Supply Chain

Management
Sessions 11, 12
Amit Sharan Jain

December 2017
Please note
• Project submission
• Word document + Presentation
• Strategic Fit, Supply Chain Drivers, Distribution strategy, Financial Performance

• Assignment issues

• Simulation game issues

• Feedback

2
Agenda
Inventory Management

Case Study

Supply Chain Coordination

3
Agenda
Inventory Management

Case Study

Supply Chain Coordination

4
Inventory Fundamentals
Why do we need inventory?
Inventory is required to manage the gap between production and
consumption. The gap could be time, distance and/or quantity.

Concepts
• Cycle Stock
• Safety Stock
• Demand Uncertainty
• Cycle Service Level: Capital vs. Lost Sales
• Supply Uncertainty
• Lot Size: Quantity that is either produced or purchased by a stage of
a supply chain at a time
• Ordering Cost: Buyer time + Transportation + Receiving + Others
• Holding Cost: Cost of capital + Cost of physically holding inventory
+ Obsolescence cost + Miscellaneous cost
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Cycle Stock
Cycle Inventory: Average inventory between 2 successive
replenishments
Inventory
Q

Time t
Cycle Inventory = Q / 2

• Primary role of cycle inventory is to take advantage of economies of

scale
• Enable different stages to purchase product in lot sizes (Q) that
minimize the sum of material, ordering, and holding costs 6
Lot sizing for a single product
In a continuous review inventory system, lot size is selected such that the
total inventory cost is minimized

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 Lot sizing for a single product
Annual ordering and holding cost = (D / Q ) S + (Q / 2) hC

Ordering Cost = (D / Q) S Inventory Holding Cost = (Q / 2) hC

• Annual Demand = D • Cycle Inventory = Q / 2
• Quantity per order = Q • Cost per unit = C
• Number of orders per year = D / Q • Holding cost as a fraction of
• Fixed ordering cost per order = S Product Cost = h

Economic Order Quantity, Q* = √(2DS / hC)

Optimal ordering frequency, n* = D / Q*
= √( DhC / 2S )

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Lot sizing for a single product:
Example (11.1)
• Demand for Deskpro computers: 1000 per month
• Fixed order placement cost = $ 4000
• Cost of computer = $500
• Holding cost = 20%

• EOQ, Q* = √(2 D S / hC)

= √(2 (1000*12) (4000) / (0.2 X 500)) = 980 units

• No. of orders per year, n* = D / Q*

= (1000*12) / 980 = 12.24 orders

• Annual ordering and holding cost = (D / Q*) S + (Q* / 2) hC = $97,980

If ordering quantity 900 units (truck capacity), annual cost changes to $ 98,333

Note: Total ordering and holding costs are relatively stable around the EOQ, order
convenient sizes around the EOQ. 9
Annual inventory cost:
Example 1
Motorola obtains cell phones from its manufacturer in China to serve
US market. The US market is serviced through a warehouse in
Memphis, Tennessee. The daily average demand at the warehouse is
5000 units. The company is debating whether to use air or sea
transportation. Sea transportation costs $0.5 per phone and air
transportation costs $1.5 per phone. Cost of phone is $100 and holding
costs are 20%. Minimum lot sizes are 100,000 phones for sea
transportation and 5000 units for air transportation. Under a
continuous review, which transportation route do you recommend?

10
Annual inventory cost:
Example 1 solution
Annual ordering and holding cost = (D / Q*) S + (Q* / 2) hC
• Annual demand, D = 5000*365 = 1,825,000 units
• Holding cost, h = 20%
• Cost of product, C = $100

Sea transportation Air transportation

• Order quantity, Q = 100,000 • Order quantity, Q = 5000
• Ordering cost, S = 0.5 * 100000 • Ordering cost, S = 1.5 * 5000
• Annual ordering and holding cost • Annual ordering and holding cost
= 1,912,500 = 2,787,500

