Inventory-Optimization and Multi-Echelon Strategies

9-1
Inventory Policy
Decisions
CR (2004) Prentice Hall, Inc.
Chapter 9 part II
Every management mistake ends up in inventory.

Michael C. Bergerac
Former Chief Executive
Revlon, Inc.
9-2
Multi-Echelon Inventories
Control the entire channel inventory levels, not just a
single echelon.
E
n
d

c
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t
o
m
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d
e
m
a
n
d
R
1
R
2
R
3
1
,
1 d
s d
2
,
2 d
s d
3
,
3 d
s d
W
R
e
t
a
i
l

l
e
a
d
-
t
i
m
e
,

L
TR
Retailer
Warehouse
S
Supplier
Warehouse
lead-time, LT
w
Warehouse
echelon
How much stock here when
retailers also carry stock?
9-3
Multi-Echelon Inventories (Contd)
Example
An item has the following cost characteristics. Item
values are C
R
=$10/unit and C
W
=$5/unit. Carrying cost
is I = 20%/year. Ordering costs are S
R
=$40/order and
S
W
=$75/order. Lead times are LT
R
=0.25 month and
LT
W
=0.5 months. In-stock probability for retailers and
warehouses is 90%. Monthly demand statistics are
given in book as below:
Monthly
avg., units
Std. dev.,
units
Retailer 1 202.5 16.8
Retailer 2 100.5 15.6
Retailer 3 302.5 18.0
Combined 605.5 32.4
9-4
Solution
Based on reorder point inventory control, the retailers
inventory statistics are
The retailer 1 order quantity is
units 312 or 80 . 311
) 10 ( 20 . 0
) 40 )( 12 5 . 202 ( 2
2
1
1
= = =
x
IC
S D
Q
R
R R
units 61 38 . 61
25 . ) 8 . 16 ( 28 . 1 ) 25 (. 5 . 202
1 1 1
or
LT zs xLT d ROP
R d R
=
+ = + =
The average inventory AIL is
units 167 or . 65 . 166
25 . 0 ) 8 . 16 ( 28 . 1
2
8 . 311
2
1
1
1
=
+ =
+ =
R d
LT zs
Q
AIL
9-5
Solution
Based on reorder point inventory control, the retailers
inventory statistics are
Retailer 1 Retailer 2 Retailer 3
Reorder qty, Q 312 220 381
Reorder point, ROP 61 35 87
Avg. inv., AIL 167 120 202
The warehouse echelon order quantity is
units 1,044 or , 98 . 043 , 1
) 5 ( 20 . 0
) 75 )( 12 5 . 605 ( 2
2
= = =
x
IC
S D
Q
W
W W
W
units 332
5 . ) 4 . 32 ( 28 . 1 ) 5 (. 5 . 605
=
+ = + =
W W W W W
LT zs xLT d ROP
9-6
The warehouse echelon inventory is
units 551 or . 32 . 551
5 . 0 ) 4 . 32 ( 28 . 1
2
98 . 043 , 1
2
=
+ =
+ =
W W
W
W
LT zs
Q
AIL
The average warehouse inventory is the warehouse
echelon inventory less the retailers inventory, or 551
167 120 202 = 62 units.
Rule When the total warehouse inventory (sum of
retailers inventory, inventory at the warehouse and on
order, and retailers orders less any inventory committed
to customers drops below 332 units, order 1,044 units.
9-7
Inventory Consolidation
(Risk Pooling)
Suppose there is a product stocked in two warehouses. Avg.
territory monthly demand in warehouse 1 is d1=41 units with a
standard deviation of sd1=11 units /month. And for warehouse 2,
d2=67 and sd2=9.
The replenishment quantities are determined by the economic
order quantity formula. The replenishment lead-time is 0.5 months,
the cost for a replenishment order is $50, the inventory carrying
cost is 2% per month, and the item value is $75 per unit. The
probability of an out of stock during the lead-time period is 5%.
The demand is normally distributed with typical demand over six
months as follows.
Illustration of risk pooling
9-8
Estimate the average inventory levels for two-
warehouse and one-warehouse supply channels.
Risk Pooling (Contd)
Month
Demand
in Whse
A
Demand
in Whse
B
Combined
Demand in a
Central
Whse
1 35 67 102
2 62 83 145
3 46 71 117
4 25 62 87
5 37 55 92
6 43 66 109
Avg. ( D ) 41.33 67.33 108.66
Std. Dev. ( s
d
) 11.38 8.58 19.07
6
9-9
Regular stock
units 50 . 33
2
00 . 67
2
) 75 ( 02 . 0
) 50 )( 33 . 67 ( 2
units 25 . 26
2
49 . 52
2
) 75 ( 02 . 0
) 50 )( 33 . 41 ( 2
2
2
2
= = =
= = =
= =
B
A
RS
RS
IC
DS
Q
RS
Regular stock in system is
units 75 . 59 50 . 33 25 . 26 = + = + =
B A
RS RS
s
RS
9-10
Regular stock if item is entirely in one warehouse
units 56 . 42
2
11 . 85
2
) 75 ( 02 . 0
) 50 )( 66 . 108 ( 2
= = =
C
RS
Safety stock
units 01 . 10 5 . 0 ) 58 . 8 ( 65 . 1
units 28 . 13 5 . 0 ) 38 . 11 ( 65 . 1
) (
= =
= =
=
B
A
d
SS
SS
LT s z SS
System safety stock in 2 warehouses
units 29 . 23 01 . 10 28 . 13 = + = +
B A
SS SS
Safety stock in central warehouse based value of z=1.65
units .58 16 0.5 ) 1.65(14.21 = =
c
SS
Total inventory
AIL = Regular stock + Safety stock
AIL = 59.75 + 23.29 = 83.04 units
In a one-warehouse channel
AIL = 42.56 + 16.58 = 59.14 units
Two
warehouses
Conclusion There is a reduction in the average
inventory level of an item as the number of stocking
points in the supply channel is decreased. In this
example, both regular stock and safety stock decline.
9-77
.21 14
2
9
2
11
2
2
2
1
= + = + = S S
c
S
9-12
Virtual Inventories
Stock-outs are filled from other stocking locations in
the distribution network
Customers may be assigned to a primary stocking
location but it is rare that inventory is maintained to
meet all demand request from primary location.
Expectation is that lower system-wide inventories
can be achieved while maintaining or improving
stock availability levels
The combination of inventory sites is referred to as
a virtual inventory.
9-13
Stock
location A
Stock
location B
Demand 1
Demand 2
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Secondary
assignment
Stock
location A
Stock
location B
Demand 1
Demand 2
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Secondary
assignment
Cross Filling Among 2
Stocking Locations
Virtual Inventories
9-14
Potential Benefit
of Cross Filling
Suppose that an item is stocked at a fill rate of 80% in
4 stocking locations. If cross filling is used, what is
the effective fill rate for the customer?
Fill rate = [1 (.20)(.20)(.20)(.20)] x 100 = 99.8%

