Module:5

Planning & Managing

Inventories in a Supply
Chain
Dr. Kishore Kumar
Mahato Assistant
Professor,
School of Mechanical Engineering VIT University
[email protected]
9861375851
 Module:5 Planning & Managing Inventories in a Supply Chain
Module:5 Planning & Managing Inventories in a Hours: 7 CO 4
Supply Chain
Part I Optimize inventory level in a
The role of cycle inventory in a supply chain –Managing cycle inventory in a multi Supply Chain.
echelon supply chain – Estimating cycle inventory and related costs in practice.
Part II
The role of safety inventory in a supply chain – Managing safety inventory in a multi
echelon supply chain – Estimating and managing safety inventory in practice.

Learning Objectives of this Module – Part I

• Describe the role of cycle inventory in a supply chain.
• Choose the optimal lot size given fixed ordering costs in a supply chain.
• Develop replenishment policies to improve synchronization in multi-echelon supply chains.

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Prof. Kishore Kumar Mahato- VIT University
 Inventory

Where do we hold inventory?

• Suppliers and manufacturers
• warehouses and distribution centers
• retailers

Types of Inventory
• WIP
• raw materials
• finished goods

Why do we hold inventory?

• Economies of scale
• Uncertainty in supply and demand

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 4
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 Inventory Functionality and Definitions
 Inventory management involves risk which varies depending upon a firms position in the
distribution channel .
 The typical measures of inventory exposure are time duration, depth, and width of
commitment.

1. Manufacturer
 For a manufacturer inventory risk is long term. Its begin with raw material and components
parts purchase, include work-in-process, and ends with finished goods.
 In addition finished goods are often placed in warehouses in anticipation of customer demand.
In some situation, manufactures are requested to consign inventory to customer facilities.
 Although a manufacturer, typically has a narrower product line than a retailer or wholesaler,
the manufacturers inventory commitment is deep and of long duration.

Prof. Kishore Kumar Mahato- VIT University

2. Wholesaler
 A wholesaler purchases large quantities from manufacturers and sells small quantities to
retailers.
 The economic justification of a wholesaler is the capability to provide customers an
assortment of merchandise from different manufactures in specific quantities.
 When the product are seasonal, the wholesaler may be required to take an inventory
position far in advance of the selling season, thus increasing depth and duration of risk.
3. Retailer
 For a retailer, inventory management is about the velocity of buying and selling.
 Retailers purchase a wide variety of products and assume substantial risk in the marketing
process
 Retail inventory risk can be viewed as wide but not deep. Because of the high cost of store
location, retailers place prime emphasis on inventory turnover.
 Inventory turnover is a measure of inventory velocity and is calculated as the ratio of sales
for a time period divided by average inventory.

Prof. Kishore Kumar Mahato- VIT University

 Inventory Functionality
 From an inventory perspective, the ideal situation would be a response based
supply chain.
 While a zero inventory supply chain is typically not attainable, it is important
to remember that each dollar invested in inventory is a trade-off to an alternative
use of assets.
 Inventory is a current asset that should provide return on the capital
invested.
 The return on investments is the marginal profit on sales that would not occur
without inventory
 Accounting experts have long recognized that measuring the true cost and
benefits of inventory on the corporate profit and loss is difficult.
 The forces driving this generalization are understood better through a review of
the four prime functions of inventory.
 The following table summarizes inventory functionality.
 These four functions are geographical specialization, decoupling, balancing
supply and demand, and buffering uncertainty, require inventory investment
to achieve operating objectives.

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Prof. Kishore Kumar Mahato- VIT University
Inventory Carrying cost

Order costs
• Fixed
• Variable

Holding Costs
• Insurance
• Maintenance and Handling
• Taxes
• Opportunity Costs
• Obsolescence

Prof. Kishore Kumar Mahato- VIT University

Understanding Inventory

The inventory policy is affected by:

• Demand Characteristics
• Lead Time
• Number of Products
• Objectives
• Service level
• Minimize costs
• Cost Structure
 Variable costs
Two important variable costs
1. Ordering cost /set up cost
• Buyer time
• Transportation costs
• Receiving costs
• Other costs
2. Inventory Holding cost – represented as a percentage of materials
• Obsolescence cost
• Handling cost
• Occupancy cost
• Miscellaneous costs
 Theft, Security, Damage, Tax, Insurance

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The Inventory Cycle

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Inventory Analysis Methods
ABC Analysis
 This analysis categorizes items based on their annual consumption value. Sometimes, Inventory
Managers can Use Pareto’s Principle for classification.
 Pareto’s Principle classifies the important items in a certain group that usually constitute a small
portion of the total items in the group. Then, the majority of the items, as a whole, will seem to
be of minor significance.
 Here is how ABC Analysis looks like:
A: 10% of total inventories contributing to 70% of total consumption
value.
B: 20% of total inventories, which account for about 20% of the total
consumption value.
C: 70% of total inventories, which account for only 10% of the total
consumption value.
This can then be further supplemented by XYZ Analysis, which helps forecast the difficulty of
selling a particular item. X is used as a symbol for those that are easier to sell, whereas Z classifies
the most difficult items to sell

Dr. Kishore Kumar Mahato, SMEC, VIT

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FSN Analysis
 This analysis classifies inventory based on quantity, the rate of consumption and frequency of issues and
uses. Here is the basic depiction of FSN Analysis:

F stands for Fast moving, S for Slow moving and N for Nonmoving items.

Fast Moving (F) – Items that are frequently issued/used

Slow Moving (S) – Items that are issued/used less for a certain period
Non-Moving (N) – Items that are not issued/used for more than a certain duration

VED Analysis
 This is an analysis whose classification is dependent on the user’s experience and perception.
 This analysis classifies inventory according to the relative importance of certain items to other items, like in
spare parts. In VED Analysis, the items are classified into three categories which are:

Vital – inventory that consistently needs to be kept in stock.

Essential – keeping a minimum stock of this inventory is enough.
Desirable – operations can run with or without this, optional.

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HML Analysis
 HML Analysis classifies inventory based on how much a product costs/its unit price. The classification is
as follows:

High Cost (H) – Item with a high unit value.

Medium Cost (M) – Item with a medium unit value.
Low Cost (L) – Item with a low unit value.

SDE Analysis
 This analysis classifies inventory based on how freely available an item or
scarce an item is, or the length of its lead time. This is how the inventory is
classified:

Scarce (S) – Imported items and require longer lead time.

