Effects of Demand / Lead Time Variability

Safety Stock level

s

Expected demand ataverage demand rate d

Placeorder

Receiveorder

L

Variable demand

QUESTION: How much inventory is

needed during lead time L?

KEY POINT: s is larger when there is uncertainty

about demand or L

Summary of Inventory ModelsUse EOQ model

•When: inventory level drops to 0 if lead time is 0 L·D if lead time L > 0•How much: EOQ formula, Q* = sqrt(2D ·K / h)

Use EOQ model•When: inventory level drops to 0 if lead time is 0 L·D if lead time L > 0•How much: EOQ formula, Q* = sqrt(2D ·K / h)

Use (s, S) model•When: inventory position drops below s s = AVG·L + z·STD ·sqrt(L)•How much: EOQ formula, Q* = sqrt(2AVG ·K / h) (S = s+Q*)

Use (s, S) model•When: inventory position drops below s s = AVG·L + z·STD ·sqrt(L)•How much: EOQ formula, Q* = sqrt(2AVG ·K / h) (S = s+Q*)

Is demand rate Is demand rate deterministic?deterministic?

YesYes

NoNo

Risk Pooling• (safety) stock based on standard deviation

– square root law: stock for combined demands usually less than the combined stocks

• Centralizing inventory control reduces safety stock, hence average inventory level for the same service level.

(This phenomenon is called risk pooling)

• works best for – negatively correlated demand.

– high coefficient of variation, which increases required safety stock.

• other kinds of risk pooling: across markets, products, time

Risk Pooling Example• Consider two systems:

Warehouse 1

Warehouse 2

Market 1

Market 2

Supplier

Decentralized System:Two warehouses,each serving one customer

WarehouseMarket 1

Market 2

SupplierCentralized System:One warehouse,serving both customers

Questions: Q1: For the same service level, which system will require more inventory?Q2: For the same total inventory level, which system will have better service?

Example

AVG STD SS s Q SAverage

Inventory

Warehouse 1 39.3 13.2 25.08 65 132 197 91

Warehouse 2 38.6 12.0 22.8 62 131 193 88

CentralizedWarehouse

77.9 20.7 39.35 118 186 304 132

Decentralized system: total SS = 47.88

total avg. invent. = 179

Safety Stock SS = z ·STD · L

Reorder Point s = AVG·L + SSOrder Quantity Q = sqrt(2K·AVG/h)Order-up-to-level S = s + QAverage Inventory SS + Q/2

WarehouseMarket 1

Market 2

d1+d2: (, 2)

Calculating demand variability of centralized systemCalculating demand variability of centralized system

Warehouse 1

Warehouse 2

Market 1

Market 2

d1: (1, 12)

d2: (2, 22)

2 = 1

2 + 22 + 212,

where -1 12

= 12 + 2

2 + 212,

where -1 1

: correlation coefficient of d1, d2

1+ 2 1+ 2

Conclusions: 1. Stdev of aggregated demand is less than the sum of stdev of individual demands2. If demands are independent or negatively correlated, the std of aggregated demand is much less

Conclusions: 1. Stdev of aggregated demand is less than the sum of stdev of individual demands2. If demands are independent or negatively correlated, the std of aggregated demand is much less

1. If d1, d2 positively correlated, > 02. If d1, d2 are independent, = 03. If d1, d2 negatively correlated, < 0

= 1 + 2

= ??

1+2

10-1

22

21

P.C.N.C. Ind.

DecentralizedCentralized

Inbound transportation cost (from factories to warehouses)

Facility/Labor cost

Outbound transportation cost (from warehouses to retailers)

Inventory cost

Responsiveness to customers (lead time)

Centralized vs. Decentralized

Means to Achieve Risk Pooling

• Universal product• Modularity/Component commonality• Product differentiation postponement

• Inventory aggregation (centralized system)

A Typical ABC Curve

% of SKU

% of Total Dollar Value

A

B

C

20% 50% 100%

60%

90%100%

Sport Obermeyer Case 1. Identification of major issues in the supply chain. 2. Recommendation on ordering units of each style during

initial phase of production.(using sample data in Exhibit 10; assume all ten styles in the sample problem are made in Hong Kong, and that Obermeyer's initial production commitment must be at least 10,000 units; ignore price differences among styles in your initial analysis.)

