Supply Chain Management

Lecture 21
Outline
• Today
– Finish Chapter 11
• Sections 1, 2, 3, 7, 8
– Skipping 11.2 “Evaluating Safety Inventory Given Desired Fill rate”
– Start with Chapter 12
• Sections 1, 2, 3
– Section 2 up to and including Example 12.2

• Friday
– Homework 5 online
• Due Thursday April 8 before class
• Next week
– Finish Chapter 12
– Start with Chapter 14
Managing Inventory in Practice
• India’s retail market
– Retail market (not inventory) projected to reach
almost $308 billion by 2010
– Due to its infrastructure (many mom-and-pop stores
and often poor distribution networks) lead times are
long

ss = Fs-1(CSL)L
Managing Inventory in Practice
• Department of Defense
– DOD reported (1995) that it had a secondary
inventory (spare and repair parts, clothing, medical
supplies, and other items) to support its operating
forces valued at $69.6 billion
– About half of the inventory includes items that are not
needed to be on hand to support DOD war reserve or
current operating requirements
Safety Inventory

A new technology allows books to be printed in ten

minutes. Borders has decided to purchase these
machines for each store. They must decide which
books to carry in stock and which books to print on
demand using this technology. Would you
recommend Borders to use the new technology for
best-sellers or for other books?
Measuring Product Availability
1. Cycle service level (CSL)
• Fraction of replenishment cycles that end with all customer
demand met
• Probability of not having a stockout in a replenishment cycle
2. Product fill rate (fr)
• Fraction of demand that is satisfied from product in inventory
• Probability that product demand is supplied from available
inventory
3. Order fill rate
• Fraction of orders that are filled from available inventory
 Product Fill Rate
inventory
fr = 1 – 10/1000 = 1 – 0.01 = 0.99

Q = 1000

0 time
ESC = 10
inventory fr = 1 – 970/1000 = 1 – 0.97 = 0.03

0 time

Q = 1000

ESC = 970
Expected Shortage per Replenishment
Cycle
• Expected shortage during the lead time

ESC   ( x  ROP) f ( x)dx
x  ROP
where f(x) is pdf of DL

• If demand is normally distributed

  ss   ss 
ESC   ss 1  Fs     L f s  
   L  L 

Does ESC decrease or increase with ss?

Product Fill Rate
• fr: is the proportion of customer ESC
demand satisfied from stock. fr  1 
Q
Probability that product
demand  ss 
is supplied from inventory.
ESC   ss{1  F S  }
• ESC: is the expected shortage
 L 
per replenishment cycle (is  ss 
the demand not satisfied from   L f S  
inventory in stock per  L 
replenishment cycle)
• ss: is the safety inventory
• Q: is the order quantity
Example 11-3: Evaluating fill rate
given a replenishment policy
• Recall that weekly demand for Palms at B&M is
normally distributed, with a mean of 2,500 and a
standard deviation of 500. The replenishment
lead time is two weeks. Assume that the
demand is independent from one week to the
next. Evaluate the fill rate resulting from the
policy of ordering 10,000 Palms when there are
6,000 Palms in inventory.
Example 11-3: Evaluating fill rate
given a replenishment policy
Lot size Q= 10,000
Average demand during DL = LD = 2*2,500 = 5,000
lead time
Standard dev. of demand L = SQRT(L)D =
during lead time SQRT(2)*500 = 707
Expected shortage per ESC = -ss(1-Fs(ss/L))+Lfs(ss/L) =
replenishment cycle -1000*(1-Fs(1,000/707) +
707fs(1,000/707) =
25.13
Product fill rate fr = 1 – ESC/Q =
1 – 25.13/10,000 = 0.9975
Cycle Service Level versus Fill
Rate

What happens to CSL and fr when the safety

inventory (ss) increases?