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Annual inventory cost
Example 2
A company is examining two alternative choices for moving goods
from its plant in Thane to its depot in Chennai. It has been traditionally
shipping goods in FTL mode so as to save transportation costs. Its
finance department has been complaining about high inventories in
Chennai. A full truck load results in shipment size of 160 units, while
LTL shipments allows the firm to get lots of 40 units each. The average
demand at the Chennai depot is 80 units per month. The cost of the
product is Rs 500 per unit and the firm works with an inventory
carrying cost of 20 percent. Shipping through FTL mode results in a
transportation cost of Rs 40 per unit while LTL mode shipment results
in a transport cost of Rs 50 per unit.
• Should the company shift to LTL shipments? Justify your answer.
• If 1% of the good are damaged in LTL, will it affect your answer?

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Annual inventory cost
Example 2 solution
Annual ordering and holding cost = (D / Q*) S + (Q* / 2) hC
• Annual demand, D = 80*12 = 960 units
• Holding cost, h = 20%
• Cost of product, C = $500

Full Truckload (FTL) Less than Truckload (LTL)

• Order quantity, Q = 160 • Order quantity, Q = 40
• Ordering cost, S = 40 * 160 • Ordering cost, S = 50 * 40
• Annual ordering and holding cost • Annual ordering and holding cost
= 46,400 = 50,000

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Lot sizing for multiple products or
customers
Lot sizing for multiple products or customers can follow three
approaches:
• Each product ordered independently
• Economies of scale due to aggregation not considered. Hence, high overall
inventory costs. (Tip: Review example 11.3 in book)

• Aggregate orders with all products in each order

• Transportation economies are considered. However, useful only if similar
demand patterns. Otherwise, high ordering costs for low volume products.

• Aggregate orders with one or more products in each order

• Transportation and ordering economies are considered. Fixed ordering costs
are attributed to the most frequently ordered product(s)

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Aggregated orders with all products in
each order
When all products are aggregated in each order:
• Frequency of orders = n
• Quantity per order for product i, Qi = Di / n (viz. D1 / n, D2 / n, D3 / n)

• Fixed ordering cost = S

• Ordering cost for each product / delivery = si (viz., s1, s2, s3 etc.)
• Total ordering cost, S* = S + s1 + s2 + s3

• Optimal ordering frequency, n* =

√ (D1hC1/2 S* + D2hC2/2 S* + D3hC3/2 S* )

• Annual ordering cost = n S*

• Annual holding cost = D1hC1/2n + D2hC2/2n + D3hC3/2n

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Aggregated orders
Example 1
Johnson & Johnson manufactures two different types of products in its
Chennai unit and Mumbai unit. The products need to be shipped to its
8 distribution centers. Product 1 is made only in Mumbai unit and
product 2 is only manufactured in Chennai. Product 1 is high in
demand and requires 5000 units per week by each of its distribution
center. Product 2 is slow moving product with 6000 units per month
demand by each distribution center. Product 1 is of 50 INR per product
and product 2 is of INR 500 per unit. Holding cost is 10% of the cost of
the product per unit annum. Cost of sending one truck load from
Mumbai or Chennai to any of the distribution center is estimated 2000
INR, per destination 200 INR extra as administrative cost. These being
big truck, capacity per truck is 40000 units of product 1 (exclusive) but
only 36000 units for product 2 (exclusive). Johnson & Johnson’s new
supply chain manager is finalizing the contract with third party logistics
and wish to know should the company go for direct shipping or milk
run (for two centers at a time) ? What transportation strategy would
you like to recommend for which product and why ?

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Aggregated orders
Example 1 solution (1/2)
Product 1
• Demand per distribution center = 5000 * 52
• Fixed ordering cost, S = 2000
• Per destination ordering cost, s = 200
• Cost of product, C = $500
• Holding cost, h = 10%

Individual deliveries Milk-run for 2 units at a time

• Order quantity, Q = 40,000
• Ordering cost, S = 2000+200
• Annual ordering and holding cost
per DC = Rs. 1,014,300
• Annual ordering and holding cost
for 2 DCs = Rs. 2,028,600
• Order quantity, Q = 40,000
• Ordering cost, S = 2000+200+200
• Annual ordering and holding cost
for 2 DCs = Rs. 1,031,200
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Aggregated orders
Example 1 solution (2/2)
Product 2
• Demand per distribution center = 6000 * 12
• Fixed ordering cost, S = 2000
• Per destination ordering cost, s = 200
• Cost of product, C = $50
• Holding cost, h = 10%

