costs
Manufacturing overheads and labor costs
Distribution center costs, transportation rates
Cost of capital, cash situation and budgets
Managerial accounting principles
Management methods Inventory management
Forecasting and demand planning
Network planning

Table 1-4: Breadth of Knowledge Required by

the Supply Chain Analyst
Open table as spreadsheet
Area
Specifics
Metrics and review processes
Information
Enterprise data availability
technology
Enterprise system features
Information exchange workflows
System usageERP and planning systems
Spreadsheet calculations and reporting
Summary
Supply chain management is the process of efficiently coordinating the flow of
material across suppliers, transportation providers, manufacturers, distributors,
and retailers. Executed properly, SCM will improve customer service and
revenue achievement while simultaneously reducing operatingcosts. Achieving
this goal requires a structured approach towards managing production,
distribution, and working capital. The remaining chapters provide the details of
the methods for managing demand and supply. Chapter 2 is on inventory
planning and describes the approach toward managing mismatches between
demand and supply. These approaches connect operating inefficiencies
to cost and margins, and this understanding is required for understanding the
benefit from planning and effective supply chain management.
Chapter 3 is on demand planning and describes methods for specifying the
demand signal considering several factorshistorical sales, market conditions,
customer budgets, demographics, and environmental factors. The benefit from
an accurate demand signal is without debate, and companies in almost every
industry will find that some or all these methods are useful for improving
accuracy.
Chapter 4 is on supply planning and describes methods for converting the
demand signal into a production and procurement signal considering several
factorson-hand inventories within the enterprise and in the channels, open
purchase orders, manufacturing and supply lead times, manufacturing
capacities, and safety stock targets.
Chapter 5 is on sales and operations planning, which is the process step that
brings the different parts of an organization to a common understanding and
plan. This process needs to be designed with care since it involves executives
from different disciplinesan improperly designed process can have the
adverse effect of wasting precious time.
Chapter 6 is on network planning and describes several approaches toward
understanding optimal placement of manufacturing and distribution locations
in the supply chain network.
Chapter 7 is on supply chain performance and provides metrics for managing
the various supply chain functionsmanufacturing, procurement,

transportation, and the overall supply chain. This chapter also introduces some
ideas for continuous improvement.
Chapter 8 is on the evolving supply chain and introduces several developments
that can have a lasting impact on the supply chain, specifically in the areas of
production, fulfillment, real-time information, systems, and carbon footprint.
Finally, Chapter 9 concludes with some key takeaways from all these areas. For
many companies, supply chain practices have been developed in an ad hoc
manner, which can result in disparate approaches toward managing different
product lines and business situations. The points highlighted in this chapter list
some of the common mistakes made by adopting these ad hoc approaches.

Chapter 2: Inventory Planning

Overview
Goods-producing companies hold inventory to fulfill orders or in anticipation of
customer demand. Indeed, inventory is reported as an asset on the balance
sheet, so a company's executives may approve holding high inventory levels in
order to meet its obligations. However, in a challenging business environment
where products are frequently discounted or discontinued, holding inventory
has become increasingly detrimental to operational performance.
A company often maintains inventory levels based on simple rules in order to
ensure availability, but with no consideration given to impact on margins.
Textbooks provide some approaches toward analyzing inventory margins, but
the mathematical models are often too rudimentary to be applied to typical
business situations. This chapter provides a comprehensive approach toward

analyzing and managing inventory situations, including the inventory-planning

procedure and mathematical models for analyzing margins. Several examples
are provided to help clarify how these models can be applied to practical
situations.
The chapter begins with a detailed review of the role of inventory in operations
and an activity-based categorization of inventory. Following this, mathematical
models for analyzing inventory levels are developed for each of these
categories. The chapter concludes by applying these models to analyze various
business situations, illustrated via numerical examples using spreadsheets.
The Role of Inventory in Operations
The importance of maintaining inventories can be seen from the U.S. Census
Bureau's survey of Manufacturer's Shipments and Inventories (see Table 2-1).
An electronics manufacturer is continually driving down inventory levels due to
the risk of price erosion and obsolescence, while an apparel manufacturer
might choose to maintain higher inventories to ensure adequate service levels.
Additionally, inventory policies can vary by product within an industrythe
same apparel manufacturer may hold lesser inventory of seasonal or fashionoriented garments. As expected, electronics manufacturers maintain low
inventories, mainly due to rapid price erosion. On the other hand,
pharmaceuticals manufacturers maintain far higher inventory levels since there
are fewer concerns related to price erosion and obsolescence.
Table 2-1: Manufacturer's Shipments and Inventory Data (in Million
USD). Source: US Census Bureau, August, 2014
Open table as spreadsheet
Industry
Shipments Inventories Inventory
(Months)
All Manufacturing
$503,106
$653,917
1.3
Durables
$245,858
$403,084
1.6
Automobiles
$9,707
$2,869
0.3
Computers
$420
$910
2.2
Defense Communications
$367
$1,075
2.9
Household Appliances
$1,801
$2,024
1.1
Wood Products
$8,601
$10,699
1.2
Non-Durables
$257,248
$250,833
1.0
Apparel
$1,177
$2,743
2.3
Beverages
$12,288
$16,678
1.4
Food Products
$66,169
$47,541
0.7
Paper Products
$14,528
$14,576
1.0
Petroleum
$69,282
$47,521
0.7
Pharmaceuticals
$14,500
$30,894
2.1
Plastic and Rubber Products $18,984
$22,568
1.2

Here are some common reasons for holding inventory:

To protect against that possibility of missed revenue if demand is higher
than anticipated.

To ensure that the lack of availability of supplies in a timely manner does

not result in missed demand.

To take advantage of quantity discounts, and in anticipation of price

increases.

To negotiate seasonal demand and smooth production schedules.

To prepare for an industry-wide shortage of raw materials or critical

parts.

However, holding inventory above the immediate needs of a company has a

negative aspect in the form of additional costs. These are represented as
holding costs, which includes the cost of storage and handling, the cost due to
tying up capital, as well as the possibility of theft, damage, and obsolescence.
Therefore, the whole effort related to optimizing inventory revolves around
balancing the benefits of inventory against these costs. A few of the questions
that need to be addressed by inventory management, keeping this trade-off in
mind, include:

What is the inventory level required to ensure a particular level of

service to the customer?

What is the quantity that needs to be ordered for a particular product or

part? How should these quantities be phased over time?

How should inventory levels be set in order to minimize transportation,

manufacturing, and purchasing costs?

How do supplier lead times and commitment windows affect inventory

policy?

How should inventory policies be set for seasonal and lifecycle products?

How should inventory be staged across the distribution network to

maximize return on investment?

How should part inventory levels be determined when the part is used
across many different products?

These questions can arise at several different stages in the supply chain, within
and across companies, as shown in Figure 2-1 and Figure 2-2. The figures list
common inventory categories based on the progression of material and
products through the supply chain. Comparing the two figures reveals
that several inventory-related questions are common for the two supply chains,
even though the products and sales models are very different. The most
common inventory categories are the following:

Cycle stock is the inventory required to meet the expected demand until
the next replenishment occurs, where the expected demand is a

combination of firm orders and forecasts. Since cycle stock does not
account for the unexpected, safety stock (or buffer inventory) is the
inventory required to account for uncertainty in demand
and supply variability.

Batch inventory is the quantity required in order to minimize

transportation, manufacturing, and purchasing costs. For transportation,
this includes supplies required to take advantage of full container or
truckloads. For manufacturing, this includes any additional production
required to minimize setup and run costs. For purchasing, this includes
the additional supplies required to take advantage of price discounts.

Seasonal or prebuild inventory refers to the accumulation of inventory

due to capacity constraints at manufacturing plants. Hedge or stockpile
inventory refers to any additional purchases made in anticipation of an
industry-wide scarcity or price hike.

Staged inventory refers to inventory at a distribution center that is not

used to service customer demand directly, but instead used to service
regional (localized) distribution centers.

Figure 2-1: Inventories in a lumber supply chain

Figure 2-2: Inventories in a camera supply chain

These inventory categories are applicable to finished goods as well as raw
material inventory. For a business, inventory simultaneously represents a
benefit and a riskthe benefit obtained from holding inventory and quickly
fulfilling orders is offset by the possibility of tying up capital and risking
obsolescence. Some of these risks and trade-offs are schematized in Table 2-2.
On account of this two-sided nature of inventory, it is necessary to analyze
business situations carefully in order to ensure that inventory levels are
frequently adjusted as changes occur. The methods and tools for determining
the optimal response for different situations are described in the remaining
sections of this chapter.
Table 2-2: Examples of Benefits and Drawbacks of Different Inventory
Categories
Open table as spreadsheet
Categor Benefits
Drawbacks
y
Safety
Reduces stockout and improves
Increases inventory levels,
stock
customer service.
holding costs, obsolescence risk.
Batch
Reduces manufacturing and
Increases inventory levels and
inventory transportation costs.
associated costs.
Seasonal Reduces
Increases inventoryinventory manufacturing costs (overtime)
related costs since material is
and tooling investment.
produced well in advance. Poor
forecast accuracy can exacerbate

Table 2-2: Examples of Benefits and Drawbacks of Different Inventory

Categories
Open table as spreadsheet
Categor Benefits
Drawbacks
y
issues.
Stockpile Improves material availability and Increases inventoryinventory purchase prices during industry- related costs since materials are
wide shortages.
procured in advance.
Staged
Reduces inventory levels while
inventory maintaining customer service
levels.
The Inventory Planning Process
In most companies, the responsibility for inventory management belongs to
the supply chain organization. If the company does not have a
separatesupply chain department, this responsibility may belong to
manufacturing, procurement, or distribution, depending on the company's
heritage. In all situations, it is important to identify a single person to be held
responsible for all inventory decisions in order to ensure that decisions are
being made in a timely and uniform manner, and that questions from others
within the company are adequately addressed.
Managing inventories is a data-intensive process, requiring, at a minimum,
demand, lead time, and cost data. An example of a planning process and the
flow of information is shown in Figure 2-3. The process begins with collecting
data, followed by calculating demand and supply variability. These uncertainty
values drive the level of buffers required in the system. In addition, when
variability is tracked over time, it provides insight into items for which
operational performance has deteriorated. For example, if the supply variability
for an item has changed from 3 days to 10 days, it highlights the need to
review the procedures in place with the relevant supplier and transportation
provider.