Customer service levels can be quite high
even if the item fill rate is low!
But are inventory costs lower?
Virtual Inventories
Regular Stock in 2 Locations
Meaning of regular stock
How it varies with:
Demand dispersion
Method of stock control
Fill rate
Virtual Inventories
Stock
location A
Stock
location B
Demand 1
Demand 2
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Secondary
assignment
Stock
location A
Stock
location B
Demand 1
Demand 2
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Secondary
assignment
Stock
location A
Stock
location B
Demand 1
Demand 2
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Secondary
assignment
Stock
location A
Stock
location B
Demand 1
Demand 2
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Secondary
assignment
9-82
9-16
Stock Control Methods
and Regular Stock
If control is EOQ-based, average inventory level (AIL) is
If stock-to-demand control
1.0
kD AIL=
AIL is a function of
demand with
exponents ranging
from 0.5 to 1.0
EOQ
formula
Virtual Inventories
0.5
0.5
kD
2
D
IC
2S
2
Q
AIL = = =
|
|
|
.
|
\
|
9-17
Observation about
Regular Stock
A system of multiple stocking locations
will carry its maximum regular stock
when demand is balanced among them
Virtual Inventories
9-18
Fill Rate and Regular Stock
Cross filling increases regular stock as lower fill rates
are specified
Example
2 locations
Demand is dispersed 50 and 150
Fill rate is 90%
Stocking policy is D
0.5
with k=1
Virtual Inventories
Example (Contd)
Location A Location B Location A Location B
Demand 1 50 0 45
a
5
b
Demand 2 0 150 15 135
Total 50 150 60 140
Regular stock 7.1 12.2 7.7 11.8
System inv. 19.3 19.5
No cross filling Cross filling
a
50x.90=45
b
[50x(1-0.90)]x0.90~5
Regular stock increases
with cross filling
Virtual Inventories
9-87
60=7.7
Safety Stock in 2 Locations
Meaning of safety stock
Safety stock depends on
Demand dispersion (variance is proportional
to (demand)
Fill rate
A system of multiple stocking
locations will carry its minimum
safety stock when demand is
balanced among them
Observation
Virtual Inventories
Stock
location A
Stock
location B
Demand 1 Demand 2
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Secondary
assignment
Stock
location A
Stock
location B
Demand 1 Demand 2
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Secondary
assignment
Stock
location A
Stock
location B
Demand 1 Demand 2
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Secondary
assignment
Stock
location A
Stock
location B
Demand 1 Demand 2
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Secondary
assignment
9-89
9-21
Safety Stock Estimation
Safety stock is estimated by