Individual deliveries Milk-run for 2 units at a time

• Order quantity, Q = 40,000
• Ordering cost, S = 2000+200
• Annual ordering and holding cost
per DC = Rs. 103,960
• Annual ordering cost for 2 DCs =
Rs. 207,920
• Order quantity, Q = 20,000
• Ordering cost, S = 2000+200+200
• Annual ordering and holding cost
for 2 DCs = 108,640
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Aggregated orders
Example 2
Harley- Davidson has its motor cycle assembly plant in Pennsylvania.
Harley purchases its components from three suppliers. Components
purchased from Supplier A are priced at $5 each and used at a rate of
20,000 units per annum. Components purchased from Supplier B are
priced at $4 each and used at a rate of 2500 units per annum.
Components purchased from Supplier C are priced at $5 each and used
at a rate of 900 units per annum. Currently, Harley purchases separate
truckload from each supplier. As part of its JIT drive, Harley has
decided to aggregate purchases from three suppliers in each order.
The trucking company charges a fixed cost of $400 for the truck with
an additional charge of $100 for each stop. Thus if Harley asks for
pickup from one supplier, the trucking company charges $500; from
two suppliers $ 600 and so on. Assume holding cost of 10%.
Compare the costs of two replenishment strategies i.e. ordering and
delivering the three components independently with ordering and
delivering the three components jointly in terms of order quantities
and associated total costs for the three components.
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Aggregated orders
Example 2 solution (1/2)
Individual deliveries
Calculate EOQ for each part
• Part 1: 6324
• Part 2: 2500
• Part 3: 1341

Total inventory ordering and holding cost

• Part 1: $ 3162
• Part 2: $ 1000
• Part 3: $ 671
• Total: $ 4833

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Aggregated orders
Example 2 solution (2/2)
Aggregated deliveries
Assuming h=20%,
• Optimal ordering frequency, n*
= √ (D1hC1/2 S* + D2hC2/2 S* + D3hC3/2 S* )
= √ ( (20,000 * 10% *5 + 2500 * 10% * 4 + 900 * 10% * 5) / ( 2 * 700))
= 2.86

• Ordering cost = n S* = 2.86*700 = Rs. 2002

• Inventory holding cost = D1hC1/2n + D2hC2/2n + D3hC3/2n

= ( (20,000 * 10% *5 + 2500 * 10% * 4 + 900 * 10% * 5) / ( 2 * 2.86))
= Rs. 2002

• Total inventory holding and ordering cost = 4004

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Aggregated orders with capacity
constraints
• Capacity constraints typically arise due to limitations in products that
can be transported in a truck
• Typically, it is economical to limit products to full-truckload
quantities, rather than sending based on EOQ or n*
• If capacity constraint is provided, calculate ordering frequency (n)
basis the capacity constraint
• Thereafter, calculate holding costs and ordering costs based on this
ordering frequency
• Refer example 11.5 for details

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Aggregated orders with one or more
products in each order
• Order aggregation, where every product is included in every order, is
useful where the demand of products is comparable
• However if the demand is not comparable, it is not necessarily optimal
to include every item in every order.
• A better approach is to selectively order a subset of products in each
order
• In this approach, the most frequently ordered is identified, which will be
included in every order. The base fixed ordering cost (S) is entirely
allocated to this product
• For all the other products, the ordering frequency is identified using only
product-specific ordering cost (s)
• The frequencies are then adjusted so that the ordering frequency is an
integer
• Refer Example 11.6

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Aggregated orders with one or more
products in each order: Approach
Step 1: Identify the most frequently ordered product assuming each
product is ordered independently

Step 2: For all products i ≠ i*, evaluate the ordering frequency

Step 3: For all i ≠ i*, evaluate the frequency of product i relative to

the most frequently ordered product i* to be mi (round up)