Difficult (D) – Items which require more than a fortnight to be available, but less than 6 months lead time.
Easily available (E) – Items which are easily available

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Role of Inventory in the Supply Chain

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Role of Cycle Inventory in a Supply Chain

 Lot, or batch size: quantity that a supply chain stage either produces or orders
at a given time.
 Cycle inventory is held primarily to take advantage of economies of scale in
the supply chain and reduce cost within a supply chain.
 Cycle inventory: average inventory that builds up in the supply chain because
a supply chain stage either produces or purchases in lots that are larger than
those demanded by the customer
 Q = lot or batch size of an order
 D = demand per unit time

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 Primary role of cycle inventory is to allow different stages to purchase product in lot sizes
that minimize the sum of material, ordering, and holding costs

 Ideally, cycle inventory decisions should consider costs across the entire supply chain, but in
practice, each stage generally makes its own supply chain decisions. This increases total cycle
inventory and total costs in the supply chain

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Case of jeans at Jean Mart, a department store

• Inventory profile: plot of the inventory level over time

• It is assumed here that the demand is stable (while considering safety inventory, it is not so)
• Cycle inventory = Q/2 (depends directly on lot size).................(1)
• Average flow time = Average inventory / Average flow rate (Little’s Law) = average length of time
that elapses between the time material enters the supply chain to the point at which it exits.
• But, for any supply chain, average flow rate equals demand
• Thus, average flow time from cycle inventory = Q/(2D)

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Q = 1000 units
D = 100 units/day
It takes 10 days for the entire lot to be sold
Cycle inventory = Q/2 = 1000/2 = 500 = Avg. inventory level from cycle inventory
Avg. flow time = Q/2D = 1000/(2)(100) = 5 days
Thus, jeans spend in the supply chain an average time of 5 days

• Therefore, cycle inventory adds 5 days to the time a unit spends in the supply chain
• Lower cycle inventory is better because:
• Average flow time is lower. The larger the cycle inventory, the longer is the lag time between
when a product is produced and when it is sold. A lower level of cycle inventory is always
desirable, because long time lags leave a firm vulnerable to demand changes in the marketplace.
• Working capital requirements are lower
• Lower inventory holding costs

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 Role of Cycle Inventory in a Supply Chain

If
Q = 1000 units
D =100 units/day
Cycle Inventory = ?
Average flow time = ?
𝑸
𝑪𝒚𝒄𝒍𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 =
Assume holding cost of one bottle = 0.50 paise
𝟐 Then for 5 days => Holding Cost = 0.50 x 5 = 2.50

Cycle inventory =
Rupees
1000
= 500 = Average Inventory level from cycle
2
inventory If your Profit = 4 Rs. Per bottle

𝑸
Then if a bottle is stored and sold after 5 days

Average flow time from Cycle inventory =

then your Profit decreases to 1.50

𝟐𝑫
( Rs. 4.00 – Rs. 2.50 = Rs.1.50)

More the AFT –CI 𝖾 more the incurred

Cycle inventory adds 𝟓 𝐝𝐚𝐲𝐬 to the time a unit spends in the
supply chain cost Cycle Inventory ~ Quantity

More the Quantity 𝖾 More the Cycle Inventory

Prof. Kishore Kumar Mahato- VIT University
 Role of Cycle Inventory in a Supply Chain

Lower cycle inventory is better because:

 Average flow time is lower
 Working capital requirements are lower E.g:- Toyota > C.I of only a few hours of production
 Lower inventory holding costs

Then why do we have C.I?

o Take advantage of economies of sale.

o Reduce cost in the supply chain.

Prof. Kishore Kumar Mahato- VIT University

 Role of Cycle Inventory in a Supply Chain
H = Holding Cost –Say Rs.50/u/yr
Supply chain costs influenced by lot h = % (Fragile/Self/Temp/..) of C [Material
size: Cost] H = hC
 Material cost = C
 Fixed ordering cost = S [Contains all costs that do not vary with the size of the order but are incurred each time
the order is placed]
 Holding Cost = H (H = hc) cost for carrying one unit of inventory for a specified period of time, usually one year.

The primary role of cycle inventory is to allow different stages to purchase products in lot sizes that minimize the
sum of material, ordering, and holding costs.

Ideally cycle inventory decisions should consider costs across the entire supply chain, but in practice, each stage
generally makes its own supply chain decisions – increases total cycle inventory and total costs in the supply chain
decisions – increases total cycle inventory and total costs in the supply chain

Prof. Kishore Kumar Mahato- VIT University

Cycle inventory is held to take advantage of economies of scale and reduce cost within a supply chain.

For example, apparel is shipped from Asia to North America in full container loads to reduce the
transportation cost per unit.
Similarly, an integrated steel mill produces hundreds of tons of steel per lot to spread that high cost of
setup over a large batch. To understand how the supply chain achieves these economies of scale, we first
identify supply chain costs that are influenced by lot size.

The average price paid per unit purchased is a key cost in the lot-sizing decision. A buyer may increase the
lot size if this action results in a reduction in the price paid per unit purchased.
For example, if the jeans manufacturer charges $20 per pair for orders under 500 pairs of jeans and $18 per
pair for larger orders, the store manager at Jean-Mart gets the lower price by ordering in lots of at least 500
pairs of jeans. The price paid per unit is referred to as the material cost and is denoted by C. It is measured
in dollars per unit. In many practical situations, material cost displays economies of scale - increasing lot
size decreases material cost.

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The fixed ordering cost includes all costs that do not vary with the size of the order but are incurred each
time an order is placed. There may be a fixed administrative cost to place an order, a fixed trucking cost to
transport the order, and a fixed labor cost to receive the order. Jean-Mart incurs a cost of $400 for the truck
regardless of the number of pairs of jeans shipped. If the truck can hold up to 2,000 pairs of jeans, a lot size
of 100 pairs results in a transportation cost of $4/pair, whereas a lot size of 1,000 pairs results in a
transportation cost of $0.40/pair. Given the fixed transportation cost per batch, the store manager can reduce
transportation cost per unit by increasing the lot size. The fixed ordering cost per lot or batch is denoted by S
(commonly thought of as a setup cost) and is measured in dollars per lot. The ordering cost also displays
economies of scale—increasing the lot size decreases the fixed ordering cost per unit purchased.

Holding cost is the cost of carrying one unit in inventory for a specified period of time, usually one year. It is
a combination of the cost of capital, the cost of physically storing the inventory, and the cost that results from
the product becoming obsolete. The holding cost is denoted by H and is measured in dollars per unit per year.
It may also be obtained as a fraction, of the unit cost of the product. Given a unit cost of C, the holding cost
H is given by

H = hC....................................................(2)

Dr. Kishore Kumar Mahato, SMEC, VIT

 The total holding cost increases with an increase in lot size and cycle inventory.
 To summarize, the following costs must be considered in any lot-sizing decision:
• Average price per unit purchased, $C/unit
• Fixed ordering cost incurred per lot, $S/lot
• Holding cost incurred per unit per year, $H/unit/year = hC

Any stage of the supply chain exploits economies of scale in its replenishment decisions
in the following three typical situations:

1. A fixed cost is incurred each time an order is placed or produced.

2. The supplier offers price discounts based on the quantity purchased per lot.
3. The supplier offers short-term price discounts or holds trade promotions.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

 Module:5 Planning & Managing Inventories in a Supply Chain
Module:5 Planning & Managing Inventories in a Hours: 7 CO 4
Supply Chain
Part I Optimize inventory level in a
The role of cycle inventory in a supply chain –Managing cycle inventory in a multi Supply Chain.
echelon supply chain – Estimating cycle inventory and related costs in practice.
Part II
The role of safety inventory in a supply chain – Managing safety inventory in a multi
echelon supply chain – Estimating and managing safety inventory in practice.

Learning Objectives of this Module – Part II

• Describe the role of safety inventory in a supply chain.
• Choose the optimal lot size given fixed ordering costs in a supply chain.
• Develop replenishment policies to improve synchronization in multi-echelon supply chains.