Figure 2-3: The inventory planning process

Once these uncertainty values have been updated, the next step is to calculate
the optimal service level and the resulting safety stock requirements. The
optimal service level is calculated based on several factors, including demand
and supply variability, the projected demand, inventory holdingcosts, and
shortage costs associated with inadequate inventory. These new targets are
compared with the current values for safety stock (for material planning
purposes) or reorder points (for replenishment). At this point, the workflow for
accepting changes may differ by company depending on the number of items
that need to be planned as well as item costs and margins. If there are several
thousands of items, then a "control limits" approach can be used to
automatically accept changes if they are below a threshold. However, if the
differences exceed a certain threshold or if the cost of inventory is high, these
changes can be manually reviewed. During manual review, the analyst needs
to evaluate the reasons for the change, determine if any changes to the inputs
(variability, lead times, and costs) need to be made, and redo the calculations,
if necessary.
Once a list of changes has been created, the next step is to compare the
implications of the change on cash requirements. Typically, inventory budgets
are specified at a product line or facility level; therefore, the cash requirements
across a set of items will need to be added and compared with the budget. If
the requirements are higher, then the analyst has to determine, with help from
finance, whether there is a reason to revise the budgets. However, if budget
changes are not an option, then the analyst has to allocate the available cash

to the different items. An example of a cash allocation procedure is provided

later in this chapter.
The final step in the process is to export the data to other systems, including
updated reorder points to replenishment systems, and updated safety stock
targets to supply planning and materials requirements planning systems.
Changes to these policies are also used to update targeted metricstarget
turns and days of inventory, cash investment levels, and the updated gross
margin return on inventory (GMROI).
The frequency with which the inventory planning process needs to be
performed is determined by several factors, including the following:

Updates to the demand forecast

Updates to inventory budgets

Addition of new products, customers, parts, and suppliers

Addition of new distribution locations

Of these factors, only the first two are periodic in nature: demand planning is
usually performed on a monthly basis, and budgeting is performed on a
quarterly basis. Therefore, inventory planning is performed on a quarterly
basis, with monthly reviews in case demand patterns have changed
significantly. In addition, inventory planning will need to be performed on an asneeded basis as new products and facilities are added.
Measures of Inventory Performance
To determine how much inventory a company needs to maintain, it is first
necessary to define a few metrics to represent goals. The most fundamental
metric for maintaining inventory is customer service. If there is sufficient
inventory, then the customer's order is fulfilled in a timely manner and the
customer is satisfied. Otherwise, the customer may have to wait, be offered a
reduced price, or leave empty-handed and buy a competing product. A few
common measures of inventory performance are briefly described below.
(Chapter 7 describes at length the methods for evaluating and managing
inventory performance.)

Stockout service level. This is the probability of fulfilling all orders from
inventory in a particular period. If an order is short-shipped even a single
unit, then it is considered a stockout. This metric is useful in situations
when a customer charges a penalty for receiving partially filled
shipments. Another way to think about the stockout metric is the
probability that stock will be depleted before the arrival of new supplies.

Fill rate. This is the number of units fulfilled from inventory. This is less
exacting than the stockout metric since credit is given for fulfilling a
portion of the order. For example, if 100 units are ordered in a period
that has only 95 units of inventory, then the fill rate is calculated as

95%. However, since not all 100 units were shipped from inventory, the
stockout metric for this period is 0. The fill rate metric is useful when the
penalty is best reflected by the number of units left unfulfilled, or when
partial shipments are not penalized.

Period fill rate. This is the number of units fulfilled from inventory and
replenishments, as a proportion of the total units ordered in a time
period. Since this measurement includes inventory that can be made
available over a period of time, it is the least exacting of the three
customer service measurements. This metric is useful when the
turnaround time required by the customer allows for replenishments,
after factoring the time taken to ship products to the customer.

Days of inventory. The number of units or financial value of inventory, in

isolation, can be misleading if demand changes significantly. A more
revealing measure is days of inventory, measured as the number of days
of sales that can be supported by the inventory. An alternative way to
calculate this metric as the number of units of inventory divided by the
average daily demand.

Inventory turns. This is the number of times inventory is turned over in a

year. When turns is calculated based on units of sales, then it is equal to
the annual sales divided by average inventory over the year. Upon
comparing this measurement with the days of inventory, it is easy to see
that the two measurements share an inverse relationship and it is
possible to derive one from the other. However, it is common to calculate
turns based on the financial value of sales; the formula is the cost of
goods sold divided by average inventory. This financial calculation can
result in different values as compared to the units-based calculation due
to cost variances over the year. Inventory turns is the most popular
measure of inventory performance, and is also referred to as inventory
turnover or stock turnover.

GMROI. This is the income generated from every dollar spent on

inventory, calculated as the annual profit divided by the average value
of inventory over all the weeks of the year. Note that the GMROI aligns
with return on assets for companies for which inventory is the primary
operating asset, such as distributors and retailers.

Variability in the Supply Chain

Demand and supply variability are the primary factors driving the need for
buffers in the supply chain (other factors include an increase in defective parts
and lower-than-anticipated manufacturing yields). Demand uncertainty arises
due to several factorschanging consumer preferences, economic conditions,
environmental factors, new regulations, and competitive pressures, to name a

few. Since it is impossible to eliminate these sources of variability, companies

have attempted to reduce the impact by increasing the lead time that is
available to satisfy demand (the order lead time). When the order lead time
can be extended to the level that it is greater than the lead time required to
procure raw material and manufacture product, then the company operates in
a build-to-order (BTO) environment.
An example of a BTO environment is the custom furniture supply chain. Only
after the order from the customer has been confirmed does the manufacturer
order raw materials and produce the item. This results in delivery of product to
the consumer four to five months after order placement. Due to this
commitment provided by the customer, BTO models do not experience demand
uncertainty. However, most companies do not have the luxury to dictate lead
times. Retailers have to deal with zero order lead times since the product has
to be available on the store shelves when the consumer walks into the store.
Manufacturers usually have a one-to two-week order lead time to ship material
after receiving the order from the retailer, and the manufacturer has no option
but to manufacture products to a forecast. This situation is referred to as buildto-forecast (BTF) or build-to-stock(BTS). Short lead times are important in
business-to-business situations as well, as underscored in this excerpt from an
annual report of the Houston Wire & Cable Company:
Our cable management program is an inventory management system that preallocates specialty wire and cable for a customer's specific project and includes
a custom program designed to manage all of the wire and cable requirements
for the project. The major benefits of our cable management program include
guaranteed availability of materials, plus safety stock; immediate shipment of
material upon field release; firm pricing and a dedicated project manager.
- Houston Wire & Cable Company, 2008 Annual Report
Chapter 3 provides additional examples and details regarding the impact of
demand uncertainty on companies.
Another component of variability is related to supply, and this also increases
the level of safety stock that is required. Supply-side variability is introduced
due to several reasons, including variance in production activities at suppliers'
plants, an increase in the time taken to transport material due to load
consolidation, an increase in the time taken to clear customs, as well as
external factors such as weather. Examples of reasons contributing to a
delayed shipment are shown in Figure 2-4.

Figure 2-4: Examples of factors contributing to shipment delays

Supply lead time compounds the negative effect of variability in two ways.
First, the forecasting horizon has to be increased to match this lead time,
resulting in an associated increase in error. Second, inventory positions have to
be committed to for the duration of the lead time, magnifying the impact of
poor decisions.
An increase in lead times can raise the exposure due to unfavorable pricing of
components for products that undergo high price erosion. Another by-product is
an increase in work-in-process inventory (inventory that remains in various
stages of manufacturing or transportation), which increases the cash-to-cash
cycle time for suppliers. During tough economic conditions, tight cash flow
situations can adversely affect the viability of small- and mid-sized companies.
Notwithstanding these drawbacks, lead times have steadily increased from the
mid-1990s thanks largely to the promise of lower labor costs associated with
outsourced, overseas manufacturing. The following excerpt from an annual
report of Domino, a supplier of printing products, illustrates this extension and
variance across products:
Our manufacturing operations benefited in 2010 from the restructuring and
consolidation undertaken in the prior year. Cost efficiencies coupled with
volume increases have enabled us to report an increase in gross margin rate to
just below 50 per cent. This was achieved against a backdrop of increasing

lead time in supply chains as global demand increased at a faster rate than
component manufacturing capacity, and increased costs, in particular freight
charges, as actions were taken to expedite parts supply to our factories. Whilst
component availability was an issue in particular through the second quarter of
the year, we were able to utilise buffer stocks to avoid any significant impact
on supply to our customers. At year end the situation was largely back to
normal, inventories have been replenished and lead times from our suppliers
have returned to normal.
- Domino Printing Sciences plc, 2010 Annual Report
The excerpt emphasizes the importance of the close relationships with
suppliers required to remain responsive in the face of increasing lead times. If
such collaborative measures are not put in place, only a part of the anticipated
benefit from outsourcing will be realized. Reasons that an increase in lead time
results in lower flexibility and disruptions include the following:

Reliance on partners for timely execution. The reliance on a different

company for manufacturing can increase revenue risk when capacity is
tight and the manufacturer is provided other more profitable
opportunities to utilize capacity.

Increased possibility of disruptive events. As the horizon for procurement

and manufacturing increases, the number of disruptive events that can
affect timely fulfillment also increase. Examples of these events include
machine failures, industry-wide commodity shortages, and weather
effects.

More complex processes. Outsourced and off-shore manufacturing have

introduced several additional steps in the delivery process, including
ocean freight and customs clearance. These additional steps introduce
variability due to dependence on other companies and governmental
agencies, many more hand-offs, additional regulations, and additional
paperwork requirements.

Supplier operations introduce variability related to production schedules,

capacity shortfall, or rework due to poor quality resulting in delayed availability
of goods. These sources of variability can be addressed by implementing
appropriate processes for quality control and collaboration of relevant demand
and capacity information.
In-bound transportation introduces variability related to missed shipment
windows, unavailability of capacity, and extended wait times in order to
consolidate loads. These issues can be partly or completely addressed by
ensuring alignment between production and transportation schedules, and by
communicating mid- and long-term shipment requirements to transportation
providers.

Purchasing and information-sharing processes can introduce variability, either

due to data errors while processing orders, delays in calculating purchasing
requirements and communicating these orders to suppliers, or due to lumpy
orders caused by consolidation and pricing concerns. Data errors can be
reduced by the use of systems to limit manual inputs. Furthermore, systems
can help with timely processing of purchases and communication of orders.
Finally, lumpy demand can be eliminated by negotiating price agreements
based on quarterly or annual purchasing amounts (as opposed to each
individual shipments), or by the use of low-cost transportation options for small
shipments.
Finally, supply variability can be caused by external factors such as inclement
weather, heavy seaport traffic and congestion, or customs delays. While little
can be done to reduce the variability associated with these factors, good
planning can help mitigate the effects. Table 2-3 lists some examples of
variability and management aids to reduce or deal with each.
Table 2-3: A Few Methods to Address Supply Variability
Open table as spreadsheet
Category
Source of Variability
Management Aids
Supplier
Capacity shortages.
Collaboration related to capacity,
operations
Unavailability of raw
production schedules, and purchase
materials.
orders.
Transportatio Unavailability of
Forecast collaboration.
n
transportation
Alignment of production and
equipment.
transportation schedules.
Missed shipment
windows.
Information
Delay in communication Rigorous replenishment process to
sharing
of orders to suppliers.
release purchase orders in a timely
Data errors.
manner.
Use of electronic exchanges to
automate information sharing.
External
Weather.
factors
Customs delays.
Labor/union issues.
Safety Stock (Buffer Inventory)
Since a majority of businesses operate in an environment where material is
produced ahead of firm customer orders (build-to-forecast), there is a
widespread need to hold buffer inventory. This buffer inventory is required to
fulfill higher-than-expected demand as well as a cushion against delayed arrival
of raw materials. Supply chain professionals have long dealt with buffer
inventory, and the most common methods employed to determine these levels

are the service level model and the newsvendor model. The service level
method determines inventory levels based on the probability of meeting
demand. This determination is based solely on the uncertainty that is inherent
in demand and not on any financial consideration. On the other hand, the
newsvendor model determines optimal inventory levels according to a trade-off
between the profit obtained from holding inventory against an estimate of
the cost of holding inventory. Though the newsvendor model is attractive due
to its simplicity, it makes several assumptions that make it applicable only to
products with short lifecycles (for example, newspapershence the nameor
groceries). It is therefore necessary to utilize a different model for products that
do not become obsolete in a short period of time. Such a model, called
the incremental margin model, is introduced toward the end of the section.
The Service Level Method
The service level method estimates the safety inventory in consideration of the
uncertainty of demand over the lead time for supply (Figure 2-5). Demand
variability or uncertainty is commonly specified using the variability in demand
(when replenishment models such as reorder points are used for maintaining
inventory levels), or by the standard deviation of the forecast error (when
forecasts and material requirements plans are used to maintain inventory
levels). The entire value of uncertainty is determined by multiplying the
variance in forecast error with the supply lead time since an inventory position
needs to be taken for the entire duration of the lead time. The model also
requires the estimation of a service level factor (k), which represents a
measure of the probability of meeting demand directly from on-hand inventory,
referred to as the service level. The stockout service levelis defined as the
probability that demand can be met from on-hand inventory. The value
of k depends on the nature of probability distribution that best describes the
demand signal. It is common to use the normal probability distribution unless
the analyst can determine a more appropriate distribution.Figure 2-5 lists
values of k for various service level values. Higher values of k result in higher
inventories and service levels.

