Chapter 9 (Advanced Inventory Management)

Cost of Overstocking

Cost associated with having a single unity left over at the end of a selling season; typically includes acquisition costs, transportation costs, disposal costs and, salvage value - if you order too many newspapers, you will be left with unsaleable newspapers at the end of the day

Cost of Understocking

Cost associated with stocking out by a single unit; typically includes profit foregone, loss of goodwill and/or cost of upgrades - if you order too few newspapers, you will incur stockouts

Stockout Costs

Costs associated with an out-of stock (or stockout) occurrence

Risk Pooling

Set of management techniques aimed at reducing exposure to (demand and/or lead time) uncertainty by spreading risk across broader sets of customers and/or suppliers - Ex. Warehouse (or DC) Consolidation - In theory, you can reduce your overall safety stock by consolidating warehouses

Why hold more safety stock?

Simply put, some mix of your exposure to risk and the optimal service level influences how much safety stock you should hold.

Order Quantity (Q)

Size of a replenishment (in units)

Lowest cost solution

is obtained when you simultaneously choose the optimal order quantity Q* and the optimal reorder point R*.

Stock Keeping Units (SKU's)

"different products"

Pareto Principle

- 80/20 rule; as applied to inventory context, this rule suggests that (about) 80% of revenues are (typically) generated by 20% of a firm's SKU's - Most companies classify SKUs based on total costs, because the data is readily available.

Newsvendor Model (single-period model)

- A single-period inventory control model that aims to define optimal order quantities to minimize expected overstock and understock costs - the model is useful whenever you place a single order for each selling season (one day for a newspaper).ol for "perishable" products that are unsaleable after a very short shelf life - Ex.) vegetables, newspapers, fruits, fast changing technology

EOQ Model

- Assumptions: Constant, known demand/Zero lead times - Costs Considered: Cycle stock holding costs/Order placement costs - Decision Variables: Order quantity

Reorder Point Model

- Assumptions:Random demand/Random lead times - Costs Considered:Cycle stock holding costs/Safety stock holding costs/Order placement costs/Stockout costs - Decision Variables: Order quantity/Reorder point

ABC Classification

- Inventory Categorization method that divides items into A (most important), B, and C (least important) categories depending on their annual usage. (Uses the Pareto Priciple to help prioritize efforts) - Strategic SKUs—the most important 5-10% of SKUs—make up a huge share of your total inventory costs (and probably firm profits). You classify them as "A" SKUs. You label the next 15-30% of high-usage/high-dollar-value SKUs as "B" SKUs. You label the remaining SKUs—the slow movers—as "C" SKUs. "ABC" classification is typically a two-step process.

Reorder point model (RQ Model)

- Inventory Control model that is defined by two parameters: reorder point (R) and order quantity (Q) - helps you decide when replenishment orders should be placed (reorder point) and how large such orders should be (order quantity).

Reorder Point (R)

- Inventory position at which replenishment orders are released in a continuous review system - when inventory gets to a certain level, you replenish inventory

Safety Stock

- Inventory used as a buffer to protect against potential stockouts

Reorder Point Model Drawback

- One drawback to using the optimal reorder point model is that many managers have no idea what a stockout actually costs. After all, stockout costs are hard to calculate. You need to know how all of your different customers really respond to stockout situations - If you find yourself in a situation where you don't know stockout costs, the best you can do is use the basic EOQ and managerially define an in-stock target. This is called a "managerial" reorder point model

ABC Classification is typically a two-step process

- Step 1: Classify SKUs by Costs- Build a SKU spreadsheet to calculate total costs/usage. That is, multiply annual demand by cost. Sort your SKUs by rank order. Then, classify the SKUs by looking for natural breaks in the cost analysis. - Step 2: Modify classifications based on strategic issues- Cost numbers tell only part of the story. You therefore need to consider other issues that might make a SKU more or less important.

Newsvendor Model (Extra)

- When managing perishable products, your goal is to minimize total costs by trading off the costs of understocking and the costs of overstocking

All the examples have two key features:

- Your customers will only buy these products during a limited selling period. - You need to make stocking decisions knowing that future replenishment may not be possible (after all, you can't just grow a Christmas tree if inventory is running low by December 22nd).