25
Prof. Kishore Kumar Mahato- VIT University
 ESTIMATING CYCLE INVENTORY-RELATED COSTS IN PRACTICE

 When setting cycle inventory levels in practice, a common hurdle is estimating the ordering
and holding costs. Given the robustness of cycle inventory models, it is better to get a good
approximation quickly rather than spend a lot of time trying to estimate costs exactly.
 Our goal is to identify incremental costs that change with the lot-sizing decision. We can
ignore costs that are unchanged with a change in lot size. For example, if a factory is running at
50 percent of capacity and all labor is full time and not earning overtime, it can be argued that
the incremental setup cost for labor is zero. Reducing the lot size in this case will not have any
impact on setup cost until either labor is fully utilized (and earning overtime) or machines are
fully utilized (with a resulting loss in production capacity).

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Inventory Holding Cost
Holding cost is estimated as a percentage of the cost of a product and is the sum of the following major
components:
• Cost of capital:
This is the dominant component of holding cost for products that do not become obsolete quickly. The
appropriate approach is to evaluate the weighted-average cost of capital (WACC), which takes into
account the required return on the firm’s equity and the cost of its debt (see Brealey and Myers, 2000).
These are weighted by the amount of equity and debt financing that the firm has. The formula for the
WACC is

Where,
E = amount of equity
D = amount of debt
Rf = risk-free rate of return (which is usually in the mid-single digits) β =
the firm’s beta, a measure of volatility of stock price
MRP = market risk premium (which is around the high single digits)
Rb = rate at which the firm can borrow money (related to its debt rating)
t = tax rate
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• Obsolescence (or spoilage) cost: The obsolescence cost estimates the rate at which the value of the
stored product drops because its market value or quality falls. This cost can range dramatically, from
rates of many-thousand percent to virtually zero, depending on
the type of product. Perishable products have high obsolescence rates. Even nonperishables can have
high obsolescence rates if they have short life cycles. A product with a life cycle of six months has an
effective obsolescence cost of 200 percent. At the other end of the spectrum are products such as crude
oil that take a long time to spoil or become obsolete. For such products, a low obsolescence rate may be
applied.

• Handling cost: Handling cost should include only incremental receiving and storage costs that vary
with the quantity of product received. Quantity-independent handling costs that vary with the number of
orders should be included in the order cost. The quantity dependent handling cost often does not change
if quantity varies within a range. If the quantity is within this range (e.g., the range of inventory a crew
of four people can unload per period of time), incremental handling cost added to the holding cost is
zero. If the quantity handled requires more people, an incremental handling cost is added to the holding
cost.

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• Occupancy cost: The occupancy cost reflects the incremental change in space cost due to
changing cycle inventory. If the firm is being charged based on the actual number of units held
in storage, we have the direct occupancy cost. Firms often lease or purchase a fixed amount of
space. As long as a marginal change in cycle inventory does not change the space requirements,
the incremental occupancy cost is zero. Occupancy costs often take the form of a step function,
with a sudden increase in cost when capacity is fully utilized and new space must be acquired.

• Miscellaneous costs: The final component of holding cost deals with a number of other
relatively small costs. These costs include theft, security, damage, tax, and additional insurance
charges that are incurred. Once again, it is important to estimate the incremental change in these
costs on changing cycle inventory.

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Ordering Cost
The ordering cost includes all incremental costs associated with placing or receiving an extra order that are
incurred regardless of the size of the order. Components of ordering cost include the following:
• Buyer time: Buyer time is the incremental time of the buyer placing the extra order. This cost should
be included only if the buyer is utilized fully. The incremental cost of getting an idle buyer to place an
order is zero and does not add to the ordering cost. Electronic ordering can significantly reduce the buyer
time to place an order.
• Transportation costs: A fixed transportation cost is often incurred regardless of the size of the order.
For instance, if a truck is sent to deliver every order, it costs the same amount to send a half-empty truck as it
does a full truck. Less-than-truckload pricing also includes a fixed component that is independent of the
quantity shipped and a variable component that increases with the quantity shipped. The fixed component
should be included in the ordering cost.
• Receiving costs: Some receiving costs are incurred regardless of the size of the order. These include any
administration work such as purchase order matching and any effort associated with updating
inventory records. Receiving costs that are quantity dependent should not be included here.
• Other costs: Each situation can have costs unique to it that should be considered if they are incurred for
each order regardless of the quantity of that order. The ordering cost is estimated as the sum of all its
component costs.
 ECONOMIES OF SCALE TO EXPLOIT FIXED COSTS

To better understand the trade-offs discussed in this section, consider a situation that often arises in daily life the
purchase of groceries and other household products. These may be purchased at a nearby convenience store or
at a Costco (a large warehouse club selling consumer goods), which is generally located much farther away.
The fixed cost of going shopping is the time it takes to go to either location. This fixed cost is much lower for
the nearby convenience store.
Prices, however, are higher at the local convenience store. Taking the fixed cost into account, we tend to tailor
our lot size decision accordingly. When we need only a small quantity, we go to the nearby convenience store
because the benefit of a low fixed cost outweighs the cost of higher prices at the convenience store. When we
are buying a large quantity, however, we go to Costco, where the lower prices over the larger quantity
purchased more than make up for the higher fixed cost.
In this section, we focus on the situation in which a fixed cost associated with placing, receiving, and
transporting an order is incurred for each order. A purchasing manager wants to minimize the total cost of
satisfying demand and must therefore make the appropriate cost tradeoffs when making the lot-sizing
decision. We start by considering the lot-sizing decision for a single product.

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 Lot Sizing for a Single Product (Economic Order Quantity)
As Best Buy sells its current inventory of HP computers, the purchasing manager places a
replenishment order for a new lot of Q computers. Including the cost of transportation, Best Buy
incurs a fixed cost of $S per order. The purchasing manager must decide on the number of computers
to order from HP in a lot. For this decision, we assume the following inputs:

D = Annual demand of the

product S = Fixed cost incurred
per order C = Cost per unit of
product
h = Holding cost per year as a fraction of product cost

Assume that HP does not offer any discounts, and each unit costs $C no matter how large an order is.
The holding cost is thus given by H = hC (using Equation 2). The model is developed using the
following basic assumptions:

1. Demand is steady at D units per unit time.

2. No shortages are allowed that is, all demand must be supplied from stock.
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3. Replenishment lead time is fixed (initially assumed to be zero).

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The purchasing manager makes the lot-sizing decision to minimize the total cost for the store. He or she
must consider three costs when deciding on the lot size:

• Annual material cost

• Annual ordering cost
• Annual holding cost
Because purchase price is independent of lot size, we have
Annual material cost = CD
The number of orders must suffice to meet the annual demand D. Given a lot size of Q, we thus have

�
� ………………………. (3)
Number of orders per year =
�
�

Annual ordering cost = (𝐷/𝑄)S…................................(4)

Because an order cost of S is incurred for each order placed, we infer that

Given a lot size of Q, we have an average inventory of Q/2. The annual holding cost is thus the cost of
holding Q/2 units in inventory for one year and is given as

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 The total annual cost, TC, is the sum of all three costs and is given as

Figure 1 shows the variation in different costs as the lot size is changed. Observe that the annual
holding cost increases with an increase in lot size. In contrast, the annual ordering cost declines
with an increase in lot size. The material cost is independent of lot size because we have assumed
the price to be fixed. The total annual cost thus first declines and then increases with an
increase in lot size.