3. Recommendation of operational changes to lower risk and improve performance.

4. How should Obermeyer management think (both short-term and long-term) about sourcing in Hong Kong vs. China?

The Supply Chain

Lining Fabric

Lining Fabric

Shell Fabric

Shell Fabric

Insulation Materials

Insulation Materials

SnapsSnapsZippersZippers

OthersOthers

Cut/Sew

Distribution Center

Retailers

Textile Suppliers

Obermeyer

Obersport

Retailers

Speculative vs. Reactive Capacity

Initial Forecast

Orders

Speculative Production Capacity

Reactive Production Capacity

Scenario Outcome

Excess inventory

Stock out

End of Season Problem

•Loss of 8%/unit ~ $9

•Limited capacity effects (could have used that capacity to produce something that stocked out

•Loss of profit (24%/unit) ~ $27

Increasing Reactive Capacity

New Info / 2nd prod’n order

Increase Total CapacityAdditional Reactive capacity

Decrease Lead TimesAdditional Reactive capacity

Obtain Information EarlierAdditional Reactive capacity

New Info

Base case

Material LT Prod’n LT Delivery LT

Mar/93

Nov/92

Jun/93 Sept/93

Aug/93

1st Prod’n Order

Original Reactive capacitySpeculative production capacity

The Forecast Process: Input for Production Planning

• Independent versus consensus forecasts

• Aggregation of expert estimates

– Average of expert estimates is a proxy for the mean of

the demand distribution

– Standard deviation among expert estimates is a proxy for

half the standard deviation of demand distribution

• Forecast updates

Which Units are Safest to Build First?

• Highest demand– More likely that unit will sell

• Less variable (lower /)

• Less expensive– Lower overage costs – In speculative capacity, you are worried about

being over – being under not a problem, because you can always use reactive capacity

Risk-Based Production Planning: Accurate Response

• how to develop initial probabilistic forecast of demand?

• risk measures? assess _________ and _________ costs

• determine appropriate initial production quantities:– produce ___________________ units early

• “read” early demand indicators• update demand forecast• determine final production quantities

What Obermeyer did

• Early Write program gets sales info one month in advance of Las Vegas Show.

• More stocking of raw materials in Hong Kong.

• Risk-based production planning with forecast uncertainties captured by independent expert estimates used.

• Try to extend risk-based production planning concept to raw materials production.

• Increase commonality of zipper by 5-fold. Increase raw materials sharing across styles.

Did They pay off? Obermeyer Results

Before Accurate Response

After Accurate Response

Total production (units) 121,432 124,805

Over-production (units) 25,094 22,036

Under-production (units) 7,493 792

Over-production as % of sales 1.74% 1.30%

Under-production of % of sales 1.56% 0.18%

Total cost as % of sales 3.30% 1.48%

Obermeyer Results (cont.)

• Improved profits by 50% by

reducing inventory costs to

1.48% of sales (from 3.3% of

sales) - Profit margins in

industry around 3% of sales

• No. 1 customer rating.

Obermeyer 2.94Bogner 2.88White Stage 2.82Helly Hansen 2.80Nordica 2.63Marker 2.56North Face 2.55Columbia 2.52Descente 2.48Roffe 2.40Couloir 2.37… …Head 1.74

Dealer Confidence IndexApparel, 1/94

Sports Research Inc.

Summary

• Intelligent forecast process:– obtain early signal;– forecast uncertainty as input to production planning;– forecast update.

• Power of risk-based production planning.• Use inventory to establish de-coupling point in supply

chain (e.g., stock of raw materials in HK).• Material commonality to improve flexibility.• Coordinated demand and supply roles.

Distribution Strategies

• Direct shipping

– Examples:

• Shipping via warehouses

– Examples:

• Shipping via cross docks– Cross docks serve as ____________________ points– Products spend __________________ at cross docks– Examples:

• allowing transshipments

Strategy 1: Direct ShippingStrategy 1: Direct Shipping

retailermanufacturer

Type 1. Single origin single destination

Direct shipping with milk runs

manufacturer retailer

Type 2. Single origin multiple destinations

manufacturer retailer

Type 3. Multiple origins single destination

manufacturer retailer

Type 4. Multiple origins multiple destinations

Strategy 2: Shipping via WarehouseStrategy 2: Shipping via Warehouse

manufacturers retailers

Type 1. Without milk runs Type 2. With milk runs

manufacturers retailers

warehouse warehouse

Role of WarehousesRole of Warehouses

• Warehouses play important roles in the supply chain– Position _________ ___________ to customer– ______________ function