Figure 2-5: Illustration of the service level method for determining safety
stock
Example 2-1: Applying the Service Level Method
Demand (actual sales) and forecast data for a consumer good are shown
in Figure 2-6 for eight months of history. Since the lead time for supply is two
months, orders are based on the two-month prior forecast. Forecast error is
calculated as the difference between actual sales and the two-month prior
forecast, and the root mean square error (RMSE) is calculated to be 2,123 units
(i.e., 19% of average monthly sales), as shown inFigure 2-6.

Figure 2-6: Procedure for determining forecast errors

In the spreadsheet, the RMSE has been calculated according to Equation 2-1.
(2-1)

where n is the number of observations. If the company desires a service level

of 95%, the equivalent value of k is 1.65 (from Figure 2-5). From the same
figure, the safety stock is calculated as

Therefore, the company should hold 4,953 units (approximately 12 days of

inventory, based on average monthly demand) in order to provide the desired
service level. If a service level of 99% is desired, then the calculation would
result in a safety stock of 6,994 units (approximately 18 days of inventory).

The popularity of the normal distribution for representing the probability of

forecast error is not arbitrary. Under certain situations, statistical estimates
converge to a normal distribution, as outlined by the central limit theorem. [1]
While it is important to select the appropriate probability function, in reality no
single function can accurately represent demand. Therefore, a certain amount
of error in inventory estimates cannot be avoided, and it is necessary to
monitor performance and make adjustments when needed. Such a review
procedure is described in Chapter 5.
In practice, the standard deviation of demand (demand variability) has often
been used instead of forecast error in the equation. This assumption is
acceptable when demand is steady, uniform, and without seasonal effects.
However, if seasonality exists and the forecasting method accounts for these
effects, the use of standard deviation of demand can result in excessively highinventory requirements since demand can fluctuate more than the forecast
error, as illustrated in Figure 2-7. Therefore, the use of standard deviation of
demand for calculating inventory requirements is not recommended.

Figure 2-7: Potential issues in the use of standard deviation of demand vs.
standard deviation of forecast error for calculating safety stocks
In many practical situations, safety stock is required to cover demand
uncertainty as well as supply variability. Supply variability refers to the
difference between the expected and actual delivery time for raw materials.
Since supply variability introduces additional uncertainty, additional inventory
is required to provide the same service level. This additional inventory can be
calculated by modifying the equation in Figure 2-5 to include asupply variance
term, as shown in Equation 2-2.
(2-2)

where the first term under the square root symbol is the same as in Figure 2-5,
and the second term represents the additional inventory requirement due
to supply variability.
represents average demand and S represents the
standard deviation of the differences between the actual and
expectedsupply lead times.
The equation assumes that the variabilities in demand and supply are not
related (i.e., they are independent of each other)for this assumption allows a
combined variance to be calculated as the sum of the two individual variances.
But if the uncertainty in demand is correlated with variability insupply, this
calculation is not valid. Instead, the safety stock has to be calculated
separately for the two terms, as shown in Equation 2-3 for the perfectly
correlated case.
(2-3)

The difference between Equation 2-2 and Equation 2-3 is that in the latter the
variances are not combined and safety stock is computed separately for each.
Note that the correlated case will always result in a higher inventory level than
the independent case. When demand and supply uncertainties are not
perfectly correlated, the required safety stock will be in between these two
estimates. For formal treatments of covariance and correlation, consult any
standard statistics textbook.[2]
It is desirable to use the safety stock calculation for the independent case since
it results in lower inventories. However, independence requires that production
capacity (at the company and key suppliers' manufacturing plants) be far
greater than any unanticipated increase or decrease in demand. This condition
is often not true for dedicated production lines and manufacture of custom
parts since production capacity is usually set based on an expected value of
demand. In such cases, higher-than-expected demand will result in tight
capacity and a corresponding increase in production lead time. Therefore,
unless it is possible to determine that supplies for all assemblies and parts for a
product are independent of demand, it is recommended that the second
method (covariance) be used for calculating safety stock. Similarly,
transportation lead time variances may need to be considered as correlated if
the company expects a significant company-wide increase in demand or the
entire industry is experiencing an increase; in such cases, the transportation
providers may face a similar shortage of transportation capacity, and lead
times will increase as it takes longer to find free ocean containers or trucks.

Example 2-2: Applying the Service Level Method for Demand

Uncertainty and Supply Variability
For the data given in Example 2-1, the time taken to receive goods has been
noted to differ from the expected lead time of one month. Data is collected for
eight months of history and is shown in Figure 2-8. The average lead time is
calculated to be 37 days and supply variability (as measured by the root mean
square error, where error is the difference between actual and expected lead
time) is calculated to be 8 days. The spreadsheet formulas for the calculation
are shown in the respective cells.

Figure 2-8: Procedure for determining supply lead time variance

With this information, safety stock requirements can be calculated based on
demand and supply variability. Since the supply lead time variability is in days,
the daily average demand needs to be used for units to be consistent. The
calculation is
Average daily demand = 11,438 / 30 = 381 units.
If demand and supply variability are assumed to be independent, then the
calculation for a 95% service level is

Therefore, safety stock levels have increased from 4,953 (Example 2-1) to
7,059 units due to supply variability. This translates to an additional 6 days of
inventory, resulting in a total of 18 days. If the analyst perceives that the
supplier's production capacity is tight and that any increase in demand will be
accompanied by delays in supplies, then perfect correlation results in the
following calculation of safety stock by Equation 2-3:

The results reveal that covariance has resulted in an additional 2,923 units, or
8 days of inventory, for a total of 26 days. Depending on the cash positions of
the company, the analyst can select a safety stock level between the two
values18 days if the available budgets are tight and 26 days if customer
service and material availability are the priority.
An advantage of separating inventory requirements for demand
and supply variability is that the magnitude and improvement areas are
apparent. For example, if most of the safety stock requirement is to cover for
uncertainty in demand, then the areas requiring improvement are forecasting
and collaboration with channel partners. On the other hand, if supply variability
has a large impact, then areas to focus on include capacity alignment and
collaboration with key suppliers.
In conclusion, the service level method is simple to use and provides an
important connection between inventory level and customer service. On the
other hand, this method suffers from the following limitations:

No guidance is provided regarding the optimal service level for an item.

For example, is a 95% service level excessively high? Intuitively, it would
appear that a higher service level should be provided for a high margin
item, as compared to an item with a lower margin. However, the service

level method provides no guidance regarding how service levels should

be tailored by item.

No guidance is provided regarding the price required to provide a service

level to a customer, because costs, margins, and price are not included
in the formulation.

Addressing these questions requires that the financial aspects related to

inventory be included in the model. A simple method for performing this
analysis is the newsvendor model, described next.
The Newsvendor Model
The newsvendor model can be readily understood from the following statement
of the problem. Consider a newsvendor who needs to determine the quantity of
newspapers that needs to be purchased for each day. If demand is greater than
the purchased quantity, then the benefit (margin) from that additional demand
is lost. On the other hand, if the purchased quantity is greater than demand,
then the leftover newspapers are not sold and are disposed of the following day
as scrap. Given that the demand on any given day is not specified (it varies
randomly), how should the optimal inventory be determined?
The model is based on balancing two costs:
the shortage cost and obsolescence cost (also referred to as the scrap cost),
defined as follows:

The shortage cost (cS) is the penalty for not meeting demand.
This cost depends on the sales model of the company and, in businessto-business cases, on customer obligations and contracts. For example,
the shortage cost for a retailer is the margin that is lost due to inventory
not being available. For a food manufacturer shipping goods to a retailer,
the shortage cost could be a financial penalty for each order that is not
shipped in its entirety (ship-complete). In addition to penalties,
shortage costs can also include expedite costs related to rush
transportation, such as air shipments vs. ocean, or less-than-truckload
shipments vs. full truckloads.

The obsolescence cost (co) is the penalty due to inventory that is not
sold. It is calculated as the difference between the cost of procuring or
producing the item and the salvage price that can be obtained for the
leftover inventory (i.e., unit cost minus salvage price). Note that the
news-vendor model is a single-period model, and it requires that the
salvage price be lower than the unit cost. If this is not the case, a multiperiod model needs to be utilized. (One such model is developed in the
following section.)

The important aspect of the newsvendor model is that it explicitly considers

demand to be a random variable, characterized by an expected value and a
forecast error. The derivation of the model is shown in Figure 2-9. In the figure,

the first equation lists the profit function as the margin obtained from sales
minus two cost terms. The first term is due to holding excess inventory,
calculated as the unit obsolescence cost multiplied by excess inventory. The
second term is due to inventory shortage, calculated as the unit
shortage cost multiplied by the number of units of demand that cannot be met
from on-hand inventory. Because demand is random, it is necessary to
calculate an expected value of the cost incurred by assuming a particular
probability function for demand. In the derivation shown, a normal probability
function has been used to specify demand, which uses a bell curve to
determine the probability that demand will be greater or less than the expected
value. With this assumption, the optimal level of supply is determined by
differentiating the profit function with respect to the level of supply s, and
setting that expression to zero. This results in the following formula for
determining the optimal service level and supply:
(2-4)

Figure 2-9: The newsvendor model derivation

where
is the optimal supply. The standard deviation
represents the
combined variability due to demand and supply, calculated according
toEquation 2-2. The term F(

) is the cumulative probability function,

calculated in Microsoft Excel by the formula NORMDIST ( , , , true). It

represents the optimal service level because it captures the probability of
meeting demand. The cost ratio in Equation 2-4 is sometimes referred to as
the critical fractile.

The newsvendor model is useful for estimating supply targets over a single
month, quarter, or other period of a supply contract, as long as price
andcosts are constant throughout the period. Another assumption made by the
model is that the product needs to be disposed at a scrap value at the end of
the period. While these assumptions do limit the number of situations that the
model can be applied to, the fundamental insights provided by the model are
still very useful. Therefore, this model will be studied in depth in the following
pages preliminary to the development of a model that is applicable to a
broader variety of situations.
Newsvendor Model Applied to a Retail Situation
The situation considered in Example 2-3 is a perishable product stocked on the
retail shelf, such that any demand that is in excess of the inventory on the
retail shelf is lost. Because retail products are replenished on a frequent basis
(typically one to two times per week), it is possible to apply the newsvendor
model to products for which the lifespan is aligned with the replenishment
schedule.
Example 2-3: Application of the Newsvendor Model to a Perishable
Grocery Product
An expected weekly demand for a grocery item is 10,000 lbs, with a forecast
error of 20%. Inventory is replenished on a weekly basis. The item is purchased
for $1.50 per pound and sold for $2.50 per pound. The product lifespan is
approximately one week, and any leftover inventory is thrown away.
Determining the Optimal Inventory Level
Because leftover inventory has no value, the obsolescence cost is the purchase
price, $1.50 per pound. The company incurs no penalty for insufficient
inventory. Therefore, the optimal service level is calculated from Equation 23 as

The model dictates an optimal service level of 40%. For expected demand of
10,000 lbs and forecast error of 2,000 lbs (= 20%*10,000), the optimal order
quantity can be determined from the following spreadsheet function:

Therefore, the model dictates that the company should order 9,493 lbs every
week. Note that this quantity is less than the expected demand, due to the
high obsolescence costs.
It is possible to build upon the model and compute other useful measures.
(25)

where the Microsoft Excel functions for the distribution terms are F(s, ,
NORMDIST(s, , ,true), F(s, ,s) = NORMDIST(s, , ,false).