FIGURE 1: Effect of Lot Size

on Costs at Best Buy

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From the perspective of the manager at Best Buy, the optimal lot size is one that minimizes the total
cost to Best Buy. It is obtained by taking the first derivative of the total cost with respect to Q and
setting it equal to 0 (see Appendix 11A at the end of this chapter). The optimal lot size is referred to as
the economic order quantity (EOQ). It is denoted by Q* and is given by the following equation:

… …………………. (5)

For this formula, it is important to use the same time units for the holding cost rate h and the demand D.
With each lot or batch of size Q*, the cycle inventory in the system is given by Q*/2. The flow time
spent by each unit in the system is given by Q*/(2D). As the optimal lot size increases, so does the cycle
inventory and the flow time. The optimal ordering frequency is given by n*, where

… …………………………..(6)

In Example 1 we illustrate the EOQ formula and the procedure to make lot-sizing
decisions.

Dr. Kishore Kumar Mahato, SMEC, VIT

 Economic Order Quantity
EXAMPLE 1
Demand for the Deskpro computer at Best Buy is 1,000 units per month. Best Buy incurs a fixed order
placement, transportation, and receiving cost of $4,000 each time an order is placed. Each computer costs
Best Buy $500 and the retailer has a holding cost of 20 percent. Evaluate the number of computers that the
store manager should order in each replenishment lot.

Solution:
In this case the store manager has the following inputs
Annual demand, D = 1,000 x 12 = 12,000 units
Order cost per lot, S = $4,000
Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2

Using the EOQ formula (equation 5), the optimal lot size is

Dr. Kishore Kumar Mahato, SMEC, VIT

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE
A few key insights can be gained from Example 1 . Using a lot size of 1,100 (instead of 980)
increases annual costs to $98,636 (from $97,980). Even though the order size is more than 10
percent larger than the optimal order size Q*, total cost increases by only 0.67 percent. This issue
can be relevant in practice. Best Buy may find that the economic order quantity for flash drives is
6.5 cases. The manufacturer may be reluctant to ship half a case and may want to charge extra for
this service. Our discussion illustrates that Best Buy is perhaps better off with lot sizes of six or
seven cases, because this change has a small impact on its inventory-related costs but can save on
any fee that the manufacturer charges for shipping half a case.

Key Point
Total ordering and holding costs are relatively stable around the economic order quantity. A
firm is often better served by ordering a convenient lot size close to the EOQ rather than the
precise EOQ.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

 If demand at Best Buy increases to 4,000 computers a month (demand has increased by a
factor of 4), the EOQ formula shows that the optimal lot size doubles and the number of
orders placed per year also doubles. In contrast, average flow time decreases by a factor of 2.
In other words, as demand increases, cycle inventory measured in terms of days (or months)
of demand should reduce if the lot-sizing decision is made optimally. This observation can
be stated as the following Key Point:

Key Point
If demand increases by a factor of k, the optimal lot size increases by a factor of . The
number of orders placed per year should also increase by a factor of . Flow time attributed to
cycle inventory should decrease by a factor of .

Let us return to the situation in which monthly demand for the Deskpro model is 1,000
computers. Now assume that the manager would like to reduce the lot size to Q = 200 units
to reduce flow time. If this lot size is decreased without any other change, we have

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This is significantly higher than the total cost of $97,980 that Best Buy incurred when
ordering in lots of 980 units, as in Example 1. Thus, there are clear financial reasons that the
store manager would be unwilling to reduce the lot size to 200. To make it feasible to reduce
the lot size, the manager should work to reduce the fixed order cost S. If the fixed cost
associated with each lot is reduced to $1,000 (from the current value of $4,000), the optimal
lot size reduces to 490 (from the current value of 980). We illustrate the relationship
between desired lot size and order cost in Example 2 (see worksheet Example 2).

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 EXAMPLE 2 Relationship Between Desired Lot Size and Ordering Cost
The store manager at Best Buy would like to reduce the optimal lot size from 980 to 200. For this lot
size reduction to be optimal, the store manager wants to evaluate how much the ordering cost per lot
should be reduced.
Solution
In this case, we have

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
Managing Uncertainty
 Although it is useful to understand inventory relationships under conditions of
certainty, formulation of inventory policy must realistically consider uncertainty.
 One of the main functions of inventory management is to plan safety stock to
protect against out-of-stocks.
 Two types of uncertainty have a direct impact upon inventory policy. 1. Demand
uncertainty is rate of sales during inventory
replenishment.
2. Performance cycle uncertainty concerns inventory replenishment
time variations.

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Demand Uncertainty
 Sales forecasting estimates unit demand during the inventory replenishment cycle.
 Even with good forecasting, demand during replenishment cycle often exceeds or falls short
of what is anticipated. To protect against a stockout when demand exceeds forecast, safety
stock is added to base inventory.
 Under conditions of demand uncertainty, average inventory represents one-half order quantity
plus safety stock. Figure below illustrates the inventory performance cycle under conditions
of demand uncertainty. The dashed line represents the forecast.
 The solid line illustrates inventory on hand from one performance cycle to the next. The task
of planning safety stock requires three steps. First, the likelihood of stockout must be gauged.
 Second, demand potential during a stockout period must be estimated. Finally, a policy
decision is required concerning the desired level of stockout protection.

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Assume for purposes of illustration that the inventory performance cycle is 10 days. Historical experience
indicates that daily sales range from 0 to 10 units with average daily sales of 5 units. The economic order is
assumed to be 50, the reorder point is 50, the planned average inventory is 25, and sales during the
performance cycle are forecasted to be 50 units.

Figure 2: Inventory relationship, demand uncertainty, and constant performance cycle

Dr. Kishore Kumar Mahato, SMEC, VIT

During the first cycle, although daily demand experienced variation, the average of 5 units per day
was maintained. Total demand during cycle 1 was 50 units, as expected. During cycle 2, demand
totaled 50 units in the first 8 days, resulting in a stockout; thus, no sales were possible on days 9
and 10. During cycle 3, demand reached a total of 39 units. The third performance cycle ended
with 11 units remaining in stock. Over the 30-day period total sales were 139 units, for average
daily sale of 4.6 units.

Dr. Kishore Kumar Mahato, SMEC, VIT

 TABLE 1 -Typical Demand Experience During Three Replenishment Cycles

From the history recorded in Table 1, it is observed that stockouts occurred on 2 of 30 total days. Since sales never exceed 10
units per day, no possibility of stockout exists on the first 5 days of the replenishment cycle. Stockouts were possible on days 6
through 10 based on the remote possibility that demand during the first 5 days of the cycle averaged 10 units per day and no
inventory was carried over from the previous period. Since during the three performance cycles 10 units were sold on only one
occasion, it is apparent that the real risk of stockout occurs only during the last few days of the performance cycle, and then only
when sales exceed the average by a substantial margin.

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Some approximation is possible concerning sales potential for days 9 and 10 of cycle 2. A
maximum of 20 units might have been sold if inventory had been available. On the other hand, it
is remotely possible that even if stock had been available, no demand would have occurred on
days 9 and 10. Based on average demand of 4 to 5 units per day, a reasonable appraisal of lost
sales is 8 to 10 units.