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Aggregated orders with one or more
products in each order: Approach
Step 4: Recalculate the ordering frequency of the most frequently
ordered product i* to be n

Step 5: Evaluate an order frequency of ni = n/mi and the total cost of

such an ordering policy

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Example: Harley Davidson (1/2)
Step 1: Supplier A parts are ordered most frequently. Therefore,
fixed ordering cost to these products, ordering frequency

= √ ( (10% * 5 * 20000)/(2 * 500) ) = 3.16

Step 2: For products B and C, evaluate the ordering frequency

Product B, = √ ( (10% * 4 * 2500) / (2 * 100)) = 2.23

Product C, = √ ( (10% * 5 * 900) / (2 * 100)) = 1.5

Step 3: For all i ≠ i*, evaluate the frequency of product i relative to

the most frequently ordered product i* to be mi (round up)

Product B, = | 3.16 / 2.23 |= 2

Product C, = | 3.16 / 1.5 |= 3
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Example: Harley Davidson (2/2)
Step 4: Recalculate the ordering frequency of the most frequently ordered
product A to be n
Ordering frequency for product A
= √ ( (10000+2000+1300) / 2(400+100+100/2 + 100/3) ) = 3.38

Ordering frequency for B = 4.78 / 2 = 1.69

Ordering frequency for C = 4.78 / 3 = 1.12

Step 5: Evaluate an order frequency of ni = n/mi and the total cost of

such an ordering policy

= 4.78 * 400 + (3.38*100 + 1.69*100 + 1.12*100)

+ 20,000*0.1*5/(2*3.38) + 2500 *0.1*4/(2*1.69)
+ 900*0.1*5/(2*1.12)
= 1353 + 338 + 169 + 113 + 1478 + 296 + 199
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= 3946
Safety Stock
• Inventory carried for the purpose of satisfying demand that exceeds
the amount forecasted in a given period

• Trade-off
• Higher levels of product availability and customer service
• Higher level of average inventory and therefore increases holding costs

• Most important questions

• What is the appropriate level of safety stock?
• What actions help in reducing safety stock while improving product
availability?

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 Calculating appropriate safety stock
Safety Stock

Z √ ( σD2 L + D2 σL2 )

Product availability Demand uncertainty Supply uncertainty

Z = Norminv (CSL) √ (σD2 L) √ D 2 σL 2

where, where, where,

CSL = Cycle Service σD = Standard deviation of σL = Standard deviation of
Level demand for a period lead time
L = Lead Time D = Demand for a period

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Safety stock calculation:
Example
Motorola obtains cell phones from its contract manufacturer located
in China to serve the US market. The US market is served from a
Warehouse in Memphis, Tennessee. Daily demand at the Memphis
warehouse is normally distributed with a mean of 5000 and a standard
deviation of 4000. The warehouse aims for a CSL of 99 percent. The
company is debating whether to use sea and air transportation from
china. Sea transportation results in a lead time of 36 days and costs
$0.50 per phone. Air transportation results in a lead time of 4 days and
costs $1.50 per phone. Each phone costs $100 and Motorola uses
holding costs of 20 percent. Given the minimum lot sizes, Motorola
would order 100,000 phones at a time (on average, once every 20
days) if using sea transport and 5000 phones at a time (on average,
daily) if using air transport. Warehouse works 365 days in a year. (
NORMINV(0.99 ) = 2.33 )

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Safety stock calculation:
Example solution
Z √ ( σD 2 L + D 2 σL 2 )
Z = Norminv(CSL) = Norminv (0.99) = 2.33
σD = 4000, σL = 0

Sea transportation Air transportation

• Lead time, L = 36 days • Lead time, L = 4 days
• Safety stock = 2.33 * √ (36 ∗ 40002) • Safety stock = 2.33 * √ (4 ∗ 40002)
= 55,920 = 18,640
• Holding cost for safety stock • Holding cost for safety stock
= SS * h*C = SS * h*C
= $1,118,400 = $372,800
• Ordering cost for SS# = SS*0.5 • Ordering cost for SS # = SS*1.5
= $559,200 = $559,200