What happens to CSL and fr when the lot

size (Q) increases?
Lead Time Uncertainty

Why do some firms have zero tolerance for

early/late deliveries?
Example 11-6: Impact of lead time
uncertainty on safety inventory

Inventory

Reorder point
Demand during lead time

0
Time
Lead time

L = SQRT(L2D + D2s2L)
Example 11-6: Impact of lead time
uncertainty on safety inventory
• Daily demand at Dell is normally distributed, with
a mean of 2,500 and a standard deviation of
500. A key component in PC assembly is the
hard drive. The hard drive supplier takes an
average of L = 7 days to replenish inventory at
Dell. Dell is targeting a CSL of 90 percent for its
hard drive inventory. Evaluate the safety
inventory of hard drives that Dell must carry if
the standard deviation of the lead time is 7 days.
Example 11-6: Impact of lead time
uncertainty on safety inventory
Demand D= 2,500
Standard dev. of demand D = 500
Lead time L= 7
Demand during lead time DL = LD = 5,000
Standard dev. of lead sL = 7
time
Standard dev. of demand L = SQRT(LD2 + D2sL2) =
SQRT(7*5002 + 25002*72) =
during lead time
17,550

Fs-1(CSL)L =
Safety inventory ss =
Fs-1(0.90)*17,550 = 22,491
Summary

L: Standard deviation of When lead time is constant

demand during lead time
sL: Standard deviation of  L  L D
lead time
When lead time is uncertain

 L  L  D s
2
D
2 2
L
Summary
L: Lead time for replenishment
D: Average demand per unit
time
D L
 LD
D:Standard deviation of
demand per period
 L
 L D
DL: Average demand during ROP  D L  ss
lead time
L: Standard deviation of CSL  F ( ROP, D L , L )
demand during lead time
CSL: Cycle service level
ss: Safety inventory
ROP  F (CSL, D L , L )
1

ROP: Reorder point

Average Inventory = Q/2 + ss
Summary
• fr is the product fill rate (fraction ESC
of demand satisfied from fr  1 
inventory) Q
• ESC is the expected shortage
 ss 
per replenishment cycle (the ESC   ss{1  F S  }
demand not satisfied from  L 
inventory per replenishment
cycle)  ss 
• ss is the safety inventory   L f S  
• Q is the order quantity  L 
Example Question
• Weekly demand for canned fruit at a grocery
store is normally distributed, with a mean of 250
and a standard deviation of 50. The lead time is
two weeks. Assuming a continuous review
replenishment policy, how much safety inventory
should the store carry to achieve a CSL of 90
percent?
Example Question
• You may use the table below to calculate the
safety inventory

Fs-1(0.9) 1.28
F-1(0.9, 250, 50) 314.08
F-1(0.9, 250, 70.71) 340.62
F-1(0.9, 500, 50) 564.08
F-1(0.9, 500, 70.71) 590.62
None of the formulas can be
used to calculate the safety
inventory
Safety Inventory

Why is Amazon.com able to provide a large variety of

books and music with less safety inventory than a
bookstore chain selling through retail stores?
Borders versus Amazon

~500 Borders stores versus ~20 Amazon warehouses

Demand D 100 Demand D 2500

Stddev of demand s_ D 40 Stddev of demand s_ D 200
Lead time L 1 Lead time L 1
Demand during lead time D_L 100 Demand during lead time D_L 2500
Stddev of demand during lead time s _L 40 Stddev of demand during lead time s _L 200
Cycle service level CSL 0.95 Cycle service level CSL 0.95
Safety inventory ss 65.79 Safety inventory ss 328.97
Total safety inventory for 25 stores 25*ss 1644.9 Safety inventory for 1 warehouse 1*ss 328.97

ss = Fs-1(CSL)L
Amazon versus Borders

“Company-wide, Borders has knocked eight days off

of its days inventory outstanding through
improvements in its supply chain. Nevertheless,
inventory stuck around 176 days in 1999, turning just
over twice a year. That's not very often. Barnes &
Noble turned its inventory 2.5 times last year, and
Amazon managed nine turns. If Borders could turn its
inventory as often as Barnes & Noble, it would free up
an additional $400 million for use during the year.”