It should be apparent that the risk of stockouts created by variations in sales is limited to a short
time and includes a small percentage of total sales. Although the sales analysis presented in
Table 10-8 helps achieve an understanding of the opportunity, the appropriate course of action is
still not clear. Statistical probability can be used to assist management in planning safety stock.
The following discussion applies statistical techniques to the demand uncertainty problem.

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
The sales history over the 30-day period has been arranged in Table 2 in terms of a frequency
distribution. The main purpose of a frequency distribution is to observe variations around the
average daily demand. Given an expected average of 5 units per day, demand exceeded average
on 11 days and was less than average on 12 days. An alternative way of illustrating a frequency
distribution is by a bar chart, as in Figure 3 below.
TABLE 2-Frequency of Demand

Figure 3: Historical analysis of demand history

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

Given the historical frequency of demand, it is
possible to calculate the safety stock necessary to provide
a specified degree of stockout protection. Probability
theory is based on the random chance of a specific
occurrence within a large number of occurrences.
The situation illustrated uses 28 days. In actual
application, a larger sample size would be desirable.
FIGURE 4-Normal distribution

The probability of occurrences assumes a pattern around a measure of central tendency, which is
the average value of all occurrences. While a number of frequency distributions can be used in
inventory control, the most basic is the normal distribution.
A normal distribution is characterized by a symmetrical bell-shaped curve, illustrated in Figure
above. The essential characteristic of a normal distribution is that the three measures of central
tendency have equal value. The mean (average) value, the medium (middle) observation, and the
mode (most frequently observed) value are all the same. When these three measures are nearly
identical, the frequency distribution is normal.

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The first step in setting safety stocks is to calculate the standard deviation. Most calculators and
spreadsheets calculate standard deviation, but if one of these aids is not available, another
method to compute the standard deviation is:

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 Table 3 – Calculation of Standard Deviation of Daily Demand

The above example illustrates in table 3 shows, how statistical probability can assist with the
quantification of demand uncertainty, but demand conditions are not the only source of uncertainty.
Performance cycles can also vary.
Dr. Kishore Kumar Mahato, SMEC, VIT
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 Performance Cycle Uncertainty
 Performance cycle uncertainty means that inventory policy cannot assume consistent
delivery.
 The planner should expect that actual performance cycle experience will cluster near
the average and be skewed in excess of the planned duration. If performance cycle
uncertainty is not evaluated statistically, the most common practice is to base safety
stock requirements on the planned replenishment time.
 However, if there is substantial variation in the performance cycle, a formal
evaluation is desirable.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

Figure 5: Combined demand and performance cycle uncertainty
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Table 4 – Calculation of standard deviation of replenishment cycle duration

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Table 4 presents a sample frequency distribution of performance cycles. Although 10
days is the most frequent, replenishment experience ranges from 6 to 14 days. If the
performance cycle follows a normal bell-shaped distribution, an individual
performance cycle would be expected to fall between 8 and 12 days 68.27 percent of
the time.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

 Determining Safety Stock with Uncertainty
 The typical situation confronting the inventory planner is illustrated in Figure 5,
where both demand and performance cycle uncertainties exist.
 Treating both demand and performance cycle uncertainty requires combining two
independent variables. The duration of the cycle is, at least in the short run,
independent of the daily demand.
 However, in setting safety stocks, the joint impact of the probability of both demand
and performance cycle variation must be determined. Table presents a summary of
sales and replenishment cycle performance. The key to understanding the potential
relationships of the data in Table is the 10-day performance cycle. Total demand
during the 10 days potentially ranges from 0 to 100 units. On each day of the cycle,
the demand probability is independent of the previous day for the entire 10-day
duration. Assuming the full range of potential situations illustrated in Table 5, total
sales during a performance cycle could range from 0 to 140 units. With this basic
relationship between the two types of uncertainty in mind, safety stock requirements
can be determined by either numerical or simulation procedures.

Dr. Kishore Kumar Mahato, SMEC, VIT

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Table 5 – Frequency distribution- demand and replenishment uncertainty

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Numerical Compounding
The exact compounding of two independent variables involves multinomial
expansion. This type of procedure requires extensive calculation. A direct method is
to determine the standard deviations of demand and performance cycle uncertainty
and then to approximate the combined standard deviation using the convolution
formula:

Where,
σc = Standard deviation of combined probabilities;
T = Average performance cycle time;
St = Standard deviation of the performance cycle;
D = Average daily sales; and
Ss = Standard deviation of daily sales.

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 Substituting from Table 5,

This formulation estimates the convoluted or combined standard deviation of T days with an average
demand of D per day when the individual standard deviations are Ss and St respectively. The average
for the combined distribution is the product of T and D, or 50.00 (10.00 x 5.00).
Thus, given a frequency distribution of daily sales from O to 10 units per day and a range in
replenishment cycle duration of 6 to 14 days, 13 units (1 standard deviation multiplied by 13 units) of
safety stock is required to protect 84.14 percent of all performance cycles. To protect at the 97.72
percent level, a 26-unit safety stock is necessary. These levels assume a one-tail distribution since it is
not necessary to protect against lead time demand below average.

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
It is important to note that the specific event being protected against is a stockout during the
performance cycle. The 68.27 and 97.72 percent levels are not product availability levels. These
percentages reflect the probability of a stockout during a given order cycle. For example, with a
13-unit safety stock, stockouts would be expected to occur during 31.73 (100 - 68.27) percent of
the performance cycles. Although this percentage provides the probability of a stockout, it does
not estimate magnitude. The relative stockout magnitude indicates the percentage of units stocked
out relative to demand.
Average inventory requirements would be 25 units if no safety stock were desired.
The average inventory with 2 standard deviations of safety stock is 5 1 units [25 + (2 x 13)]. This
inventory level would protect against a stockout during 97.72 percent of the performance cycles.
Table 10- 13 summarizes the a1ternatives confronting the planner in terms of assumptions and
corresponding impact on average inventory.

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
 Estimating Fill Rate
 The fill rate represents the magnitude of a stockout rather than the probability.
 The case fill rate is the percentage of units that can be filled when requested from available
inventory. Figure 6 graphically illustrates the difference between stockout probability and
stockout magnitude.
 Both illustrations in Figure 6 have a safety stock of 1 standard deviation or 13 units. For both
situations, given any performance cycle, the probability of a stockout is 31.73 percent.
 However, during a 20-day period, the figure illustrates two instances where the stock may be
depleted. These instances are at the ends of the cycle. If the order quantity is doubled, the
system has the possibility of stocking out only once during the 20-day cycle.
 So, while both situations face the same demand pattern, the first one has more stockout
opportunities and potential. In general, for a given safety stock level, increasing the order
quantity decreases the relative magnitude of potential stockouts and conversely increases
customer service availability.

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VELLORE
 The mathematical formulation of the relationship is:

Where,
SL = The stockout magnitude (the product availability level);
f(k) = A function of the normal loss curve which provides the area in a right tail
of a normal distribution;
σc = The combined standard deviation considering both demand and
replenishment cycle uncertainty; and
Q = The replenishment order quantity.

