Chapter 15

Risk pooling strategies to reduce and hedge

uncertainty

PROD 529: Chapter 15

Learning Objectives for Chapter 15

Strategies for reducing risk

Strategies should address the reason for uncertainty
Uncertainty varies by location location pooling
Uncertainty varies by product model product pooling
Use of product design to manage risk
Use of process design to manage risk

PROD 529: Chapter 15 2

Risk pooling strategies
The objective of a risk pooling strategy is to redesign the
production process, the product, or the supply chain, to:
reduce the uncertainty the firm faces
hedge uncertainty so that the firm is in a better
position to mitigate the consequence of uncertainty.
Four versions of risking pooling:
location pooling
product pooling
lead time pooling
delayed differentiation
consolidated distribution
capacity pooling

PROD 529: Chapter 15 3

Risk pooling strategies:

Location pooling

PROD 529: Chapter 15

Variation in Demand:
Safety Stock in Individual Locations
Consider 3 store locations in a region
Lets assume that the demand distribution at each store has a mean of mi
and a standard deviation of si

Store 2 Store 3
Store 1
si
z*si si z*si si z*si

mi
mi mi

If only an inventory of m is held, then

Demand will be met 50 % of the time
Probability of shortage would be 50 %
Safety stock is held to reduce the probability of shortage z

How much safety stock? z*s

PROD 529: Chapter 15 5
Pooling the Inventory

Store 2 Store 3
Store 1
si
z*si si si z*si
z*si
mi
mi mi

= z *3s i
Pool Inventory Centrally
s i2 + s i2 + s i2
= z *s i 3
3mi
=si 3

PROD 529: Chapter 15 6

 Location pooling

The location pooling strategy:

A single location stores inventory used by stores.
Stores no longer hold their own inventory, they must pull
inventory from the pooled location.
Inventory is automatically replenished at the pooled
location as depleted by demand at each store
For a single product, location pooling can be used to
decrease inventory while holding service constant, or
increase service while holding inventory cost, or a
combination of inventory reduction and service increase.
Or location pooling can be used to broaden the product
line.

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Location pooling pros, cons and alternatives
Pros:
Reduces demand uncertainty which allows a firm to reduce
inventory, increase service, expand the product line, or a
combination of all three.
Cons:
Location pooling moves inventory away from customers:
May create costs to ship product to customers, but may
reduce inbound transportation because of consolidation.
Alternatives:
Virtual pooling:
Each store keeps its own inventory, but shares inventory with
nearby stores if needed.
Drop shipping: If a firm doesnt have enough demand at each
location to justify holding inventory, the firm can location pool
with other firms via a drop shipping firm

PROD 529: Chapter 15 8

Risk pooling strategies:

Product pooling

PROD 529: Chapter 15

Product Pooling Universal Design
If a company sells multiple models of a product,
What happens, if a single universal model is used
that has features from all the models?
Demand distribution for the universal model is the
sum of the individual demand distributions
The uncertainty for the universal model is less than
the uncertainty in each of the models (similar to
location pooling)

PROD 529: Chapter 15 10

Product Pooling Universal Design
So in creating the universal design, uncertainty is
reduced and lower safety stock needs to be help to
meet the service level
Product pooling is most effective if the coefficient of
variation of the universal product is lower than the
coefficient of variation (COV) of the individual
products
Negative correlation in demand for the individual
products is best for reducing COV

PROD 529: Chapter 15 11

Limitations of product pooling/universal design
A universal design may not provide key functionality to
consumers with special needs:
High end road bikes need to be light, high end mountain bikes
need to be durable. It is hard to make a single bike that performs
equally well in both settings.
A universal design may be more expensive to produce
because additional functionality may require additional
components.
But a universal design may be less expensive to
produce/procure because each component is needed in a larger
volume.
A universal design may eliminate brand/price
segmentation opportunities:
There may be a need to have different brands (e.g., Lexus vs
Toyota) and different prices to cater to different segments.
PROD 529: Chapter 15 12
Risk pooling strategies:

Lead time pooling

PROD 529: Chapter 15

Lead Time Pooling Consolidated Distribution
Consider the following two systems:
In each case weekly demand distribution is mean of m and standard
deviation of s
If demands were independent
across stores, then DC demand
would have less uncertainty

s i2 + s i2 + s i2 ...
=si n

In addition, the
uncertainty only
needs to consider the
8 week lead time
once to the DC

PROD 529: Chapter 15 14

Consolidated Distribution
Consolidated distribution
reduces retail inventory
is not as effective at reducing inventory as location pooling
but consolidated distribution keeps inventory near
demand, thereby avoiding additional shipping costs (to
customers) and allowing customers to look and feel the
product
reduces inventory even though the total lead time increases

PROD 529: Chapter 15 15

Consolidated Distribution Summary
Consolidated distribution reduces inventory in a supply chain via lead
time risk pooling
Due to lead time risk pooling the supply chain only needs to decide
the total quantity to ship from the supplier, not a total quantity and its
allocation across locations. Hence, some uncertainty is avoided.
Most effective if demands are negatively correlated across locations.
Most effective if the supplier lead time is long and the DC to store
lead time is short.
But consolidated distribution increases total distance traveled and
total lead time from supplier to stores.

Other benefits of consolidated distribution:

Easier to obtain quantity discounts in purchasing.
Easier to obtain economies of scale in transportation:
the DC may be able to order a full truck load every day, whereas
an individual store might requires much more time to order a full
truckload
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Lead Time Risk Pooling Delayed Differentiation
Postponement of differentiation into separate models
Produce up to the common product level for all models
Add the differentiating features as the demand actually occurs
for each specific model
This is similar to assemble to order strategy used by Dell, HP
When does delayed differentiation make sense:
Customers demand variety.
There is less uncertainty with total demand than demand for
individual versions.
Variety is created late in the production process.
Variety can be added quickly and cheaply.
Components needed for variety are inexpensive relative to
the generic component.

PROD 529: Chapter 15 17

Other Examples of Delayed Differentiation
Private label soup manufacturer:
Problem: many different private labels (Giant, Kroger, A&P, etc)
Solution: Hold inventory in cans without labels, add label only when
demand is realized.

Black and Decker:

Sell the same drill to different retailers that want different packaging.
Store drills and package only when demand is realized.

Nokia:
Customers want different color phones.
Design the product so that color plates can be added quickly and
locally.

PROD 529: Chapter 15 18

Risk pooling strategies:

Capacity pooling

PROD 529: Chapter 15

 Capacity pooling with flexible manufacturing
Flexibility allows production shifts to high selling products to avoid lost
sales.
Consider a two plant, two product example and two configurations, no
flexibility and total flexibility:

If demand turns out to be 75 for product A, 115 for product B then..

With no flexibility With total flexibility
Production Production
Product Demand Plant 1 Plant 2 Sales Product Demand Plant 1 Plant 2 Sales
A 75 75 0 75 A 75 75 0 75
B 115 0 100 100 B 115 15 100 115

Total Sales 175 Total Sales 190

Plant Utilization 88% Plant Utilization 95%

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Some Flexibility Observations
Flexibility is most valuable when capacity approximately
equals expected demand.
Flexibility is least valuable when capacity is very high or
very low.
A little flexibility goes a long way
If flexibility is cheap relative to capacity, add flexibility.
But if flexibility is expensive relative to capacity, add
capacity.

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Risk pooling summary
Risk pooling strategies are most effective when total
demand uncertainty is lower than the uncertainty for
individual products/locations.
A little bit of risk pooling goes a long way:
With location pooling the biggest bang is from pooling
a few locations
With capacity pooling a little bit of well designed
flexibility is very effective.
Risk pooling strategies do not help reduce pipeline
inventory.
Risk pooling allows a firm to have its cake and eat it too
It is possible to lower inventory and increase service
simultaneously.
PROD 529: Chapter 15 22