where s
*
is the demand standard deviation at
location N

When cross filling,

where s
d
is the demand standard deviation at the
primary location

At any location N

LT zs ss
*
=
2 2 *
d
s FR s =
2 2 1 *
] ) 1 ( [
d
N
N
s FR FR s

=
Virtual Inventories
9-22
Safety Stock in 2 Locations
Example
2 locations
Weekly demand and std. dev. are (50,5) and
(150,15)
Lead time is 1 week
Fill rate (FR) is 95%
z is 1.65 for 95% stocking level (demand normally
distributed)
Inventory control is EOQ based
Virtual Inventories
Location A Location B Location A Location B
Std. Dev. 1 5 0 4.7500

0.2375

Std. Dev. 2 0 15 0.7125 14.2500
Combined 5 15 4.8 14.3
Safety stock 8.3 24.8 7.9 23.5
System inv. 33.1 31.4
Safety Stock for 2 Locations
No cross filling Cross filling
Safety stock decreases
with cross filling
Virtual Inventories
9-92
ZsLT= 1.65
*4.8*1= 7.9
9-24
Simplifying the Decision
Problem
An item potentially can be cross filled from 1 backup
warehouse. The item has a value of $200/unit, a carrying
cost of 25%/per year, a stocking level of 6-weeks demand, a
replenishment lead-time of 8 weeks, and a target fill rate of
95%. To cross haul the item from the secondary warehouse
incurs an extra $10/ unit in transportation. The stock control
policy is not known. Demand statistics are as follows:

Location
Mean demand,
units
Std. Dev.,
units
1 300 138
2 100 80
System 400 160
Should the item be cross filled?
Virtual Inventories
9-25
Simplifying the Decision
Answer
Solve for K in AIL=KD
o
. K=D
1-o
/TO, where TO is 52
weeks/6 weeks of demand or 8.67. This assumes a
control policy based on o of 0.7. Hence,
K=(400x52)
1-.7
/8.67=2.28. The demand ratio r between
the 2 locations is 100/400=0.25. Now solve for two
parameters of the cross-filling curve.