Safety Stock

- if you want to reduce the stockout probability and achieve greater customer service levels, you need to carry safety stock - You need to choose a safety stock level that balances inventory holding and stockout costs. Finally, when building your reorder point model, you need to include order placements costs—just like in the basic EOQ model.

Total Cost Function will include the sum of following:

1) Cycle stock holding costs 2) Safety stock holding costs 3) Order placement costs 4) Stockout Costs

Once you classify SKUs, you need to establish appropriate inventory policies. In other words, you want to answer three questions:

1) Review: How frequently are you going to monitor each SKU? 2) Replenishments: How large and frequent should your orders be? 3) Safety Stock: How much safety stock do you need to protect against uncertainty and risk? - Figure 9-3 / Section 9.5

Conclusion:

1) Too much inventory can cost you a lot of money, robbing you of your ability to compete. When you look at product filling a warehouse rack or sitting on a shelf, you are really looking at stacks of money. Further, excess inventory can hide inefficiencies and tempt you to become complacent—again, stealing your competitive edge. 2) As insurance, inventory enables you to conduct business in a chaotic world. It protects you against customer demand and lead time uncertainty. It allows you to keep producing, selling, and delivering product when things don't go as you expected. Simply put, inventory is essential.

Throughout this chapter we have emphasized two points about uncertainty:

1) Uncertainty complicates your decision-making regarding inventory management. 2) Uncertainty drives costs, especially inventory holding and stockout costs.

Adding Safety Stock increases 3 things:

1) Your reorder point. 2) Your total inventory levels. 3) Your carrying costs.

Customer Service

A seller's ability to satisfy customer demand

Distribution System

A system of stocking locations used to get products from suppliers or a manufacturing facility to end customers

Stockout

Also called out-of-stock event which occurs when demand for an item cannot be filled from existing inventory

EOQ model makes two critical, but flawed assumptions:

Assumption #1: Customer demand is constant. Assumption #2: Orders are replenished instantly; that is, with zero lead time.

The bottom line:

Greater risk raises the likelihood that things will go wrong

Cycle stock

Inventory a seller plans to cycle through to satisfy demand

Safety stock

Inventory used as buffer to protect against potential stockouts

In-stock probability

Likelihood that a given product will be in stock (an no stockouts will be observed) in a given time period

3) Order placement costs

Order placement costs are the total number of orders placed per year ( D/Q) multiplied by the cost of placing a single order ( K).

Distribution of lead time demand

Probability distribution of customer demand during lead times. It combines demand and lead time distributions and is defined by its mean (average demand during the average lead time) and the standard deviation of lead time demand

Critical Factile - F(Q*)

Ratio of the cost of understocking (Cu) and the sum of understock (Cu) and overstock (Co) costs; determines the optimal in stock probability in a newsvendor model.

Lead time uncertainty

Refers to the degree of variability of demand; often measured as the standard deviation of lead times

Demand Uncertainty

Refers to the degree of variablility of customer demand; often measured as the standard deviation of demand

Replenishment orders

The placement of an order specifically designed to restock a facility with inventory

Lead Time

Time that elapses between order placement and order reciept

Inventory Holding Costs (1&2)

Total inventory holding costs, which are calculated as the sum of cycle stock (Q/2) and safety stock (SS) multiplied by the holding cost per unit per year (h).

You face a dilemma:

You can choose to hold more safety stock to avoid stockouts when demand is greater than you expected or when incoming shipments are delayed. Or, you can choose to forego such buffer inventory and live with the risk of stocking out. Each option brings unique costs. You are thus faced with a tradeoff.

EOQ Model

a simple but effective tool to illustrate and optimize the tradeoff between ordering and holding costs. We call it simple because we assume away all demand and lead time uncertainty

4) Stockout Costs

annual stockout costs are obtained by multiplying the unit stockout cost ( p) with the number of units out-of-stock per cycle [n(R)] and then multiplying this product by the number of cycles per year ( D/Q).

Notice:

the optimal order quantity is similar to the basic EOQ. The only difference is that stockout costs per cycle are added as part of your tradeoff considerations