Distribution Inventory Systems

Dr. Everette S. Gardner, Jr.

Competing interests in inventory management

Controller: Inventory investment

Marketing manager: Customer service

Inventory

Operations manager: Stock replenishment workload

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Average inventory behavior with stable demand

12 11 10 9 Stock 8 On hand

7 6 5 4
3 2 1 0 0 4 8 12 16 Day
Inventory

Avg. inv.

ROP

20

24

28
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Average inventory behavior with stable demand (cont.)

Demand = 1 unit per day Leadtime = 2 days Leadtime demand (LTD) = 2 units Reorder point (ROP) = LTD = 2 units Order quantity (Q) = 10 units Maximum inventory = Q = 10 units Avg. investment = Q/2 = 5 units

Inventory

The economic order quantity

Objective
Minimize total variable costs (TVC) OC = Cost per order x Nbr. of orders Nbr. of orders = Demand/Order qty. HC = Holding cost per unit per year x Avg. inv. balance Avg. inv. balance = Order qty./2 TVC = OC + HC
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Ordering costs (OC)

Holding costs (HC)

Total variable costs

The economic order quantity (cont.)

$ Total costs

Ordering costs

EOQ

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Economic order quantity (cont.)

EOQ in units of stock
QU = ((2 * demand in units * cost per order) / holding cost per unit per year)1/2

EOQ in dollars of stock

Q$ = ((2 * demand in dollars * cost per order) / holding rate)1/2

where the holding rate is a fraction of inventory value

Inventory

EOQ.xls

Economic order quantity (cont.)

Example
annual demand cost per order holding cost per unit unit price holding rate = = = = = 100 units $10 $5 $25 .20 = 20 units = $500
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QU = ((2 * 100 * 10) / 5)1/2 Q$ = ((2 * 25 * 100 * 10) / .20)1/2

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EOQ in perspective
Ordering and holding costs should be marginal

(out of pocket) costs.

Accounting systems generate average costs. In reality, ordering costs are semifixed.

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EOQ in perspective (cont.)

Assumption: Total ordering costs Nbr. of orders Nbr. of orders Reality:

In reality, holding costs depend on executive judgments on

the cost of capital.

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Using the EOQ when costs are unknown

Costs can be taken out of EOQ formulas and used as policy variables to achieve management goals for workload and average cycle stock investment. Formula for EOQ in dollars
Q$ = ((2 * demand in dollars * cost per order) / holding rate)1/2

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Using the EOQ when costs are unknown (cont.)

Remove all constants and unknowns
K = ((2 * cost per order) / holding rate)1/2

K is called the EOQ constant

Simplified EOQ formula

Q$ = K (demand in $)1/2

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Calculations with the EOQ cost constant

Let unit price = $10, annual demand = 100 units

Low investment, high workload policy

K=1 Q = K (demand in $)1/2 = 1 ($10 * 100)1/2 = $31.62 Avg. investment = order qty./2 = $31.62/2 = $15.81 Workload = demand/order qty. = $1000/$31.62 = 31.62 orders
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Calculations with the EOQ cost constant (cont.)

High investment, low workload policy
K=6 Q = K (demand in $)1/2 = 6 ($10 * 100)1/2 = $189.74 Avg. investment = order qty./2 = $189.74 / 2 = $94.87 Workload = demand/order qty. = $1000 / $189.74 = 5.3 orders

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Tradeoffs between investment and workload

K 1 2 3 4 5 6 6.32 8 10 20 Avg. invest. = order qty./2 $15.81 31.62 47.43 63.24 79.04 94.86 100.00 126.48 158.10 316.20
Inventory

Workload = demand/order qty. 31.62 orders 15.8 10.5 7.9 6.3 5.3 5.0 4.0 3.5 1.6
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Tradeoffs between investment and workload (cont.)

$ 300

Avg. investment

250 200 150 100

The optimal policy curve

50

10

15

20
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25

30
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Workload

Optimal policies for multi-item inventories

Given only the sum of square roots of demand in $, you can compute aggregate workload and investment.
Read as the sum of:

Investment formula
Single-item Q$ = K (demand in $)1/2 Q$ / 2 = (K/2) * (demand in $)1/2 Multi-item Q$ = K (demand in $)1/2 Q$ = K (demand in $)1/2 Q$ / 2 = K/2 (demand in $)1/2
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Inventory

Optimal policies for multi-item inventories (cont.)