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 FIGURE- 6: Impact of order quantity on stockout magnitude

TABLE 6: Information for Determining Required Safety Stock

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VELLORE
To complete the example, suppose a firm desired 99 percent product availability or
case fill rate. Assume the Q was calculated to be 300 units. Table 6 summarizes the
required information.
Since f(k) is the item used to calculate safety stock requirements, the above equation
must be solved for f(k) using algebraic manipulation. The result is:

Substituting from Table 6

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The calculated value of f(k) is then compared against the values in Table to find the one
that most closely approximates the calculated value. For this example, the value of k
that fits the condition is 0.4. The required safety stock level is:

Where,

SS = Safety stock in units;

k = The k factor that corresponds with f(k);
σc, = The combined standard deviation.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

TABLE: 7 Table of Loss Integral for Standardized Normal
Distribution

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VELLORE
 TABLE 8: Impact of Order Quantity on Safety Stock

The safety stock required to provide a 99 percent product fill rate when the order quantity is 300 units is
approximately 5 units. Table 8 shows how the calculated safety stock and average inventory levels vary
for other order quantities. An increased order size can be used to compensate for decreasing the safety
stock levels, or vice versa. The existence of such a trade-off implies that there is a combination of
replenishment order quantities that will result in desired customer service at the minimum cost.

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VELLORE
Inventory Management Policies
 Inventory management is the process that implements inventory
policy.
 The reactive or pull inventory approach uses customer
demand to pull product through the distribution channel.
 An alternative philosophy is a planning approach that proactively
allocates inventory based on forecasted demand and product
availability.
 A third, or hybrid, logic uses a combination of push and pull.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

1. Inventory Control
 Inventory control is the managerial procedure for implementing an
inventory policy.
 The accountability aspect of control measures units on hand at a
specific location and tracks additions and deletions.
 Accountability and tracking can be performed on a manual or
computerized basis.
TABLE 9 - Sample Demand, Performance Cycle, and Order Quantity
Characteristics

Inventory control defines how often inventory levels are reviewed to

determine when and how much to order. It is performed on either a
perpetual or a periodic basis.
Dr. Kishore Kumar Mahato, SMEC, VIT
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Perpetual Review
 A perpetual inventory control process reviews inventory status daily
to determine inventory replenishment needs.
 To utilize perpetual review, accurate tracking of all stock keeping
units (SKUs) is necessary.
 Perpetual review is implemented through a reorder point and order
quantity

ROP = D x T + SS,
Where,

ROP = Reorder point in units;

D = Average daily demand in units;
T = Average performance cycle length in days; and
SS = Safety or buffer stock in units.

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
The order quantity is determined using the EOQ.
For purposes of illustration, assume no uncertainty so no safety stock is
necessary. Table summarizes demand, performance cycle, and order quantity
characteristics. For this example,

= 20 units/day x 10 days + 0 = 200 units

The perpetual review compares on-hand and on-order inventory to the item's
reorder point. If the on-hand plus on-order quantity is less than the established
reorder point, a replenishment order is required.
Mathematically, the process is:

If, I + Qo ≤ ROP, then order Q

where
I = Inventory on hand;
Qo = Inventory on order from suppliers;
ROP = Reorder point in units; and
Q = Order quantity in units.

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VELLORE
For the previous example, a replenishment order of 200 is placed whenever the
sum of on-hand and on-order inventory is less than or equal to 200 units. Since
the reorder point equals the order quantity, the previous replenishment
shipment would arrive just as the next replenishment is initiated. The average
inventory level for a perpetual review system is:
Iavg = Q/2 + SS,
Where,
Iavg = Average inventory in units;
Q = Order quantity units; and
SS = Safety stock units.
Average inventory for the previous example is calculated as:
Iavg = Q/2 + SS
= 200/2 + 0 = 100 units.
Most illustrations throughout this text are based on a perpetual review system
with a fixed reorder point. The reorder formulation is derived from two
assumptions:
purchase orders for the item under control will be placed when the reorder point
is reached, and the method of control provides a continuous monitoring of
inventory status. If these two assumptions are not satisfied, the control
parameters (ROP and Q) determining the perpetual review must be refined.
Periodic Review
Periodic inventory control reviews the inventory status of an item at regular
time intervals such as weekly or monthly. For periodic review, the basic
reorder point must be adjusted to consider the extended intervals between
reviews. The formula for calculating the periodic review reorder point is:

ROP = D(T + P/2) + SS,

Where,
ROP = Reorder point;
D = Average daily demand;
T = Average performance cycle length;
P = Review period in days; and
SS = Safety stock.

Since inventory counts occur periodically, any item could fall below the desired
reorder point prior to the review period. Therefore, the assumption is made that
the inventory will fall below ideal reorder status prior to the periodic count
approximately one-half of the review times. Assuming a review period of 7 days
and using conditions similar to those of the perpetual example, the ROP then
would be as follows:
ROP = D(T + P/2) + SS
= 20(10 + 7/2) + 0 = 20(10 + 3.5) = 270 units.
The average inventory formulation for the case of periodic review is:
Iavg = Q/2 + (P x D)/2 + SS,
where,
Iavg = Average inventory in units;
Q = Order quantity in units;
P = Review period in days;
D = Average daily demand in units;
SS = Safety stock in units.

For the preceding example, the average inventory is calculated as:

Iavg = Q/2 + (P x D)/2 + SS

= 200/2 + (7 x 10)12 + 0 = 100 + 35 = 135 units.

Because of the time interval introduced by periodic review, periodic

control systems generally require larger average inventories than
perpetual systems.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

2. Reactive Methods
The reactive or pull inventory system, as the name implies, responds to a channel member's
inventory needs by drawing the product through the distribution channel.
Replenishment shipments are initiated when available warehouse stock levels fall below a
predetermined minimum or order point. The amount ordered is usually based on some lot-sizing
formulation, although it may be some variable quantity that is a function of current stock levels
and a predetermined maximum level.
The basic perpetual or periodic review process discussed earlier exemplifies a
typical reactive system. Figure 7 illustrates a reactive inventory environment for a warehouse
serving two wholesalers. The figure shows the current inventory (I), reorder point (ROP), order
quantity (Q), and average daily demand (D) for each wholesaler. A review of the wholesaler
inventory indicates that a resupply order for 200 units should be placed by wholesaler A from the
warehouse. Since current inventory is above ROP for wholesaler B, no resupply action is
necessary at this time. However, more thorough analysis illustrates that the independent actions by
wholesaler A will likely cause a stockout at wholesaler B within a few days. Wholesaler B will
likely stock out because inventory level is close to the reorder point and the supplying warehouse
center will not have enough inventory to replenish wholesaler B.
Classical reactive inventory logic is rooted in the following assumptions. First, the
system is founded on the basic assumption that all customers, market areas, and
products contribute equally to profits.
Second, a reactive system assumes infinite capacity at the source. This assumption
implies that product can be produced as desired and stored at the production facility
until required throughout the supply chain.