# Assumption for Ordering Cost: Safety stock is built-up during the start of the year and
maintained thereafter.

Calculations for annual ordering and holding cost for cycle stock depicted in slides 9,10 31
Steps to reduce safety stock levels
Z √ ( σD2 L + D2 σL2 )

• Optimize service levels (Z)

• Product criticality
• A-B-C Classification
• Customer classification
• Reduce lead time (L)
• Production response time and flexibility
• Transportation modes
• Proximity of production and consumption points
• Reduce demand uncertainty (σD)
• Market intelligence
• Scientific forecasting methods
• Supply chain visibility
• Reduce supply uncertainty (σL)
• Scientific production and transportation planning
• Visibility of future demand to suppliers 32
Calculating safety stock for continuous
review system
In a continuous review system,
Reorder Point (ROP) = D*L + SS
where
• Avg. demand per unit time = D
• L = Lead time
• SS = Safety stock

Therefore, safety stock in a continuous review system,

SS = ROP – D*L

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Aggregation of inventory and impact on
safety stock
• A supply chain has varying degrees of inventory aggregation for
different products

• Many e-commerce retailers attempt to take advantage of aggregation

(Amazon) compared to bricks and mortar retailers (Borders)

• Aggregation has two major disadvantages:

• Increase in response time to customer order
• Increase in transportation cost to customer

• Aggregation leads to a decrease in the total safety stock carried for a

supply chain

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Safety stock in an aggregated model
• Suppose there are n regions, with demand in each region being independent and
normally distributed
• Di : Mean period demand for each region i, i = 1,…,n
• σi : Standard deviation of period demand in region i, i = 1,…,n

Decentralized option Centralized option

• Local inventories are maintained in
each region
• Safety stock is the sum of safety
stocks for individual regions
Z √ ( σι2 L)
• Aggregate all inventories in a single
location
• Mean period demand,
• Standard deviation of demand

• Safety stock, SS =

35
Safety stock in an aggregated model:
Example 1
ABC Inc. produces printers in its Chinese factory for sale in SAARC countries.
Currently, ABC Inc. assembles and packs printers for direct sale in individual SAARC
countries. The distribution of weekly demand in different countries is normally
distributed with means and standard deviation as follows:
Country Mean Standard Deviation
Sri Lanka 3000 2000
Nepal 2500 1600
Bhutan 1000 800
India 4000 2400
Assume demand in different countries to be independent and the lead time from
manufacturing factory is eight weeks. The company follows continuous
replenishment policy. ABC Inc. decides to build a central DC in one of the SARRC
countries and shall now ship printers directly to this DC. Deliveries to individual
countries shall be from DC. The printers are still manufactured in China with a lead
time of eight weeks.
How much total safety inventory does ABC Inc. require for all SAARC countries if it
targets a CSL of 95 percent? 36
Safety stock in an aggregated model:
Example 1 solution
• CSL = 95%
• Z = Norminv (95%) = 1.64
• Lead time in weeks = 8

Decentralized option Centralized option

Country Mean Standard Safety • Standard deviation of demand,
Deviation stock
Sri Lanka 3000 2000 9,277
= √ (20002+16002+8002+24002)
Nepal 2500 1600 7,422
= 3600
Bhutan 1000 800 3,711 • Safety stock =
India 4000 2400 11,133
= (1.64) (√ 8) (3600)
Total 31,543
= 16,699

Note: If number of independent stocking locations decreases by n, the expected level of

safety inventory will be reduced by square root of n
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Safety stock in an aggregated model:
Example 2 (ex. 12.12)
A paint retailer sells 100 different colors of paint. Weekly demand for each colour
Is normally distributed with mean of 30 units and standard deviation of 10 units.
Assume the demand of a colour is independent from the demand of other colours.
The replenishment lead time from factory is 2 weeks and retailer aims for a 95%
CSL. How much safety stock will the retailer have to hold if paints are mixed in
factory and held in inventory at the retailer. How does the safety stock of the
requirement change if the retailer holds base paint and mixes colour on demand.