73 . 1
) 28 . 2 )( 200 ( 25 . 0
]) 52 400 ([ 10
7 . 1
1
= = =

x
ICK
tD
X
o
and
337 . 0
) 52 400 ( 28 . 2
8 ) 160 ( 65 . 1
7 . 0
= = =
x KD
LT zs
Y
o
Now, from the decision curve, dont cross fill this item.
Virtual Inventories
9-26
Decision Curve for FR=.95 and o=0.7
Virtual Inventories
LEGEND
D = annual system demand
s = system demand std.
dev.
C = item unit cost
I = annual carrying cost
rate (%)
K,
o
= inventory
control parameters
t = transportation rate
FR = item fill rate
r = ratio of minimum
demand to system
demand
LT = lead - time in demand
std. dev. time units
z = normal deviate at FR %
ICK
tD
X
o
=
1
o
KD
LT zs
Y
=
R
a
t
i
o

o
f

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d
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a
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d

t
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t
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a
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d
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a
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d
,

r

X
Below
decision
curve dont
cross fill
Square Root Law
of Inventory Consolidation
The amount of inventory (regular stock) at multiple stocking
points can be estimated by the square root law when
Inventory control at each point is based on EOQ
principles
There is an equal amount on inventory at each point
The square root law is:
n I I
i T
=
where
I
T
= amount of inventory at one location
I
i
= amount of inventory at each of n locations
n = number of stocking points
9-97
Square Root Law (Contd)
Example Suppose that there is $1,000,000 of inventory at 3
stocking points for a total of $3,000,000. If it were all
consolidated into 1 location, we can expect:
$1,732,051 3 1,000,000 = =
T
I
If we wish to consolidate from 3 to 2 warehouses, the
level of inventory in each warehouse would be:
$1,224,745
1.41
$1,732,051
2
I
I
T
i
= = =
For a total system inventory of n x I = 2 x $1,224,745 =
$2,449,490.
CR (2004) Prentice Hall, Inc. 9-98
9-29
Square Root Law (Contd)
More simply
2,449,490
3
2
3,000,000 I
n
n
n I
n I
n
n
I I
2
1
2
1 1
2 2
1
2
1 2
= =
=
=
=
=
=
So,
locations previous of no.
locations new of no.
locations in inventory system
locations in inventory system
where
9-30
Inventory-Throughput Curve
In Square Root Law there are following assumptions

1- Equal amount of inventory at all warehouses
2- Demand and lead time are known
3- Q is determined from EOQ formula

First draw the companys stock status report, construct
a plot of average inventory level AIL against annual
warehouse shipments (D).

Each point on the plot represent a single warehouse.
It is the turnover ratio of the warehouse.
9-31
Example
Suppose two warehouses with 390,000 lb. and
770,000 lb. of throughput respectively are to be
consolidated into a single warehouse with 390,000 +
770,000 = 1,160,000 lb. of annual throughput. How
much inventory is likely to be in the single warehouse?
The inventory-throughput curve developed from the
companys multiple warehouse stocks is shown in the
figure below.

Note Reading from the plot, the inventory in the
consolidated warehouse has dropped to 262,000 lb.
from 132,000 + 203,000 = 335,000 lb. in the two
warehouses.
9-32
AIL
i
= 3.12D
i
0.628

R
2
= 0.77
132
203
262
Current
warehouse
Consolidated
warehouse
0
50
100
150
200
250
300
350
400
450
0 200 400 600 800 1000 1200 1400 1600 1800
Annual warehouse throughput, D
i
(000 lb.)
A
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l
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A
I
L

i

(
0
0
0

l
b
.
)

9-33
Turnover Ratio
inventory Average
sales Annual
ratio Turnover =
A fruit grower stocks its dried fruit products in 12 warehouses
around the country. What is the turnover ratio for the
distribution system?
Ware-
house
no.
Annual
warehouse
throughput, $
Average
inventory
level, $
Ware-
house
no.
Annual
warehouse
throughput, $
Average
inventory
level, $
1 21,136,032 2,217,790 7 43,105,917 6,542,079
2 16,174,988 2,196,364 8 47,136,632 5,722,640
3 78,559,012 9,510,027 9 24,745,328 2,641,138
4 17,102,486 2,085,246 10 57,789,509 6,403,076
5 88,228,672 11,443,489 11 16,483,970 1,991,016
6 40,884,400 5,293,539 12 26,368,290 2,719,330
Totals 425,295,236 43,701,344
$ are at cost
236 , 295 , 425 $
7 . 9
4 $43,701,34
ratio TO
= =

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