)=

The expected sales is calculated as

(2-6)

The expected fill rate is calculated as

(2-7)

where the expected demand is and expected sales is derived from Equation
2-6. The expected leftover inventory is calculated as
(2-8)
Expected values for costs and profits can now be calculated. The expected
holding cost is the unit holding cost multiplied by the leftover inventory.
(29)
The expected shortage cost is the unit shortage cost multiplied by lost sales.

(2-10)

The expected profit is the margin from expected sales minus the costs incurred
due to obsolescence and shortage:
(211)

where m is the target unit margin (selling price minus buying price). Finally,
unit margins are calculated as
(212)
The unit margin is a useful measurement for comparing against target margins
and providing guidance regarding prices.
Continuing the retail example, the following are computed:

Optimal service level = 0.40.

Optimal supply level = 9,493 lbs.

Expected lost sales = 1,076 lbs (from Eq. 2-5).

Expected sales = (10,000 1,076) = 8,923 lbs (from Eq. 2-6).

Expected fill rate = 8,923/10,000 = 89% (from Eq. 2-7).

Expected leftover inventory = 570 lbs (from Eq. 2-8).

Expected obsolescence cost = $855 (from Eq. 2-9).

Expected shortage cost = $0 (from Eq. 2-10).

Expected revenue = expected sales * price = 8,923 * 2.50 = $22,307.50.

Expected gross profit = $8,068 (from Eq. 2-11).

Expected unit margin = $0.85 per lb. (from Eq. 2-12).

Therefore, the gross margin that the company can expect is $0.15 less than the
targeted margin of $1 per lb. If the company wishes to achieve a margin of $1,
the price would need to be changed to $2.66 per lb.
Consider another situation: The company's management is not comfortable
with such a low service level because of stockout concerns and concern that
customers may be driven to other stores with better inventory positions.

Instead, a target service level of 90% is desired. This service level results in the
following:

Service level target = 0.90.

Required supply level = NORMINV(.90, 10,000, 2,000) = 12,563 lbs.

Expected lost sales = 95 lbs.

Expected sales = 9,905 lbs.

Expected fill rate = 9,905/10,000 = 99%.

Expected leftover inventory = 2,658 lbs.

Expected obsolescence cost = $3,986.

Expected shortage cost = $0.

Expected gross profit = $5,919.

Expected gross margin per unit = $0.47 per lb.

Therefore, the higher service level has resulted in significant margin erosion
due to the increase in scrap inventory. If the company wishes to retain its
margin of $1 per lb, then the price would need to be increased to $3.17 per lb.
The model can be used for several other analyses, such as analyzing the
impact of variability on margins. Figure 2-10 illustrates how an increase in
variability results in margin erosion. By quantifying the impact, management
can decide whether to invest in systems or new procedures to reduce forecast
error.

Figure 2-10: Impact of variability on unit margins

The example in Figure 2-10 illustrates the usefulness of the newsvendor model
in considering variability and costs in order to provide guidance regarding
supplies, service levels, and prices for a given retail situations.
Newsvendor Model Applied to a Strategic Buy Situation
In this section, the newsvendor model is applied to a business-to-business
situation involving a strategic purchase. Unlike the retail situation, the

company can meet unmet demand by increasing production but incurs thereby
a shortage penalty.
A company sells its goods through retail channels and needs to place a
production order with its contract manufacturer for purchasing a certain
quantity of the product line for an entire season. While the company can
estimate the expected demand, it is subject to significant error since the order
has to be placed well in advance of sales. If demand is greater than the
quantity ordered, then the company is allowed to order additional volume, but
the contract manufacturer will tack on an additional cost to cover its expenses
related to additional raw material purchases or due to overtime labor.
Conversely, if demand is less than quantity ordered, then the company will be
left with unsold inventory at the end of the season; this inventory can be
disposed, but at a steeply discounted rate.
The company needs to decide what order quantity it needs to place with the
contract manufacturer.
The newsvendor model can be used to answer this question. The model
requires the following quantities to be determined:

The expected demand (i.e., forecast) for the entire season. This quantity
can be determined based on sales of the same or similar products for the
prior year, adjusted for market conditions.

The error associated with the forecast so determined. This quantity can
be calculated by comparing the forecasts for prior seasons compared to
actual sales.

The obsolescence cost for excess inventory. Since leftover inventory at

the end of the season has to be disposed at a lower price, the
obsolescence cost is the purchase cost less salvage value.

The shortage cost for unmet demand. This is the additional cost charged
by the contract manufacturer for units in excess of the contracted
quantity.

Once these quantities have been determined, the profit equation for this
flexible production policy can be written as
(213)
Equation 2-13 is developed for the case when sales in excess of supply are not
lost since the option of increasing production is available (the model assumes
that sufficient lead times exist to increase production and satisfy retail orders).
Therefore, this profit equation is different from Equation 2-9, which is
developed for the case when sales in excess of supply are lost. Following the

procedure in Equation 2-9 for maximizing profits, the optimal service level is
calculated as
(2-14)

Example 2-4: Application of the Newsvendor Model to Determine

Seasonal Purchase Quantities
An apparel design company has created a line of products for the winter
season spanning November through March. The company uses a contract
manufacturer for production, and is required to place the order by June in order
to receive shipments by November. The company estimates the demand for
the product line to be 150,000 units, and the forecast error (RMSE) is estimated
to be 20%. The purchase cost is $15 per piece. The company desires a $10
margin and set the price at $25 accordingly. Any unsold inventory can be
disposed at $10 per piece. Finally, any production in addition to the contracted
amount will be satisfied with an incremental cost of $3 per piece to cover any
additional costs incurred by the manufacturer.
Determining the Optimal Service Level and Order Quantity
The shortage cost is $3 per piece, while the obsolescence cost is $5 (=
purchase cost salvage price = $15 - $10). From Eq. 2-14, the optimal service
level is calculated as

The model dictates an optimal service level of 38%. For expected demand of
150,000 units and forecast error of 30,000 (= 20%*150,000), the optimal order
quantity can be determined from the following spreadsheet function:

Therefore, the model dictates that the company should place an order for
140,441 units with the contract manufacturer. If demand is higher than this
level, then additional orders can be placed with the contract manufacturer.
As with the previous case, additional measurements can be generated using
the model. This situation differs from the previously described retail situation in
that demand in excess of inventory is not lost, because the apparel company
has the option of increasing production, such that

(2-15)
However, there is a possibility that production will need to be increased, which
is estimated as
(2-16)

Because there are no lost sales, the expected sales is simply the expected
demand,
(2-17)
The expected leftover inventory, obsolescence cost, shortage costs, and gross
profit are calculated as in the previous case (Equations 2-8 through 2-11). The
unit margin is calculated according to Equation 2-18:
(218)

Continuing Example 2-4, the following fields are computed:

Target service level: 38%.
Expected additional production = 17,350 (from Eq. 2-16).
Expected leftover inventory = 140,441 - 150,000 + 17,350 = 7,791.
Expected obsolescence cost = $5 * 7,791 = $38,956.
Expected shortage cost = $3 * 17,350 = $52,051.
Expected profit = $10*150,000 - $38,956 - $52,051 = $1,408,993.
Expected gross margin per unit = $1,408,993 / (140,441 + 17,350) =
$8.93.
Therefore, the model indicates that the margin that can be expected is less
than the anticipated margin of $10, and price would have to be increased by
approximately $1.07 to compensate for obsolescence and shortage costs that
may be incurred.
The newsvendor model also provides insight into the impact
of supply uncertainty. Due to supply variability, a greater level of supply is
required to provide the same service level. However, when supply is in excess
of the optimal value, the expected margin will decrease, per the newsvendor
model. This calculation is shown in Figure 2-11 with the negative impact
of supply variability being dictated by the magnitude of obsolescence cost.

Figure 2-11: Impact of supply variability on margins

The examples above illustrate the usefulness of the newsvendor model and
how it can be used to provide guidance regarding prices, profits, and policies.
There is, however, a significant drawback to this model: it is a single-period
model, with any leftover inventory at the end of the period being disposed at a
scrap value. (The period for inventory calculation purposes is the
replenishment frequency, which can range from daily when suppliers are local
to monthly for overseas shipments.) Because most products have lifecycles
that can last several months or even years, the single-period assumption is a
severe limitation since these products can continue to be sold beyond a single
replenishment period. Also, due to this single-period applicability, situations
involving variations in price, costs, and demand over time cannot be
accommodated. The first requirement of a generalized inventory model is the
ability to accommodate multiple time-periods. The incremental margin model is
one such method.
The Incremental Margin Model
The incremental margin model extends the newsvendor model to multiple
periods. In addition to the costs included in the newsvendor model, a multiperiod inventory planning model needs to include another penaltythe
holding cost. This is the penalty for holding inventory for a certain period of
time and includes the cost of storage, insurance, and spoilage. Costs that are
already present in the cost-of-goods calculation (for raw materials, production,
handling, and transportation) should not be included. Only those costs that are
incurred due to inventory being held for a certain period of time should be
included.
A multi-period inventory planning model needs to provide the following
capabilities:

Allow for inventory that is left over at the end of one period to be sold in
the following period.

Allow for the expected demand and forecast error to vary across periods.

Allow for the shortage cost, holding cost, and price to vary across
periods.

Allow the product to be sold at a salvage value at the end of any period.

The multi-period model developed in this section is referred to as the

incremental margin model, since costs and margins are incrementally
calculated for each period. The gross profit from s units of supply is calculated
by subtracting shortage, holding, and obsolescence costs from the total
margin. For the situation in which prices and material costs are uniform across
the periods, this is calculated according to:
(219
)

where n represents the number of periods corresponding to the shelf-life of the

item. Each of the terms in the equation is explained as follows:

The first cost term is the shortage cost, as explained for the newsvendor
model. It represents the penalty incurred in case shipments are not
made in a timely manner, or the cost of expediting to meet demand on
time.

The subsequent cost terms are the holding costs incurred by holding
inventory for the first and subsequent periods. Note that this
holdingcost is a period cost and includes the cost of capital. This cost is
different from the obsolescence cost term in the newsvendor model.

The final cost term is the loss due to obsolescence for the case when the
product has a shelf-life of n periods. Since the first term includes margin
from the entire s units of supply, the margin lost due to obsolete
inventory needs to be deducted. Also, if obsolete inventory can be
disposed for a price (the salvage price), then the resulting return is
calculated by multiplying the salvage benefit with the leftover inventory.
The salvage benefit is calculated as the difference between the salvage
price and the unit cost.

The expected profit per period is calculated according to Equation 2-20:

(220)

where the expected unit margin is calculated by Equation 2-19. The expected
sales depends on the sales situation and demand retention policy adopted by
the company. If unmet sales are lost (as in retail situations or when a company
chooses not to expedite or offer incentives to the customer to retain demand),
then the expected sales are given by Equation 2-6. On the other hand, if unmet
demand can be retained or backlogged, then lost sales is zero and the
expected sales equals the expected demand.
Appendix B presents a detailed development of the incremental margin model
and the methods needed to perform the computations using spreadsheet
functions. An application of the model is given in Example 2-5.
Example 2-5: Applying the Incremental Margin Model
Consider the grocery item in Example 2-3 with a shelf-life of 2 weeks. After 2
weeks, the product has no value and is disposed. Demand, costs, and price
remain uniform across the 2 weeks. The holding cost is estimated to be $0.01
per lb per week and includes the cost of capital and other inventoryrelated costs.
Determining the Optimal Inventory Level
The optimal supply is determined by plugging in different values
for s into Equation 2-19 until the gross margin is maximized to arrive at value
of 14,100 lbs. Recall that the optimal supply in Example 2-3 for the 1 week
shelf-life was 9,493 lbs. Therefore, increasing the shelf-life from 1 to 2 weeks
results in a significant increase in the optimal order quantity. The following
fields can be computed:

Optimal supply = 14,300 lbs.