• ______________ shipments from multiple suppliers• ______________ shipments to multiple customers

– Even if firms sell products directly to customers (no retailers), they may still use warehouses

Example:

Strategy 3: Shipping via Cross DocksStrategy 3: Shipping via Cross Docks

• Warehouses: Receiving, Sorting, Storing, Order Picking, Shipping

• Cross Docks = Warehouses without inventory Receiving, Sorting, Shipping

Sorting

Receiving

Inbound shipments

Shipping

Outbound shipments

Requires coordination & IT supportRequires coordination & IT support

Comparison of the Three StrategiesComparison of the Three Strategies

Transportation

Lead Timefrom mfg to retailer

Direct Shipping

Shipping via warehouses

Shipping viacross docks

Inventoryat retailersFacility

SS proportional to what factors?

Why direct shipping has higher transportation or/and higher inventory cost?Why direct shipping has higher transportation or/and higher inventory cost?

• Example: Retailer’s weekly demand = 1/2 truckload Shipping cost from manufacturer to retailer = $100

1/2 truckloadper wk

per wk per wk

Full truckloads 1/2 truckloadper wk

Direct Shipping Shipping via Warehouse

1 truckloadper two wks

per 2 wks per 2 wks

Full truckloads 1 truckloadper two wks

1/4 truckloadper 1/2 wk

per 1/2 wk per 1/2 wk

Full truckloads 1/4 truckloadper 1/2 wk

Types of Strategic AlliancesTypes of Strategic Alliances

• Third Party Logistics (3PL)

• Retailer-Supplier Partnerships (RSP)– Quick response (QR)– Continuous replenishment (CR)– Vendor managed inventory (VMI)

3PL3PL

• 3PL = Some or all of a firm’s logistics functions is taken over by an independent logistics service provider (LSP)

• Example: Ryder Integrated Logistics– Annual revenues around US$ 1.5 billion– Offers everything from transportation to network design and

consulting– Key customers: HP, Daimler-Chrysler, Ford, GM

• Advantages of 3PL:

• Issues with 3PL:

Why 3PL can achieve economy of scale & provide better service?Why 3PL can achieve economy of scale & provide better service?

• Consolidation is the key!

Example: 2 independent firms, 2 independent supply chains

Consider 2 scenarios

Scenario 1: The firms performs their own logistics functions

Scenario 2: A 3PL takes care of both firms’ logistics functions

Firm 1

Firm 2

Firm 1

Firm 2

2 warehouses2 separate distribution networks2 warehouses2 separate distribution networks

1 warehouse1 distribution network1 warehouse1 distribution network

3PL

Major 3PLsMajor 3PLs

360Federal Express

420APL Logistics

488UPS Logistics

578Fritz Companies

650North American Logistics

650Americold

659Tibbet & Britten Group

875Schneider

959Penske Logistics

$1,300Ryder Integrated Logistics

Revenues ($ million)

Company

Source: Logistics Magazine (07/00)

3PL in Practice3PL in Practice

• “3PL Study: Results and Findings of 2001 Annual Study” by Cap Gemini Ernst & Young

– 93 companies– Covering automotive, chemical, computer, consumer products, &

electronics– 52% with sales revenues over $1B, 10% between $500M to $1B

How many companies use 3PL?How many companies use 3PL?

From “3PL Study: Results and Findings of 2001 Annual Study” by Cap Gemini Ernst & Young

What 3PL functions do companies use?What 3PL functions do companies use?

From “3PL Study: Results and Findings of 2001 Annual Study” by Cap Gemini Ernst & Young

Benefits of 3PLBenefits of 3PL

From “3PL Study: Results and Findings of 2001 Annual Study” by Cap Gemini Ernst & Young

Retailer-Supplier Partnerships (RSP)• Quick Response (QR)

– Supplier receives POS data from retailers– Supplier use it to improve its own forecasting and production scheduling – but retailer still prepares its own orders

• Continuous Replenishment (CR) – Supplier replenishes retailers– Supplier receives POS data and use it to prepare shipments at previously agreed upon intervals to maintain specific levels of inventory

• Vendor Managed Inventory (VMI)– Supplier replenishes retailers– Suppliers have the total control over replenishment decisions

Increasing trust level

Increasing trust level

Inventorydecision-makingincreasinglyglobal

Inventorydecision-makingincreasinglyglobal

Barilla Case; Manugistics guest speakerBarilla Case; Manugistics guest speaker

Continuum of RSP RelationshipsContinuum of RSP Relationships

Informationsharing

VMI withsupplier inventoryownership

Suppliercontrolof inventorydecision

Jointforecasting& planning

increasing ______ level

_______inventorycontrol

_______ inventorycontrol

Quick Response Continuous replenishment

VMI

RSP Issues and AdvantagesRSP Issues and Advantages

Issues• _________ ownership• IT (heavy investment)• Mutual ______• Suppliers have more

responsibility• Sharing benefits• Confidentiality

Advantages• Improved ___________• Decreased ___________

– Lower __________– Lower __________

Why does RSP have those advantages? Why does RSP have those advantages?