Workload (F) formulas

Single-item F = (demand in $) / Q$ F = (1/K) * (demand in $)1/2

Multi-item F = (demand in $) / Q$ F = 1/K (demand in $)1/2

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Multi-item example
5,000 line-item inventory (demand in dollars)1/2 = $250,000 K 1 2 5 10 K/2 0.5 1.0 2.5 5.0 Investment $125,000 250,000 625,000 1,250,000 1/K 1.0 0.5 0.2 0.1 Workload 250,000 orders 125,000 50,000 25,000

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Multi-item example (cont.)

For K = 5:
avg. investment = Q$/2 Q$/2 = (K/2) (demand in $)1/2 = 2.5 * 250,000 = 625,000 = 1/K (demand in $)1/2 = 0.2 * $250,000 = 50,000 orders

workload

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Achieving management goals for investment

Goal = Q$/2
Goal = (K/2) * (demand in $)1/2 Solving for K yields: K = (2 * goal) / (demand in $)1/2 This value of K meets the investment goal exactly.

The workload for that K is:

F = (1/K) * (demand in $)1/2 = ( (demand in $)1/2)2 / (2 * goal)
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Average inventory behavior with uncertain demand

12 11
10 9 Stock 8 7 6 5 4 3 2 1 0 0 4 8 12 16 Day
Inventory

On hand

Avg. inv.

ROP SS

20

24

28
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Average inventory behavior with uncertain demand (cont.)

Demand = 1 unit per day Leadtime = 2 days Leadtime demand (LTD) = 2 units Safety stock (SS) = 2 units Reorder point (ROP) = LTD + SS = 4 units Order quantity (Q) = 10 units Maximum inventory = Q + SS = 12 units Avg. investment = Q/2 + SS = 7 units

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Reorder point with uncertain demand

Assumption
Length of leadtime is constant

Concepts
Reorder point = mean demand during leadtime + safety stock

standard deviation Safety stock = safety factor * of forecast errors during leadtime

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Reorder point with uncertain demand (cont.)

The standard deviation is a measure of variability of the forecast errors. With a perfect forecast, the standard deviation is zero. As forecast accuracy gets worse, the standard deviation gets larger. The larger the safety factor, the smaller the risk of running out of stock.

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Safety factor and probability of shortage

z 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80 1.90 2.00 2.10 2.20 P(z) 0.50000 0.46017 0.42074 0.38209 0.34458 0.30854 0.27425 0.24196 0.21186 0.18406 0.15866 0.13567 0.11507 0.09680 0.08076 0.06681 0.05480 0.04457 0.03593 0.02872 0.02275 0.01786 0.01390 z 2.30 2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.10 3.20 3.30 3.40 3.50 3.60 3.70 3.80 3.90 4.00 4.10 4.20 4.30 4.40 4.50 P(z) 0.01072 0.00820 0.00621 0.00466 0.00347 0.00256 0.00187 0.00135 0.00097 0.00069 0.00048 0.00034 0.00023 0.00016 0.00011 0.00007 0.00005 0.00003 0.00002 0.00001 0.00001 0.00001 0.00000
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Probability of shortage on one order cycle

P(Z) = Probability demand will exceed Z standard deviations of safety stock on one order cycle Example: Mean demand during LT = 100 units Std. dev. = 20 units Safety factor (Z) = 1.5 Reorder point = mean demand + Z (std. dev.) during LT = 100 + 1.5 (20) = 130 units From table, P(Z) = .06681
Inventory

ROP.xls

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Probability of shortage on one order cycle (cont.)

From table, P(Z) = .06681

.50 Z

.43319

0
X 100

1.5
130

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Number of annual shortage occurrences (SO)

The probability of shortage on one order cycle is misleading since the ordering rate can vary widely across the inventory. A better measure of customer service is the number of annual shortage occurrences.
Probability of shortage on one order cycle Number of annual order cycles

SO

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Number of annual shortage occurrences (SO) (cont.)

Example:
Safety factor = 1.5 Probability = .06681 Annual demand = 1000 units Order quantity = 50 units Number of annual order cycles = 1000/50 = 20 SO = .06681 * 20 = 1.34

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Units or dollars backordered as a service measure

E(Z) = Expected units backordered for a distribution with mean = 0 and standard deviation = 1 on one order cycle Expected units backordered for a distribution with mean = X and standard deviation = on one order cycle

E(Z) =

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Units or dollars backordered as a service measure (cont.)