Service level target = 98%.

Expected lost sales = 15 lbs (from Eq. 2-5).

Expected sales = (10,000 15) = 9,983 lbs (from Eq. 2-6).

Expected fill rate = 9,983/10,000 = 99.9% (from Eq. 2-7).

Expected leftover inventory = 4,155 lbs (from Eq. 2-8).

Expected unit margin = $0.993 per lb. (from Eq. 2-19).

Expected gross profit = $9,912 (from Eq. 2-20).

The expected gross margin for various supply levels is shown in Table 24 and Figure 2-12. High values of lost sales cause the steep decrease in
margins toward the left, while the gradual decrease in margins after 13,800
units is due to a comparably lower penalty associated with holdingcosts. After

approximately 15,000 units, margins decrease rapidly due to the increased

probability of scrap inventory.
Table 2-4: Impact of Shelf Life on Expected Margins
Open table as spreadsheet
Shelf-Life Optimal Su Expected Unit
Expected Gross Service
(wks)
pply
Margin (per lb.)
Margin
Level
1
9,493
$0.85
$8,068
40.0%
2
14,100
$0.993
$9,912
98.0%
3
15,400
$0.996
$9,961
99.7%
4
15,400
$0.996
$9,961
99.7%

Figure 2-12: Using the incremental margin model to calculate expected

margins
Recall that the expected unit margin for 1 week of shelf-life (Example 2-3) was
$0.85/lb. The increase in shelf-life from 1 to 2 weeks has increased the
expected margin significantly due to the reduced penalty from scrap. The
impact of shelf-life on optimal supplies and margins is shown inTable 2-4.
As expected, the increase to 3 weeks has a large impact on optimal supplies.
However, the additional increase to 4 weeks has minimal impact since the
probability of obsolete inventory is minimal (due to low demand variability).
This multi-period inventory model can be used to understand the impact of
shelf-life on optimal supplies and margins. The flexibility provided to model
lifecycle demand and end-of-life scrap loss is very useful for industries such as
grocery, pharmaceuticals, and electronics. Consider the following excerpt from
an annual report of Regeneron, a biotechnology company:
Cost of goods sold increased to $118.0 million in 2013 from $83.9 million in
2012 due primarily to increased sales of EYLEA. In addition, in 2013 and
2012, cost of goods sold included inventory writedowns and reserves totaling
$9.1 million and $17.0 million, respectively. We record a charge to cost of
goods sold to write down our inventory to its estimated realizable value if

certain batches or units of product do not meet quality specifications or are

expected to expire prior to sale.
- 2014 Annual Report, Regeneron
Increasingly, other industries are being similarly impacted, partly due to fastchanging customer preferences and the increasing presence of embedded
electronics in consumer products.
In conclusion, the incremental margin model provides an important extension
of the newsvendor model to multiple periods and time-varying prices and
demand. The flexibility of this model allows for several business situations to
be analyzed, such as price rebates, end-of-life ordering, and cash budgeting.
The remaining sections of the chapter cover such topics.
[1]

For further details and guidelines for the use of other probability functions,
see for example Athanasios Papoulis, Random Variables and Stochastic
Processes (McGraw Hill, 1989).
[2]

See, for example, Erwin Kreyzig, Advanced Engineering Mathematics (John

Wiley, 2005).
Batch Inventory
Batching refers to the production, purchasing, or transportation of material in
certain lot sizes, potentially resulting in inventory in excess of the target.
Batching is performed primarily to reduce coststo take advantage of quantity
discounts offered by suppliers, minimizing unit transportation costs by shipping
full truck or container loads, and minimizing setup-related costs in
manufacturing. The most common method for determining batch sizes is
the economic order quantity (EOQ) model, which considers the following costs:

Manufacturing setup, transportation, or purchase-ordering costs,

calculated as a fixed cost incurred for each order.

Holding cost, including the cost of money, warehousing, and other

inventory related costs. This cost is calculated based on the average
inventory levels, calculated as Order Quantity/2. (See Chapter 4 for a
detailed description of holding costs.)

The derivation of the model is shown in Figure 2-13. Example 2-6 illustrates the
use of the EOQ model for a single product.

Figure 2-13: The economic order quantity (EOQ) model

Example 2-6: Applying the EOQ Model to a Production Situation

A food item manufacturer estimates that the time taken to prepare the
production line for a particular item is 30 minutes. The daily output of the line
(based on an eight-hour shift) is $500,000. The monthly demand for the item is
250,000 units, and the holding cost is estimated to be $0.25 per unit per
month. The manufacturer wishes to determine the economic quantity for
production.

Calculating the Economic Production Batch Size

The average output for 30 minutes is calculated as ($500,000/16) = $31,250.
Since this output is lost while preparing the production line, this is set equal to
the setup cost. Applying the equation shown in Figure 2-13 yields the result,

Therefore, the economic production quantity is equal to the monthly demand.

The number of setups, calculated as (Demand/EOQ), is 1. Therefore, the EOQ
model dictates that production needs to occur only once at the beginning of
the month, and that the inventory be stocked for that entire duration.
In addition to the constant demand assumption, the EOQ model assumes that
demand is known with certainty. Since most companies deal with uncertain
demand, the guidance provided by the EOQ model will be suboptimal in the
form of excess inventory and holding costs or insufficient inventory and
shortage costs. Therefore, in most situations, the EOQ model needs to be used
in conjunction with the safety stock models discussed in the previous section:
the service level, newsvendor, and incremental margin models. The safety
stock models need to be used first to determine the optimal supply quantity,
which becomes the input for the EOQ model (as the demand) and is substituted
in the equation to calculate batch or lot sizes.
Inventory Budgeting
Since inventory of raw materials and finished goods may be needed several
weeks or even months in advance of sales, companies need to invest cash in
order to purchase and manufacture inventory. This invested cash is eventually
recovered when the product is sold at a profit. The use of cash for purchasing
and storing inventory is one of the most important business decisions for a
company since it has an impact on margins, cash flow, and viability. Consider
the following excerpt from an annual report of STEC, Inc., an electronics
manufacturer, on the impact of inventory investment on profits:
Interest income and other is comprised primarily of interest income from our
cash, cash equivalents and marketable securities. Interest income and other
decreased from $3.8 million in 2007 to $1.3 million in 2008 as a result of a
lower average cash balance in 2008 compared to 2007 and a reduction in
interest rates in 2008. The reduction in the average cash balance was due
primarily to use of cash for inventory purchases related to new SSD product
sales in 2008.
- 2008 Annual Report, STEC, Inc.

The need to tie up cash for inventory is unavoidable for most companies.
However, when inventory does not move quickly, this cash is tied up for an
extended period of time and poses two issues. First, the interest generated
from the cash value is lost for the entire duration. Second, generally accepted
accounting principles require that inventory that has not moved for a certain
period of time (say, six months) be declared obsolete, in which case the entire
cash investment is lost.
There are two aspects regarding inventory budgeting. The first is to determine
the required budget, based on determining the required cash followed by a
return-on-inventory analysis. The second is to manage to these budgets and
allocate cash when variances occur. The first aspect is discussed here; the
second aspect is further described in Chapter 5.
Inventory budgets are usually specified for an item group or all items in a
facility. The rigorous procedure outlined here is recommended, along with steps
to rationalize the product portfolio to weed out underperforming products. The
steps for determining inventory budgets are as follows:

Step 1: Plot the supply network for the products to understand lead
times and the value-add at each step.

Step 2: Calculate the inventory investment required for each stage of

the supply chain. Sum across all products to obtain the required
inventory investment.

Step 3: Calculate inventory metricsdays of inventory, turns, and GMROI

for future budget adjustments and allocations.

These steps are illustrated in Example 2-7.

Example 2-7: Determining Inventory Budgets for an Electronics
Manufacturer
ABC Co. has budgeted $360,000 for its product line inventory. The anticipated
demand is 10,000 units per month, the product is priced at an average of $20
per unit, and the unit cost is $12 per unit. Is this budget for 3 months of
inventory sufficient for supporting operations and providing the targeted
customer service?
Step 1: Plot the Supply Network
A sample depiction of the supply network is shown in Figure 2-14. For each
stage in the supply chain, the following information is captured: inventory
ownership, cost of inventory or value-add, lead times, and billing terms. In this
example, ABC Co. purchases raw materials directly from the supplier and
stocks the raw material at the contract manufacturer's facility. The cost of
production is primarily labor. ABC Co. is responsible for the shipping process
and receives materials into inventory at its distribution centers.

Figure 2-14: Sample lead times and contractual terms for Example 2-7
Step 2: Calculate Inventory Investment Required for Each Stage
of Supply Chain
The investment is calculated as a combination of cycle stock, safety stock, and
work-in-process for raw materials, intermediate (or assemblies), and finished
goods. Each of the stages is described below.
Raw Materials at the Contract Manufacturer
Since ABC Co. purchases raw materials directly from the supplier and takes
ownership of the inventory, the inventory investment is calculated as
(221)

where the inventory liability window is the time during which the company
takes ownership of inventory, and is calculated as
(222)
All the terms need to be expressed in the same time units (e.g., months). Since
the raw material shipment schedule is weekly, the maximum cycle inventory is
7 days. The target safety stock is 1 month. Therefore, the maximum on-hand
inventory is 37 days and the raw material inventory liability window is (37 30)
= 7 days.
In this example, WIP inventory during the production process at the contract
manufacturer also requires raw material for the duration of the lead time of 30
days. Therefore, this is added to the inventory liability window, resulting in a
total value of (7 + 30) = 37 days = 1.23 month.
The raw material investment is calculated from Equation 2-21 as

Finished Goods Inventory

The finished goods inventory, priced at $10 per unit ($5 for raw material and
$5 for labor) are in ABC Co.'s possession for the entire duration of the ocean
shipment of 6 weeks. Therefore the inventory investment required is

Product Inventory at Distribution Center

The ocean carrier bills ABC Co. only after goods have been recovered; since the
payment terms are Net 30, the liability window is -1 month. The maximum on-

hand inventory is 1 month for cycle inventory plus 1 month for safety stock
plus 1 month for receivables. Therefore, the liability window is (-1 + 1 + 1 + 1)
= 2 months. The inventory budget requirement is calculated as

The total inventory investment required is calculated by adding the investment

for all the stages:

Therefore, the current inventory budget of $360,000 is inadequate for

maintaining adequate inventories and service levels for the supply chain.
The cash-to-cash cycle time is calculated as the days of inventory for the
various stages plus the days receivables outstanding minus the days payables
outstanding (Equation 2-23):
(2-23)

The cash-to-cash cycle time is equivalent to the addition of the liability

windows for all the stages in the supply chain. In the example above, this
would have resulted in 1.23 months for raw materials added to 1.5 months for
finished goods and 2 months for products at the distribution, resulting in a
cash-to-cash cycle time of 4.73 months. However, this measurement is not an
accurate representation of the duration for which cash is tied up since the
inventory investment is different for the different stages of
the supply chain (for example, raw material inventory is priced lower than the
product). Therefore, it is necessary to define a new measure of the liability,
called the effective liability window, which is based on productcosts,

(224
)
For the example above, the effective liability window is calculated as

This value is lower than the previously calculated value of 4.73 months. The
effective liability window is a more accurate representation of the true cash-tocash cycle time and is a useful measure for product comparisons.
Inventory turns is yet another measure that is used to measure inventory
investment and performance. Turns are calculated as
(225)
In the example, the expected sales are 10,000 unit per month, resulting in an
annual cost of goods of (10,000 * $12/unit * 12 months) = $1,440,000. The
average inventory is calculated as ($55,000 + $150,000 + $180,000) =
$385,000, resulting in a computation of 3.7 turns.
None of these measurementsdays of inventory, liability window, cash-to-cash
cycle time, or inventory turnsis effective in conveying the benefit from
holding inventory to the company. For example, it is difficult to respond to the
question, "Are 3.7 turns too low? Should we increase turns? If so, what is the
right value?" If safety stocks have been computed using the optimization
procedures described previously, then these values can be assumed to be
"right" for the supply chain. However, are other factorssuch as manufacturing
lead time, raw material commitments, and ocean transit timeresulting in an
investment that does not provide an adequate return for the company? This
question can be answered by computing the GMROI as
(2-26)

Therefore, the GMROI is a return-on-asset measurement for only the inventory

investment. The expected gross margin is provided by the newsvendor model
(Equation 2-13). The calculation procedure is as follows:

Continuation of Example 2-7 to describe the GMROI calculation.