Without RSP: sequential, myopic optimization

Supplier Retailer

CustomerSupplier

Information flow

With RSP (particularly, VMI): Joint optimization

Information flow

Retailer optimizes its operations first. Then supplier optimizes its operations subject to the constraints imposed by the retailer.

Retailer optimizes its operations first. Then supplier optimizes its operations subject to the constraints imposed by the retailer.

Supplier optimizes its operations and the retailer’s. This is system-wide.

Supplier optimizes its operations and the retailer’s. This is system-wide.

Example of RSP SuccessExample of RSP Success

• VF Corporation’s Market Response System:

– The VF Corporation, which has many well known brand names (including Wrangler, Lee, Girbaud, and many others), began its VMI program in 1989.

– Currently, about 40 percent of its production is handled using some type of automatic replenishment scheme.

– This is particularly notable because the program encompasses 350 different retailers, 40,000 store locations, and more than 15 million replenishment levels.

– VF’s program is considered one of the most successful in the apparel industry.

Example of RSP FailureExample of RSP Failure

Spartan Stores (grocery chain)

– Shut down its VMI effort about one year after its inception

– Buyers were not spending any less time on reorders than they did before

– Issue: buyers didn’t trust suppliers -- continued to carefully monitor inventories and deliveries and to intervene at hint of trouble.

– Suppliers did little to allay these fears; suppliers did not deal well with promotions -- delivery levels were often unacceptably low during these periods of peak demand.

Other Kinds of Partnerships: Other Kinds of Partnerships: Third Party e-Fulfillment (3eF)Third Party e-Fulfillment (3eF)

• 3eF = the outsourcing of the back-end logistics of e-business including: the integration with front-end Internet

operations, order capture and processing, fulfillment of individual orders, and return logistics.

• Differences between 3PL & 3eF?

S M W R

C

Logistics: physical flow from suppliers to manufacturers, or/and frommanufacturers to retailers

M W R

E-Logistics: “last mile”, i.e. logistics of order fulfillment of e-businesses

Why is 3eF different from 3PL?

Traditional Supply Chain e-Supply Chain

Supply Chain Strategy Push Push-Pull

Shipment Type Bulk Parcel

Information Flow Unidirectional Bi-directional

Reverse Logistics Simple Highly Complex

Destination Small Number of Stores Highly Dispersed Customers

Lead Times Depends Short

3eF Examples3eF Examples

1. Fingerhut Business Services– A major provider of e-fulfillment service– Wal-Mart’s cyberstore is managed by Fingerhut

2. OrderTrust – Manages SkyMall.com’s order fulfillment

• Return Percentage in the Offline World (Online world has much higher percentages)

Industry

Magazine Publishing (50%)

Book Publishers (20-30%)

Book Distributors (10-20%)

Greeting Cards (20-30%)

Catalog Retailers (18-35%)

Computer Manufacturers (10-20%)

CD-ROMs (18-25%)

Consumer Electronics (4-5%)

Source: Rogers and Tibben-Lembke

3eF: Why Need for Reverse Logistics?3eF: Why Need for Reverse Logistics?

Case: Tale of Two Electronic Distributors 1. What is the value proposition offered by AESCO & ESCI?

Why might an OEM prefer to buy from a distributor rather than directly from a manufacturer?

2. What must AESCO and ESCI do to grow?

3. How are broad industry trends (consolidation, globalization, and the Internet) likely to affect each of these distributors?

Case Discussion

AESCO & ESCI: general description of business model.

value addition to SC channel? (elimination a la Dell direct model always good?)

role of distributor in general in SC risk-pooling (safety stock) break-bulk and mixing (allowing smaller order quantities) closer to buyer, emergency (expedited) shipments one-stop shop value-added services (e.g., some assembly, design) coordinate SC activities and reduce manufacturing costs specialized: matching inventory shortages and surpluses