Example:
Annual demand = 1000 units Order quantity = 50 units X = 25 units =5 Z = 1.2 From table, E(Z) = .05610 Reorder point = 25 + 5 (1.2) = 31 Units short per cycle = .05610 (5) = .2805 Annual order cycles = 1000/50 = 20 Units short per year = 20 (.2805) = 5.61
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Quiz #1: Computing customer service measures

Given:
Annual demand = $2,000 Order quantity = $100 Mean demand during leadtime = $80 Standard deviation = $60

Suppose we want the probability of shortage on one order cycle to be .09680. Compute the following:
Safety stock Reorder point Number of annual shortage occurrences Dollars backordered during one order cycle Dollars backordered per year Average cycle stock investment Average inventory investment
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Quiz #2: Computing customer service measures

For the same data as the previous problem, what reorder point will yield:

a. 3 shortage occurrences per year?

b. 5% of annual sales backordered?

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Inventory tradeoff curves

A variety of different workload and investment combinations yield exactly the same customer service. To develop a tradeoff curve for dollars backordered:
1. Compute and plot the optimal policy curve showing tradeoffs between cycle stock investment and workload. 2. Select a percentage goal for dollars backordered. 3. For each workload, compute the safety stock needed to meet the goal. 4. Add cycle stock to safety stock to obtain total investment.

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Inventory tradeoff curves (cont.)

$ Isoservice curve -- each point yields the same dollars backordered

Investment

Safety stock Optimal policy or cycle stock curve Workload

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U.S. Navy application of tradeoff curves

Inventory system
8 Naval supply centers Average inventory statistics at each center 80,000 line items $25 million investment

Budget constraint
Average investment limited to 2.5 months of stock
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U.S. Navy application of tradeoff curves (cont.)

Investment allocation strategies
Safety stock months Cycle stock months Total Old 1.5 months 1.0 months 2.5 New 1.0 1.5 2.5

Results of new allocation

Reordering workload cut from 840,000 to 670,000 per year $2 million annual savings in manpower
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Workload/service tradeoffs
(Total investment fixed at 2.5 months)
90%

New policy Customer service

85%

Previous policy

80%

75% 0.0 0.5 1.0 1.5 2.0

Safety stock (months)

112 121 184 240 289

Workload (thousands of orders)

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Strategic problems in managing distribution inventories

1. Controlling inventory growth as sales increase 2. Controlling inventory growth as new locations are added 3. Push vs. pull decision rules 4. Continuous review of stock balances vs. periodic review 5. Choosing a customer service measure

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Inventory growth
Inventories should grow at slower rate than sales.
Why? Order quantities are proportional to the square root of sales.

Example:
One inventory item K=1 Q$ = K (demand in $)1/2 Sales Growth --100% Average Investment 10/2 = 5 14/2 = 7 Investment Growth --40%
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Sales 100 200

Q$ 10 14
Inventory

Effects of adding inventory locations

Inventories must increase as new locations are added.
One reason is that forecasting is easier when customer demands are consolidated. Thus forecast errors are smaller and less safety stock is required.

Another reason stems from the EOQ:

One inventory item Sales of $100 K=1

With one location:

Q$ = K (demand in $)1/2 Q$ = 1 (100)1/2 = 10 Average investment = 10/2 = 5
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Effects of adding inventory locations (cont.)

With two locations:
Location 1: Q$ = 1 (50)1/2 = 7.07 Location 2: Q$ = 1 (50)1/2 = 7.07 Average investment = (7.07 + 7.07) / 2 = 7.07 Investment increase = 7.05 5 = 2.05 Percentage increase = 2.05 / 5 = 41%

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Continuous review vs. periodic review systems

Continuous review
Check stock balance after each transaction If stock on hand below reorder point, place new order in a fixed amount

Periodic review
Check stock balance on a periodic schedule If stock on hand below reorder point, place new order: in a fixed amount, or in a variable amount (maximum level on hand)

Investment requirements
Periodic review always requires more investment than continuous review to meet any customer service goal.
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Push vs. pull control systems

Push or centralized system
Central authority forecasts demand, sets stock levels, and pushes stock to each location.

Pull or decentralized system

Each location forecasts its own demand and sets its own stock levels.

Investment requirements
A pull system always requires more investment than a push system to meet any customer service goal.
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Comparison of shortage values

Inventory statistics
5,790 line items $45 million annual sales

Shortage values at investment constraint of $5 million

Shortage value minimized shortage occurrences dollars backordered Shortage occurrences 1,120 2,812 Dollars backordered $3.46 million 1.48

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