The following additional data is collected for the products:

Expected monthly demand: 10,000 units.

Forecast error: 30%.

Expedite cost: $5 per unit.

Holding cost: $0.25 per month.

The product does not have a shelf-life.

From Equation 2-14, the optimal service level is calculated to be approximately

95%, and the optimal supply is (10,000 + 1.65*0.3*10,000) = 14,950 units. If it
is possible to expedite inventory in order to satisfy demand in excess of
inventory, then there is no lost demand. The expected sales per month =
(10,000 * $20/unit) = $200,000; the expected expedited units is 59 units
(from Equation 2-5); the cost of expediting is $5*59 = $296; the expected
leftover inventory from Equation 2-8 is (14,950 - 10,000 - 50) = 5,009 units;
and the holding cost is $0.25*5,009 = $1,252. Therefore, the expected gross
profit is ($80,000 - $296 - $1,252) = $78,452.
From Equation 2-26, the GMROI is calculated to be

The GMROI of 2.08 indicates that $1 invested in inventory provides a return of

$2.08 in one year.
The GMROI is a useful measure for gauging the efficiency of the supply chain in
providing a return on the inventory asset. Note that this measure should not be
confused with return on assets (ROA), which is a balance sheet measure that
gauges the company's ability to provide a return on all the company's assets.
The GMROI is a measurement of only the gross margin and inventory
investment; any other charges that affect margin as well as investments
required to operate the supply chain have not been included in this
measurement. Therefore, while a low GMROI is an indicator of low ROA, a high
GMROI by itself does not indicate a high ROA. (See Chapter 7 for additional
discussions related to GMROI and other measures required to gauge the
performance of the supply chain.)
Special Inventory Situations
The concepts presented in the previous sections were in the context of
simple supply situations involving a single location and finished goods
inventory. In reality, additional complexities can arise due to the myriad
variations that are possible while creating the supply network and negotiating

contracts with partners. A few such situations are described in the following
sections.
Multiple Transportation Modes
The availability of multiple transportation modes allows for companies to
utilize cost-effective options when time is available to meet demand, and more
expensive expedite options when inventory levels are low. However, this same
availability complicates the inventory decision, especially when the modes
have widely differing batch sizes and costs. For example, an ocean container
provides a low unit cost, but requires large quantities and longer transportation
times. On the contrary, air shipments are faster and fewer units can be
transported, but at a higher unit cost. Since goods are often transported based
on a demand forecast, the cost trade-off between the different modes,
holding costs, and margins is not trivial. A commonly employed strategy is to
ship a bulk of the goods using the slower, lesser expensive mode, but to retain
a minimal level of inventory close to the manufacturing location. Because not
all the inventory is committed to the slower mode, it is possible to
accommodate profitable rush orders if inventory situations become tight.
Yet another important situation arises for lifecycle products, as in the
electronics and telecommunications industries. The products are characterized
by demand volumes, prices, and forecast accuracy that vary considerably over
the life of the product. It is common to segment the lifecycle of such products
into phase. The first phase, product introduction, is characterized by high
uncertainty in demand since the market acceptance for new products is
unknown. At the same time, since the technology is new, it is possible to
command a premium price and corresponding high margins as the company
targets early adopters. Therefore, the inventory strategy is to maximize fill
rates, resorting to air shipments if necessary to maintain target inventory
levels. The second phase, product maturity, is characterized by steadier
demand and predictability, a possible decrease in price as the novelty of the
technology has worn off and the company is targeting the technology followers.
In this phase, the strategy is to carefully manage inventories and costs to
maximize margins. Use of air shipments is reserved for only firm orders, to
ensure that inventory holding costs do not accrue. The final stage, product
phase-out, happens when the market anticipates the next technology revision
from the company. Demand rapidly drops off, and uncertainty is high related to
the extent and speed with which it decreases. The company may have to
reduce prices in order to spur demand, which increases margin pressures.
There is a significant penalty related to leftover inventory, due to obsolescence.
In this phase, inventory reduction and cost containment are the primary goals,
and air shipments should be used infrequently, if at all. A summary of this
policy is shown in Figure 2-15.

Figure 2-15: Example of a transportation mode strategy over the lifecycle of

an electronic product
The approach described above can be used to analyze several other
transportation situations, including full and partial truckloads and rail transport.
Such a rigorous approach toward inventory analysis can result in effective use
of multiple modes of transportation and an overall reduction in freight spend.
Staged Inventory
As the number of distribution and sales locations increase, so does the amount
of inventory being held across the network, since each location holds safety
stock to cover for variability. In such situations, staging inventory can reduce
overall inventory levels without compromising service levels. Staging
consolidates inventory at a central location, which has the effect of reducing
demand variability, as exemplified in the excerpt below from an annual report
of ScanSource, Inc. This lower variability results in lower safety stock and
inventory levels. Additional savings are possible if holdingcosts are lower at the
central facility as compared to more expensive local storage in metropolitan
areas. Finally, as the number of products and locations grow, the benefit can

further increase because the resources and investment required to operate in a

decentralized manner can be prohibitive.
We operate a 600,000 square foot centralized distribution center in Southaven,
Mississippi, which is located near the FedEx hub facility in Memphis, Tennessee
and serves all of North America. Our European operation utilizes a centralized
third-party warehouse located in Liege, Belgium that services all of Europe.
Warehouses for our Latin American operations are located in Florida, Mexico,
and Brazil. Our distribution model creates several advantages, including: (i) a
reduced amount of "safety stock" inventory which, in turn, reduces the
Company's working capital requirements; (ii) an increased turnover rate
through tighter controls over inventory; (iii) maintenance of a consistent orderfill rate; (iv) improved personnel productivity; (v) improved delivery time; (vi)
simplified purchasing and tracking; (vii) decreased demand for management
personnel; and (viii) flexibility to meet customer needs for systems integration.
Our objective is to ship all orders on the same day, using barcode technology
to expedite shipments and minimize shipping errors. The Company offers
reduced freight rates and flexible delivery options to minimize a reseller's need
for inventory.
- ScanSource Inc., 2014 Annual Report
Clearly, there are many benefits provided by inventory staging and centralized
distribution. However, staging is not without its drawbacks, and the
applicability and returns need to be evaluated for each situation. Some of its
general benefits and drawbacks are summarized in Table 2-5.
Table 2-5: Some Benefits and Drawbacks of Staging Inventory
Open table as spreadsheet
Benefits
Drawbacks
Lower inventory investment
Cost to set up new facilities
Lower holding cost at central
Limited inventory savings if demand across
facility
locations is correlated
Lower cost due to transportation
Additional transportation costs due to
consolidation into central facility
shipments from central to local facilities
Higher service level if a few local
facilities experience higher demand
Lower replenishment times into
local facilities
Methods for estimating inventory requirements for the staged network can
range from the simple and approximate, to complex methods that account
explicitly for interactions between the different locations. An sample approach
that extends the service level method is shown in Figure 2-16 even though the
formulation is developed for the simple case where demand and replenishment
schedules are the same across the different locations, it is nevertheless useful

for illustrating the benefit of staging. As expected, the magnitude of reduction

in inventory increases with the number of local facilities. In addition, the
benefits obtained from optimal placement of the central facility to reduce
replenishment times can be compelling.

Figure 2-16: Inventories in a staged supply chain

Therefore, staging inventory is an effective strategy with the potential to
reduce inventories without compromising service levels. Transportation
implications need to be studied carefully before initiating staging, since
routings will change. What was previously a single shipment from the supplier
to each of the locations will now be delivered using two shipmentsone from
the supplier to the central facility, and another from the central facility to the
location. It is not always necessary for staging to result in higher transportation

levelsif the original shipments used expensive partial truckloads, staging can
reduce costs with the use of less expensive full truckloads.
Finally, another factor that determines the effectiveness of staging is whether
demand across the different locations is correlated. The analysis presented
above assumed that demand is independent, as can be expected when the
causes of demand are determined largely by the local environment. However,
when demand is affected by non-local factors such as the economy or the
introduction of competitive products, the same demand pattern may be
experienced across multiple locations. This results in demand being correlated
across multiple locations, which reduces the effectiveness of inventory
aggregation.[3]
Raw Material Inventory
Raw materials are purchased parts and components that are required for
production of one or more products. Raw materials are connected to products
using a bill of material (BOM). Essentially, a BOM is a list of parts needed for a
product. The concept of a BOM has been extended for several different
situations. A BOM that captures the manufacturing steps and parts required for
each stage is called a manufacturing BOM. A similar concept is the modular
BOM, which describes sub-assemblies. An engineering BOM specifies parts
used in the design, and a planning BOM is used for production planning or
financial calculations. Planning bills are usually far simpler in structure and
capture only essential information. An example is shown in Figure 2-17.

Figure 2-17: An example of a planning bill

Raw material inventory targets can be determined using the procedure
described previously for staged inventory, which is illustrated in Figure 2-18.
The planning bill is used to specify the interactions between the different
products with the raw material; it collapses the several manufacturing steps
into a single level and uses an estimate of the lead time for manufacturing for
determining the finished goods and raw material safety stock.

Figure 2-18: Inventory levels for raw materials

Holding raw material inventory is another example of staging. While
distribution staging delays the commitment of inventory to a particular
location, raw material inventory defers commitment to a particular product.
The delay allows the forecast of each of the products to become clearer,
ensuring that inventory and manufacturing labor are effectively utilized. As a
result, the inventory benefits are similar to the case of staged inventory (Figure
2-18).
Postponement
Postponement is a strategy that delays the commitment of material to a final
state (form or location) in order to provide a higher level of responsiveness and
fulfillment, while simultaneously reducing inventory levels. This strategy is
widely used in the automotive, aerospace, electronics, and apparel industries,
although an increasing number of industries are adopting this strategy. [4]
An example of postponement most consumers are aware of comes from the
paint industry. Where previously many hundreds or thousands of paint colors
would need to be stocked to satisfy all color requests, it is now a common
practice for the retailer to stock only the paint base and colorants separately,
with the mixing of the two occurring during a sale to the consumer. This
strategy is illustrated in Figure 2-19. The operational efficiency that is gained is
clearnot only is it not necessary to stock hundreds of colors on the retailer's
shelves, but it is also not necessary to manufacture, transport, and store these
different combinations. The result is a decrease in inventory levels at the
distribution center and retail stores and a simultaneous increase in ability to
satisfy almost any color combination a customer requests.