FIGURE 7 - A reactive inventory environment

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

 Third, reactive inventory logic assumes infinite inventory availability at the supply location.
 Fourth, reactive decision rules assume that performance cycle time can be predicted and that cycle lengths are
independent.
 Fifth, reactive inventory logic operates best when customer demand patterns are relatively stable and consistent.
 Sixth, reactive inventory systems determine each distribution center's timing and quantity of replenishment
orders independently of all other sites, including the supply source

The final assumption characteristic of reactive inventory systems is that performance cycle length cannot be
correlated with demand. The assumption is necessary to develop an accurate approximation of the variance of the
demand over the performance cycle. For many situations higher demand levels create longer replenishment
performance cycles since they also increase the demands on inventory and transportation resources. This implies
that periods of high demand should not necessarily correspond to extended performance cycles caused by
stockouts or limited product availability.
Operationally, most inventory managers limit the impact of such limitations through the skillful use of manual
overrides. However, these overrides often lead to ineffective inventory decisions since the resulting plan is based
on inconsistent rules and managerial policy.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

3. Planning Methods
 Inventory planning methods use a common information base to coordinate inventory
requirements across multiple locations or stages in the supply chain.
 Planning activities may occur at the plant warehouse level to coordinate inventory
allocation and delivery to multiple destinations. Planning may also occur to coordinate
inventory requirements across multiple channel partners such as manufacturers and
retailers.
 The Advanced Planning and Scheduling (APS) systems represent planning method
applications. While APS systems computerize the process, it is important for logistics
managers to understand the underlying logic and assumptions.
 Two inventory planning methods are Fair Share Allocation and Distribution
Requirements Planning (DRP).

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
4. Collaborative Inventory Planning

 Replenishment programs are designed to streamline the flow of goods within the
distribution channel.
 There are several specific techniques for collaborative replenishment, all of which build on
the common denominator of rapidly replenishing inventory according to actual sales
experience.
 The intent is to reduce reliance on forecasting when and where inventory will need to be
positioned to meet consumer or end-user demand and instead allow suppliers to respond to
demand on a just-in-time basis.
 Effective collaborative replenishment programs require extensive cooperation and
information sharing among distribution channel participants.
 Specific techniques for automatic replenishment include quick response, continuous
replenishment, vendor managed inventory, and profile replenishment.

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
Inventory Management Practices
An integrated inventory management strategy defines the policies and process used to
determine where to place inventory, when to initiate replenishment shipments, and how
much to allocate. The strategy development process employs three steps to classify
products and markets, define segment strategies, and operationalize policies and
parameters.

1. Product/Market Classification

The objective of product market classification is to focus and refine inventory

management efforts. Product/market classification, which is also called fine-line or ABC
classification, groups products, markets, or customers with similar characteristics to
facilitate inventory management. The classification process recognizes that not all
products and markets have the same characteristics or degree of importance. Sound
inventory management requires that classification be consistent with enterprise strategy
and service objectives.

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
Pareto's law
 Classification can be based on a variety of measures. The most common are sales, profit
contribution, inventory value, usage rate, and nature of the item. The typical classification process
sequences products or markets so that entries with similar characteristics are grouped together. Table
below illustrates product classification using sales. The products are classified in descending order
by sales volume so that the high volume products are listed first, followed by slower movers.
Classification by sales volume is one of the oldest methods used to establish selective policies or
strategies.
 For most marketing or logistics applications, a small percentage of the entities account for a large
percentage of the volume. This operationalization is often called the 80/20 rule or Pareto's law. The
80/20 rule, which is based on widespread observations, states that for a typical enterprise 80 percent
of the sales volume is typically accounted for by 20 percent of the products. A corollary to the rule is
that 80 percent of enterprise sales are accounted for by 20 percent of the customers. The reverse
perspective of the rule would state that the remaining 20 percent of sales are obtained from 80
percent of the products, customers, etc. In general terms, the 80/20 rule implies that a majority of
sales results from a relatively few products or customers.

Dr. Kishore Kumar Mahato, SMEC, VIT VELLORE

ABC analysis
 Once items are classified or grouped, it is common to label each category with a character or
description.
 High-volume, fast-moving products are often described as "A" items.
 The moderate volume items are termed the "B" items, and the low-volume or slow movers
are known as "Cs."
 These character labels indicate why this process is often termed ABC analysis. While fine-line
classification often uses three categories, some firms use four or five categories to further
refine classifications. Grouping of similar products facilitates management efforts to establish
focused inventory strategies for specific product segments.
 For example, high-volume or fast-moving products are typically targeted for higher service
levels. This often requires that fast-moving items have relatively more safety stock.
Conversely, to reduce overall inventory levels, slower-moving items may be allowed relatively
less safety stock, resulting in lower service levels.

Dr. Kishore Kumar Mahato, SMEC, VIT

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TABLE 9- Product Market Classification (Sales)

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2. Segment Strategy Definition
 The second step is to define the integrated inventory strategy for each product/market group or
segment. The integrated strategy includes specification for all aspects of the inventory management
process including service objectives, forecasting method, management technique, and review cycle.
 The key to establishing selective management strategies is the realization that product segments have
different degrees of importance with respect to achieving the enterprise mission. Important differences in
inventory responsiveness should be designed into the policies and procedures used for inventory
management.
 Table 10 illustrates a sample integrated strategy for four item categories. In this case, the items are
grouped by ABC sales volume and as a promotional or basic stock item. Promotional items are those
commonly sold in special marketing efforts that result in considerable demand lumpiness. Lumpy demand
patterns are characteristic of promotional periods with high volume followed by post promotion periods
with relatively low demand.

Dr. Kishore Kumar Mahato, SMEC, VIT

VELLORE
Table 10 below illustrates a management segmentation scheme based on service objectives,
forecasting process, review period, inventory management approach, and replenishment
monitoring frequency. Additional or fewer characteristics of the inventory management process may be
appropriate for some enterprises. Although this table is not presented as a comprehensive inventory
strategy framework, it illustrates the issues that must be considered. The rationale behind each element is
presented based on the full-line classification.

TABLE 10 :Integrated Strategy

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VELLORE
 Three questions to answer in Planning Safety Inventory

 What is the appropriate level of safety inventory to carry?

 How much safety inventory is needed for the desired level of product availability?
 What actions can be taken to improve product availability while reducing safety inventory?

88
Prof. Kishore Kumar Mahato- VIT University
 Measuring product availability

 Product availability: a firm’s ability to fill a customer order out of available inventory
 Stockout: a customer order arrives when a product is not available
 Product fill rate (fr): fraction of demand that is satisfied from product in inventory
 Order fill rate (OFR): fraction of orders that are filled from available inventory
 Cycle service level (CSL): fraction of replenishment cycles that end with all customer demand met

89
Prof. Kishore Kumar Mahato- VIT University
 Replenishment policies

 Replenishment policy: decisions regarding when to reorder and how much to reorder
 Continuous review: inventory is continuously monitored and an order of size Q is placed when the inventory
level reaches the reorder point ROP

 Periodic review: inventory is checked at regular (periodic) intervals and an order is placed to raise the
inventory to a specified threshold (the “order-up-to” level).