Disaggregated option Centralized option

• Standard deviation of demand • Standard deviation of demand,
= Z √ ( σ 2 L)
ι

= √ (100 * 102)
= 100 * Norminv(0.95) * √ (10 ∗2)
2
= 100
= 2,326 units
• Safety stock =
= (1.64) (√ 2) (100) = 233 units
Note: Since the number of stocking units have reduced by a factor of 100, the safety
stock has reduced by a factor of 10 (viz.√ 100) 38
Agenda
Inventory Management

Case Study

Supply Chain Coordination

39
Agenda
Inventory Management

Case Study

Supply Chain Coordination

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Supply chain coordination
• All stages in the supply chain take actions that are aligned and
increase total supply chain surplus

• SC coordination requires that each stage share information and take

into account the effects of its actions on the other stages

• Lack of coordination results when:

• Little or incorrect information shared between stages
• Conflict in objectives of different stages

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Bull-whip effect
• Fluctuations in orders
increase as they move up
the supply chain from
retailers to
manufacturers

• Distorts demand
information within the
supply chain

• Results in a loss of supply

chain coordination

Whipped Beer Simulation Game: https://www.learnbizsimulations.com/

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Impact of lack of coordination
Performance Measure Impact of the Lack of Coordination
Manufacturing cost Increases
Inventory cost Increases
Replenishment lead time Increases
Transportation cost Increases
Shipping and receiving cost Increases
Level of product availability Decreases
Profitability Decreases

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Obstacles to Coordination
Incentive Obstacles
• Local optimization
• Sales force incentives

Information Processing Obstacles

• Forecasting based on orders from a supply chain stage instead of demand
• Lack of information sharing

Operational Obstacles
• Large lots
• Large replenishment lead times
• Rationing and shortage gaming

Pricing Obstacles
• Lot-sized based quantity decisions
• Price fluctuations leading to forward buying 44
Achieving Supply Chain Coordination
Aligning Goals and Incentives
• Incentives to maximize supply chain surplus
• Align incentives across functions
• Pricing for coordination
• Change sales force incentives from retailer demand to customer demand

Designing Pricing Strategies to Stabilize Orders

• Reduce forward buying
• Volume-based discounting instead of lot-based discounting
• Stabilize prices
• Building Strategic Partnerships and Trust

Improving Information Accuracy

• Sharing POS data
• CPFR
• Single stage control of replenishments
• CRP: POS data / retailer warehouse data based regular replenishment by
wholesaler or manufacturer, inventory owned by retailer
• VMI: Vendor (manufacturer / supplier) responsible for all inventory decisions, 45
inventory may / may not be owned by retailer
Collaborative Planning, Forecasting, and
Replenishment (CPFR)
“A business practice that combine the intelligence of multiple
partners in the planning and fulfillment of customer demand”
- VICS Association

Sellers and buyers in a supply chain may collaborate along any or all of
the following:
• Strategy and planning: Scope of collaboration incl. roles,
responsibilities, extent and time period
• Demand and supply management: Forecasting
• Execution: Order placement to fulfillment
• Analysis: Exceptions and metrics assessment

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 Common CPFR Scenarios
Where Applied in
CPFR Scenario
Supply Chain
Retail event collaboration Highly promoted channels
or categories
Industries Where
Applied
All industries other than
those that practice EDLP

DC replenishment Retail DC or distributor DC Drugstores, hardware,

collaboration grocery

Store replenishment Direct store delivery or Mass merchants, club

collaboration retail DC-to-store delivery stores

Collaborative assortment Apparel and seasonal goods Department stores,

planning specialty retail

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CPFR: Requirements and Risks
Requirements
• Organizational re-alignment to customer- or geography-specific
needs
• Technology enabler for timely and accurate information sharing

Risks
• Misuse of information
• Frequent alignment of technology
• Cultural mismatch
• Selection of right level of coordination
• Initiate CPFR with DC-level or event-level before moving to store-level

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Thank you

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