Figure 2-19: An illustration of postponement

Another example of postponement comes from the electronics industry with
regard to the manufacturing of printers. Electronic goods often need to satisfy
several country options related to language and power ratings. The traditional
approach of stocking inventory for each of these options can result in high
inventory levels and costly misses if demand for the country options is different
from the forecast. In this case, the postponement strategy will result in printers
being held in bulk and bundled with the appropriate country option prior to a
shipment. This will result in lower overall inventory levels and lower repackaging costs.
In general, postponement can be divided into two categoriesmanufacturing
(and assembly) postponement and logistical postponement. Manufacturing
postponement involves decisions made while the product is in production,
the strategy being to develop a platform or module that allows for different
configurations to be created with lower additional effort and cost, as
emphasized in this excerpt from an annual report of PFSWeb, a provider of
outsourced warehousing and fulfillment:

We will work with clients to re-sequence certain supply chain activities to aid in
an inventory postponement strategy. We can provide kitting and assembly
services and build-to-stock thousands of units daily to stock in a just-in-time
(JIT) environment. This service, for example, can entail the procurement of
packaging materials including retail boxes, foam inserts, and anti-static bags.
These raw material components may be shipped to us from domestic or
overseas manufacturers, and we will build the finished SKUs to stock for the
client. Also included is the custom configuration of high-end printers and
servers. This strategy allows manufacturers to make a smaller investment in
base unit inventory while meeting changing customer demand for highly
customizable products.
- PFSWeb, Inc., 2013 Annual Report
The retention of inventory in a raw form is an example of manufacturing
postponement. Logistical postponement delays decisions related to packaging,
labeling, and distribution. The staging of inventory is an example of logistical
postponement.
Characteristics that make a product a good candidate for postponement
include:

The need for a large number of configurations in order to satisfy

customer demand. This can be due to the nature of the product (for
example, paint) or due to globalization and support for many languages
and regional requirements (for example, printers).

A high level of uncertainty in demand. The delay in the commitment of

material to a finished form allows the demand picture to become clearer,
resulting in lower inventories and higher fill rates.

High holding costs, due to a high value of the product (for example,
expensive electronic items), form factor (for example, bulky furniture), or
short product lifecycles (for example, trendy music players).

Long lead times, due to outsourced manufacturing and overseas

transportation. The increase in lead time results in limited flexibility,
which has to be offset using expensive inventory.

The ability of a product to be customized with minimal expense, using a

platform or modularization strategy.

The trade-off that needs to be considered in evaluating a postponement

strategy is the benefit from holding less finished goods inventory against the
possibility of increased cost due to transportation of assemblies and parts to
the DC, as opposed to finished goods. The situation can be analyzed by
calculating the total cost for the two cases separately, and comparing the
incremental costs for manufacturing, transportation, and holding inventory. A
simple comparison, assuming that supplier lead times are uniform across
products and after postponement, is shown in Equation 2-27:

(2
27
)

where
ck is the holding cost per period,
s is the forecast error, expressed as a fraction of demand (i.e., the coefficient of
variation, which results in the computation of unit costs),
ts is the supply lead time, and
c refers to incremental unit costs for manufacturing (m) and transportation (t).
Transportation costs can be lower if suppliers are closer to the point of
postponement (closer to the point of sale) or if the base (unconfigured) unit
and parts can be shipped in bulk at a lower cost. In such cases, reduced spend
on transportation will further increase the benefit from postponement.
In general, the impact of postponement will not be restricted to a small section
of the supply chain, but can impact material routings in manufacturing facilities
and distribution centers. The cost comparison given in Equation 2-27 is far too
simple and inadequate for such situation, instead a more comprehensive
network-wide calculation of costs is required. Such methods are described
in Chapter 6.
While postponement is a strategy that can provide companies with significant
improvement opportunities, several challenges exist in identifying and
implementing the strategy. These include the ability for a traditional company
to rethink its approach to product design and fulfillment, the difficulty in
quantifying and understanding the benefits, and inertia related to changing
the supply chain to accommodate postponement. However, it appears to be
only a matter of time before postponement practices become commonplace,
due to adoption by market-leading companies and competitive pressures.
Supplier Flexibility

The need for companies to respond to changing market needs in order to

compete effectively is at odds with the general trend toward outsourcing and
off-shoring. This is the primary reason for the trend toward flexibility contracts
between buyers and suppliers. Such contracts provide for short-term
production flexibility for a price. While different industries have adopted
different flavors, they can largely be categorized as time- or quantity-based
flexibility.
Time-based flexibility, commonly referred to as blanket agreements or blanket
orders, requires that the buyer commit to a total order quantity for a season.
While a specified fraction of the total quantity is delivered at the beginning of
the agreement period, the buyer may purchase the remaining quantity at a
later date. Finally, the buyer pays a penalty for any units not purchased. In
some cases, the penalty could be the full price of the part, as is sometimes the
case in the semiconductor industry.
Quantity-based flexibility allows the buyer to vary order quantities based on a
proportion of the original order. The procedure is that the buyer initially
provides a forecast of purchases to the supplier. In subsequent periods, the
buyer is allowed to change the orders and forecast within the limits specified
by the flexibility contract. Usually, the flexibility provided is limited in the
immediate period and gradually increases over time, as shown inFigure 2-20.

Figure 2-20: An illustration of a flexibility agreement with a contract

manufacturer
The benefit provided by flexibility is enabling production adjustments based on
a more accurate forecast in the short-term. Flexibility can also improve service
levels since production can be increased in response to favorable market
conditions. The benefits obtained from flexibility increase with demand
variability. Specifically, the benefit from upside flexibility increases with
increasing shortage costs and an aggressive approach to inventory levels. The
benefit from downside flexibility increases with higher price erosion and
holding costs.
There is an additional cost incurred by the supplier to provide flexibility, due to
the need to maintain additional raw material or finished goods inventories,
spare capacity, and changes to the production schedule. As a result, suppliers
may be willing to provide flexibility if the additional price that can be charged is

sufficient to cover the incremental costs. Similarly, the buyer will be willing to
pay the additional price as long as the incremental benefit exceeds the cost.
The ability and willingness of a supplier to provide flexibility is dependent on
the nature of the product and manufacturing operations. Situations that limit
the ability to provide flexibility in the short term include:

The use of custom parts, since the risk associated with high inventory
levels increases.

Complex manufacturing steps that require specialized labor, due to the

time required to identify, hire, and train new resources.

High factory utilization, since support for upside flexibility will require
reliance on overtime or additional machinery.

A sensitive labor environment, such as a unionized workforce, that limits

the ability to lower production.

Conversely, other situations allow the supply chain to be more flexible:

Low factory utilization, since an increase in production can be supported

and will increase the profitability of the plant.

A supplier with a diversified customer and product portfolio, since

production increases and decreases can be absorbed by other product
lines.

Use of mass-produced components (as opposed to custom parts) that

are inexpensive to stock or can be used across multiple products.

Manufacturing operations that are of low or moderate complexity, so

that additional resources can be added quickly.

Easy availability of labor and a flexible labor force.

In conclusion, supply flexibility can be an effective method for improving

margins and service levels for products that display moderate to high
uncertainty in demand. In order for effective use of this strategy, both parties
need to implement appropriate processes to ensure that the guidelines and
requirements are being followed.
Correlated Demand
Most of the situations described in the previous sections assume that demand
is independent across the different time periods. When this is not the case, the
safety stock requirement is calculated as
(228
)

where n is the number of periods for which demand is perfectly (positively)

correlated, and demand and supply variances are independent. Since the
beneficial effect of reducing variance when demand is independent is lost, the
resulting safety stock levels are higher. The impact of the additional inventory
on margins is similar to the effect discussed for supply variability (Figure 2-11).
Correlated demand can occur due to several reasons, including the following:

Economic shifts that cause sustained up- or down-trends in demand.

These economic factors can include changes in interest rates, a housing
market collapse or surge, and even changes in a country's regulations.

Competitive activity, including the introduction of new products that

have the capability to fundamentally change demand patterns. Note that
the competition's promotional activity does not have the same impact
since prices revert to original quantities after a duration, resulting in a
return to equilibrium for the product.

Introduction of large business customers who can increase demand for

several months at a stretch. Similarly, the loss of large customers can
have the effect of decreasing demand for several months.

Introduction of new products for which consumer perception is unclear.

The first few months of sales can display consistent up- or down-trends
based on the market's response.

Cannibalization of demand due to additional sales of other products in

the portfolio.

In addition, even though demand may be independent for several months at a

stretch, correlation can occur due to any one of the factors described above.
Indeed, it is not clear when such factors will surface, which increases the
challenge of planning inventories. If inventory levels are set based on an
assumption of independent demand, it is easy to see
why supply chain "surprises" and high levels of expedites or inventories can
occur.
Example 2-8: Effect of Correlated Demand on Inventory Levels
An electronic product displays a forecast error of 25% (relative to the expected
monthly demand), a supply variability of 10 days, and a supplylead time of 2
months.
If the desired service level is 97%, the safety stock is calculated from Figure 25 for the independent demand case as

On the other hand, if demand is perfectly (positively) correlated, safety stock is

calculated as

It is clear that the effect of correlation is to increase inventory levels in order to

provide a targeted service level. If lead times are large, the impact of
correlated demand is magnified, as shown in Table 2-6.
Table 2-6: Impact of Demand Correlation on Inventory Levels
Open table as spreadsheet
Supply Lead Safety Stock for
Safety Stock for Dependent
Time
Independent Demand
Demand
2 months
35 days
46 days
3 months
41 days
67 days
4 months
46 days
88 days
Finally, if there is reason to believe that a certain level of correlation exists
between demand and supply variability, these inventory requirements will
further increase, as explained previously in the derivation of the service level
method.
[3]

When demand is independent, the RMSE of forecast error for the central

facility is calculated as
, where s is the standard deviation of forecast
error for each of the m facilities. However, when demand is not independent,
the relationship is if perfectly correlated, and the beneficial effect of
aggregation is lost.
[4]

Susan M. Rietze, "Case Studies of Postponement in the Supply Chain,"

Department of Civil and Environmental Engineering, Massachusetts Institute of
Technology, 2006.
Summary
The chapter introduced several important concepts regarding the importance
of inventory for a business and the different methods available to the analyst
to ensure that margins and profits are adequately considered in the decision-

making process. While the success of the inventory strategy depends on the
processes and systems put in place, an equally important factor is the role of
the analyst. The analyst has the challenging task of managing uncertainty and
balancing the constant demand for inventory from the rest of the organization
against the cost of excesses.
One of the important steps that drives the effectiveness of the inventory plan is
defining safety stock requirements. Several methods have been introduced in
this chapter, each with its advantages and disadvantages, and applicability to
different situations. Since the choice of methods can be confusing, a simple set
of guidelines has been provided in Table 2-7. It is important to recognize that
these industry-specific guidelines are approximate. Products in any of these
categories can briefly or permanently display characteristics that make it wellsuited for other methods. Therefore, it is important that the inventory analyst
gain an understanding of the different inventory categories and management
methods.
Table 2-7: Some Guidelines for Using Different Inventory Models
Open table as spreadsheet
Product
Situation
Appropriate Method
Groceries
Limited shelf-life, high
Newsvendor model
obsolescence rate
Consumer Steady price, low
Service level method if
staples
obsolescence cost
shortage costs are low, else incremental
margin model
Electronics Significant price
Incremental margin model
changes, lifecycle
products
Consumer High holding and
Incremental margin model
durables
shortage costs
Choosing the appropriate method merely improves the quality of the guidance
provided. Given that several assumptions have been made while constructing
these models, this guidance needs to be modified based on the analyst's
knowledge of out-of-bounds or special situations. The use of control limits (that
is, upper and lower bands for maintaining inventory) is recommended for
ensuring that small changes in underlying variables do not disrupt the
performance of the supply chain.
When several hundreds or even thousands of items have to be managed, it is
easy to overlook poor performance and incur additional costs. Therefore, it is
important to implement a rigorous performance review process that identifies
poorly performing items (further discussed in Chapter 7).
In many situations, it is not easy to calculate service levels and fill rates
accurately due to loss of information during the sales process. For example, if a

salesman is aware of low inventory levels for a particular product and guides a
customer toward the purchase of an alternative product, metrics based on
sales data will fail to capture this shortfall. In fact, the data can lead the
inventory analyst to believe that the inventory planning process is performing
well, which can be contrary to the belief of the rest of the organization and the
company's customers. In such situations, it is necessary to augment the
quantitative measurement with surveys and interviews with the sales and
marketing division and channel customersany perception that a particular
product is always in short supply needs to be considered while setting
inventory parameters and safety stock levels.