90
Prof. Kishore Kumar Mahato- VIT University
 Continuous review policy: Safety Inventory and Cycle Service Level

𝐷 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑

𝜎𝐷= Standard deviation of the demand per
period 𝐷𝐿 = 𝐷𝐿
𝐿 = 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑓𝑜𝑟 𝑟𝑒𝑝𝑙𝑒𝑛𝑖𝑠ℎ𝑚𝑒𝑛𝑡
𝐷𝐿= Mean demand during lead time
𝜎𝐿= Standard deviation of the demand lead
𝜎= 𝐿𝜎𝐷
time 𝐿

𝑅𝑂𝑃 = 𝐷𝐿 + 𝑠𝑠
𝐶𝑆𝐿 = 𝐶𝑦𝑐𝑙𝑒
𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙

𝐶𝑆𝐿 = 𝐹 𝑅𝑂𝑃, 𝐷𝐿. 𝜎𝐿 = NORMDIST

𝑠𝑠 = 𝑆𝑎𝑓𝑒𝑡𝑦
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑅𝑂𝑃 = 𝑅𝑒𝑜𝑟𝑑𝑒𝑟 𝑅𝑂𝑃, 𝐷𝐿. 𝜎𝐿, 1
𝑝𝑜𝑖𝑛𝑡

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 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑄
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = + 𝑠𝑠
2

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Prof. Kishore Kumar Mahato- VIT University
 𝐷𝐿 = 𝐷𝐿 =(2500)(2) = 5000
Solve

Give
n:

𝑅𝑂𝑃 = 𝐷𝐿 + 𝑠𝑠
𝐷 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 =
2500/week
𝜎𝐷= Standard deviation of the demand per period =
𝑆𝑆 = 𝑅𝑂𝑃 − 𝐷𝐿 = 6000 − 5000
= 1000
500
𝐿 = 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑓𝑜𝑟 𝑟𝑒𝑝𝑙𝑒𝑛𝑖𝑠ℎ𝑚𝑒𝑛𝑡 =
2 weeks Q = 10000
𝑅𝑂𝑃 = 𝑅𝑒𝑜𝑟𝑑𝑒𝑟 𝑝𝑜𝑖𝑛𝑡 =6000
𝑄 10000
𝑫𝑳= Mean demand during lead time 𝐶𝑦𝑐𝑙𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
= 2
2
=?
𝒔𝒔 = 𝑺𝒂𝒇𝒆𝒕𝒚 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
=? Cycle inventory = ? 2

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
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Prof. Kishore Kumar Mahato- VIT University
= 5000
Average inventory = ? = 5000 + 1000 =
𝝈𝑳= Standard deviation of the demand lead time 6000

𝜎𝐿 = 𝐿𝜎𝐷 = (500)2 = 707

=?

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Prof. Kishore Kumar Mahato- VIT University
 Solve

Given:
𝐷 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐷𝐿 = 𝐷𝐿 =(12000)(1.5) = 18000

𝑅𝑂𝑃 = 𝐷𝐿 + 𝑠𝑠
12000/month
𝜎𝐷= Standard deviation of the demand per period =

𝑆𝑆 = 𝑅𝑂𝑃 − 𝐷𝐿
2500
𝐿 = 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑓𝑜𝑟 𝑟𝑒𝑝𝑙𝑒𝑛𝑖𝑠ℎ𝑚𝑒𝑛𝑡 =
1.5 months Q = 24000
𝑅𝑂𝑃 = 𝑅𝑒𝑜𝑟𝑑𝑒𝑟 𝑝𝑜𝑖𝑛𝑡 =19000 𝑆𝑆 = 19000 − 18000 = 1000
𝒔𝒔 = 𝑺𝒂𝒇𝒆𝒕𝒚 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 =?
𝝈𝑳= Standard deviation of the demand lead time =?

𝜎𝐿 = 𝐿𝜎𝐷 = 1. = 3062
5
Comment on the replenishment policy of the

(2500)
firm

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Prof. Kishore Kumar Mahato- VIT University
 Multi-Echelon Inventory Optimization and Planning

What is multi-echelon supply chain?

A multi-echelon supply chain features complex supply chain networks with many distribution points from the
point of origin to the endpoint, the consumer. In a multi-echelon supply chain, each distribution level is treated
simultaneously to recognize a level’s impact on another.

What is multi-echelon inventory system?

A multi-echelon inventory system is an efficient means of managing optimal inventory. This system relies on
creating strategies that combine all the distribution levels in a supply chain. For instance, if one applies demand or
replenishment strategies to different echelons of distribution, changes in stock levels at one distribution point
could reduce stock availability across the entire supply chain. This change can be immediately brought into effect in
the entire supply chain in a multi-echelon system.

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Prof. Kishore Kumar Mahato- VIT University
 Multi-Echelon Inventory Optimization and Planning

What is Multi-Echelon Inventory Optimization (MEIO)?

Multi-echelon inventory optimization is a method that combines all the distribution levels to help companies
optimize inventory levels throughout their distribution networks.

This method combines inventory optimization (how much stock to keep at each distribution level) and multi-
echelon planning (deciding where to keep inventory at each distribution).

What are the benefits of Multi-Echelon Inventory Optimization?

Multi-echelon inventory optimization helps companies manage optimal inventory levels, thus allowing them to
make better use of their capital and invest in optimal levels of stock that will move more fluidly throughout the
supply chain. Such an inventory planning system also leads to higher cost efficiency, better management of market
volatilities, and improved customer services.

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Prof. Kishore Kumar Mahato- VIT University
 Discussion Questions

1. Consider an IKEA manufacturer that is deciding on the size of its replenishment order from one of Europe’s leading
wholesalers for wood-based goods, the JAF Group. What costs should be taken into account when making this
decision?
2. Discuss how various costs for the IKEA manufacturer in Question 1 change as it decreases the lot size ordered from
the JAF Group.
3. As demand from the IKEA manufacturer in Question 1 grows, how would you expect the cycle inventory measured
in days of inventory to change? Explain.

4. Assume an IKEA manager from Question 1 wants to decrease the lot size without increasing the costs she incurs.
What would she need to do to achieve her goal?
5. “Though owned by different parties, members of the supply chain should coordinate with each other instead of
pursuing their own objectives.” Do you agree? Explain.
6. Do you think integer replenishment policies should be synchronized in multi-echelon supply chains? Explain.
7. Why is it appropriate to include only the incremental cost when estimating the holding and order cost for a firm?
© VIT University 2025
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 References
• Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. Boston, MA: Irwin McGraw-Hill, 2000.
• Lee, Hau L., and Corey Billington. “Managing Supply Chain Inventories: Pitfalls and Opportunities.” Sloan Management
Review (Spring 1992): 65–73.
• Maxwell, William L., and John A. Muckstadt. “Establishing Consistent and Realistic Reorder Intervals in
Production- Distribution Systems.” Operations Research (1985): 33, 1316 –1341.
• Munson, Charles L., Jianli Hu, and Meir J. Rosenblatt. “Teaching the Costs of Uncoordinated Supply Chains.” Interfaces
(2003): 33, 24 –39.
• Roundy, Robin. “A 98%-Effective Lot-Sizing Rule for a Multi-Product, Multi-Stage Production Inventory System.”
Mathematics of Operations Research (1986): 11, 699–727.
• Silver, Edward A., David Pyke, and Rein Petersen. Inventory Management and Production Planning and Scheduling. New
York: Wiley, 1998.

• Zipkin, Paul H. Foundations of Inventory Management. Boston, MA: Irwin McGraw-Hill, 2000.

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