Chapter 3: Demand Planning

Overview
Demand planning is the process of understanding customer and market
perceptions of the company's products and specifying an accurate picture of
future revenues and sales volumes. The benefits are easy to understand: good
management of demand will help improve customer service and relationships,
a paramount goal for most companies. An accurate forecast will also serve to
align supply with demand, resulting in lower inventory and capacity levels and
reduced waste and costs.
The availability of demand-related information has increased dramatically in
this increasingly digital world, but courses and textbooks on demand planning
still expound on traditional forecasting methods, mainly time series (i.e.,
forecasts generated based on sales history). But the forecaster is faced with
challenging situations almost on a daily basis, from dealing with a cloudy
economic outlook to gauging the impact of a competitor's new product.
Traditional forecasting methods provide little support for analyzing such needs.
This chapter addresses these needs by providing several approaches for
understanding and handling non-standard situations, including price elasticity,
economic indicators, expansion to new markets, the impact of weather,
distortion of channel forecasts, and collaborating with channel partners

The Importance of Demand Planning

The importance of accurate forecasts is emphasized in the following
statements by Plantronics, a manufacturer of headsets for telephones.
We determine production levels based on our forecasts of demand for our
products. Actual demand for our products depends on many factors, which
makes it difficult to forecast. We have experienced differences between our
actual and our forecasted demand in the past and expect differences to arise
in the future. Significant unanticipated fluctuations in demand and the global
trend toward consignment of products could cause the following operating
problems, among others:
If forecasted demand does not develop, we could have excess inventory and
excess capacity. Overforecast of demand could result in higher inventories of
finished products, components, and sub-assemblies. In addition, because our
retail customers have pronounced seasonality, we must build inventory well in
advance of the December quarter in order to stock up for the anticipated
future demand. If we were unable to sell these inventories, we would have to
write off some or all of our inventories of excess products and unusable
components and sub-assemblies. Excess manufacturing capacity could lead to
higher production costs and lower margins;
If demand increases beyond that forecasted, we would have to rapidly increase
production. We currently depend on suppliers to provide additional volumes of
components and sub-assemblies, and we are experiencing greater dependence
on single source suppliers; therefore, we might not be able to increase
production rapidly enough to meet unexpected demand. This could cause us to
fail to meet customer expectations. There could be short-term losses of sales
while we are trying to increase production. If customers turn to our competitors
to meet their needs, there could be a long-term impact on our revenues and
profitability;
Rapid increases in production levels to meet unanticipated demand could
result in higher costs for components and sub-assemblies, increased
expenditures for freight to expedite delivery of required materials, and higher
overtime costs and other expenses. These higher expenditures could lower our
profit margins. Further, if production is increased rapidly, there may be
decreased manufacturing yields, which may also lower our margins.
- Plantronics Inc., 2007 Annual Report
It is clear from these statements that an inaccurate forecast will result in
higher costs. Developing an accurate forecast requires an understanding of all
the factors that can impact the business, and the ability to answer questions
such as the following:

What sales can be expected for a particular product at a particular

location?

Does a product exhibit seasonality? If so, how can this seasonal demand
be estimated?

How do external factors, such as weather and economic conditions,

impact demand?

How can demand for a product in a new market be estimated?

How and why does demand information get distorted by channel

partners? How can this exchange of information be improved?

Are qualitative forecasts useful? How can quantitative and qualitative

forecasts be reconciled?

How can mismatches between demand and supply be addressed? Is it

possible to allocate scarce supply in order to meet strategic goals?

The rest of the chapter describes processes and quantitative methods that
address these needs.
The Demand Planning Process
In most companies, the demand planning process is managed by the marketing
department of a company, with inputs from customers, sales, and operations
when appropriate. The main functions of demand planning are:

Forecasting. The process of specifying the company's estimate of

product demand considers several factors, including historical data,
partner feedback, customer perceptions, environmental factors, and
competitive situations.

Collaboration. Relevant to business-to-business (B2B) situations, this

refers to the mutual sharing of information related to demand and trends
between retailers and manufacturers.

Price Adjustments. When the primary method for setting price is based
on cost (i.e., the cost-plus model), this process reevaluates and resets
prices based on inventory positions and cost variances.

The flow of information and interactions between these steps is described

in Figure 3-1. The specific steps that are required for a company depend on its
business environmentwhether the company's products are make-to-order,
make-to-forecast, or assemble-to-order. The factors that dictate the
environment are the lead time provided by the customer for fulfilling orders,
and the lead time for supply consisting of the time taken to procure raw
materials and manufacture and distribute products. The different cases are
shown in Table 3-1. Make-to-order is characterized by a supply lead time less
than the customer lead time. This business model is common for highly

engineered products such as airplanes; the order specifies the custom design
and part specifications. As a result, the company does not take on any risk
related to inventory positions. Instead, profitability is closely linked to
manufacturing efficiency.

Figure 3-1: The demand planning process

Table 3-1: Relevance of Forecasting for Different Business Models
Open table as spreadsheet
Business
Model

Relevance

Make-to-order Lead time for supply, assembly, and delivery is less than the
lead time available to fulfill demand.
No requirements for finished goods or raw material inventory.
Not reliant on demand forecasts.
Assemble-to- Lead time for assembly and delivery is less than the lead time
order
available to fulfill demand.
Forecasting required to drive raw material inventory
requirements.
Make-toforecast

Lead time for assembly and deliver is greater than the lead time
available to fulfill demand.
Forecasting required to drive finished goods and raw material
inventory.

Make-to-forecast, also termed make-to-stock, is characterized by a supply lead

time that is greater than the customer lead time. This situation is very common
for retail, distribution, and a majority of manufacturing businesses. The
difference between the supply and customer lead time is a measure of the
inventory exposure faced by the company. If the difference is large, then the
company is required to take inventory positions well in advance of sales,
resulting in greater exposure. For example, the customer lead time for a
retailer is a few minutes (the time between a customer walking into the store
and check-out), while the supply lead time is approximately four weeks.
Similarly, an electronics manufacturer may be provided two weeks to fulfill a
customer orders, but experience the same exposure due to a sixweek supply lead time. Both these companies have to take an inventory
position in order to provide a good customer experience.
Assemble-to-order is essentially a make-to-forecast system with the difference
that final assembly can be postponed to occur after the order has been
received from the customer. This postponed manufacturing step allows for
several configurations to be supported with no finished goods inventory, and
only raw material or sub-assembly inventory. If it is possible to re-design the
product to convert from make-to-stock into assemble-to-order, this will result in
lower inventory exposure.
The business model determines the processes and steps that need to be
employed. For example, a make-to-order company will have less need for a
forecasting process since material can be ordered after the customer's order
has been placed. Some examples of the relevance of the different processes for
different business environments are shown in Table 3-2. As expected,
manufacturers of make-to-stock products have the greatest need for the
different demand planning processes.
Table 3-2: Use of Forecasting Methods
Open table as spreadsheet
Industry
Customer
Lead Time
Electronics manufacturing 2 weeks

Consumer durables
manufacturing

2 weeks

by Industry
Supplier Lead Relevant
Time
Methods
14 weeks
Statistical
forecasting.
Causal forecasting.
Pyramid
forecasting.
Collaboration.
13 weeks
Statistical
forecasting.
Causal forecasting.
Pyramid
forecasting.

Table 3-2: Use of Forecasting Methods by Industry

Open table as spreadsheet
Industry
Customer
Supplier Lead Relevant
Lead Time
Time
Methods
Collaboration.
Custom-made furniture
13 weeks
10 weeks
No forecasting
required
Apparel (retail)
0 weeks
4 weeks
Statistical
forecasting.
Causal forecasting.
Pyramid
forecasting.
Building materials
1 week
8 weeks
Statistical
(distributor)
forecasting.
Causal forecasting.
Pyramid
forecasting.
Each of these processes is described in the remaining sections of this chapter.
Perusing them, you will appreciate that each of these processes has to be
tailored to suit the unique requirements of each industry and company.
Measures of Forecast Performance
Forecast accuracy is the single most important metric for gauging the
effectiveness of the forecasting process. Measures of accuracy include the
following:
Forecast bias is a measure of constant under- or over-forecasting and is
calculated as the average error per observation:
(3-1)

In Equation 3-1, di is the actual demand, di is the forecast for period i, and n is
the number of periods. Under this definition, a positive bias indicates a trend
toward under-forecasting, while a negative bias indicates over-forecasting.
The mean absolute deviation (MAD), a widely used measure of accuracy, is
calculated as the average absolute error per observation,

(3-2)

Because MAD is calculated by summing absolute forecast errors, it is always

greater than or equal to the bias.
Yet another measure is the root mean square error (RMSE), calculated as
(33)

RMSE is similar to MAD since it does not allow positive and negative errors
across time to cancel each other (due to the square term). But the RMSE is
different from MAD in that large variances have a greater influence on the
measurementmathematically, it has a standard deviation form. Therefore,
RMSE is the appropriate measurement to be used in the safety-stock models
(namely, the service level and newsvendor models) described in Chapter 2.
While MAD, bias, and RMSE measure the magnitude of error, a useful relative
measure is the mean absolute percent error (MAPE), calculated as
(3
4)

MAPE is the most commonly used and most intuitive measure of forecast error.
Finally, forecast accuracy can be calculated from the MAPE as
(3-5)
Lagged Forecast Errors
For supply chains with extended lead times, it is not sufficient to monitor
forecast accuracy for the same month (i.e., forecast for a month generated at
the beginning of that month). The most widely used method for tracking 2- and
3-month-out forecast errors is the waterfall table, shown in Figure 3-2. This
table is constructed by listing historical forecasts in rows, followed by the

actual demand for each month. Then, forecast errors are calculated by
comparing actual demand to the different forecasts for that month, as
explained in the figure.

Figure 3-2: The waterfall table for calculating forecast errors

Explanation of the Lagged Forecast Error Calculations
March's current month forecast error
= (Actual for March - Forecast for March created in March) / Actual for
March
= (95 - 120) / 95
= -26%.
March's 1-month-out forecast error
= (Actual for March - Forecast for March created in Feb) / Actual for
March
= (95 - 110) / 95
= - 16%.
March's 2-months-out forecast error
= (Actual for March - Forecast for March created in Jan) / Actual for
March
= (95 - 100) / 95
= -5%.
With this procedure, the forecaster can decide which measure of forecast
accuracy needs to be utilized. If a product has a supply lead time of 3 weeks,
then the current month error can be used to gauge forecast performance and
for safety-stock calculations. However, if the supply lead time is 12 weeks, then
the 2-month-out error needs to be used.