Soure: Brian Lund (TMF Tardior), May 19, 2000

Safety Inventory

In the 1980s, paint was sold by color and size in paint

retail stores. Today paint is mixed at the paint store
according to the color desired. What impact did this
change had on safety inventories in the supply chain?
Importance of the Level of Product
Availability
• Product availability (also known as customer
service level) is measured by
– CSL (Cycle service level)
– fr (Product fill rate)
• Product availability affects supply chain
responsiveness and costs
– High levels of product availability  increased
responsiveness and higher revenues
– High levels of product availability  increased
inventory levels and higher costs
The Newsboy/Newsvendor Problem
The Newsboy/Newsvendor Problem
• One time decision under uncertainty
– Demand is uncertain
– Plan inventory for a single cycle
• Trade-off
– Ordering too much
• (waste, salvage value < cost)
– Ordering too little
• (excess demand is lost)
• Examples
– Restaurants
– Fashion
– High tech
The Christmas Tree Problem

Sell price p = 100

Cost c = 20
Ordering Too Much…

Cost c = 20
Salvage value s = 5
Cost of overstocking
Co = c - s
Versus Ordering Too Little…

Sell price p = 100

Cost c = 20
Cost of understocking
Cu = p - c
Factors Affecting the Optimal Level of
Product Availability
• Cost of overstocking (Co = c – s)
– The loss incurred by a firm for each unsold unit at the
end of the selling season
• Cost of understocking (Cu = p – c)
– The margin lost by a firm for each lost sale because
there is no inventory on hand
• Includes the margin lost from current as well as future sales if the
customer does not return
Product Availability
• Cost of overstocking
– Liz Claiborne experiences “unexpected earnings
decline as a consequence of “higher-than-expected
excess inventories”
• The Wall Street Journal, July 19, 1993
– “On Tuesday, the network-equipment giant Cisco
provided the grisly details behind its astonishing $2.25
billion inventory write-off in the third quarter”
• News.com, May 9, 2001
• Cost of understocking
– IBM struggles with shortages in ThinkPad line due to
ineffective inventory management
• The Wall Street Journal, August 24, 1994
Example: Parkas at L.L. Bean

Demand Prob
D_i p_i
400 0.01 Cost c = $45
500 0.02
600 0.04 Price p = $100
700 0.08
800 0.09
Salvage value s = $5
900 0.11
1000 0.16 What is the expected profit?
1100 0.2
1200 0.11
1300 0.1
1400 0.04
1500 0.02
1600 0.01
1700 0.01

Expected demand = ∑Dipi = 1,026 parkas

Example: Parkas at L.L. Bean

Demand Prob Sold Unsold Profit

D_i p_i units units
400 0.01 400 600 19000 Cost c = $45
500 0.02 500 500 25000
600 0.04 600 400 31000 Price p = $100
700 0.08 700 300 37000
800 0.09 800 200 43000
Salvage value s = $5
900 0.11 900 100 49000
1000 0.16 1000 0 55000
1100 0.2 1000 0 55000
1200 0.11 1000 0 55000
1300 0.1 1000 0 55000
1400 0.04 1000 0 55000
1500 0.02 1000 0 55000
1600 0.01 1000 0 55000
1700 0.01 1000 0 55000

Expected profit = ∑profitipi = $49,900

Example: Parkas at L.L. Bean

Demand Prob CSL (1-CSL) Expected Expected Expected

D_i p_i Marg. benefit Marg. cost Marg. profit
400 0.01 0.01 0.99 1100 5500 x 0.49 = 2695 500 x 0.51 = 255 2440
1200 5500 x 0.29 = 1595 500 x 0.71 = 355 1240
500 0.02 0.03 0.97
1300 5500 x 0.18 = 990 500 x 0.82 = 410 580
600 0.04 0.07 0.93
1400 5500 x 0.08 = 440 500 x 0.92 = 460 -20
700 0.08 0.15 0.85 1500 5500 x 0.04 = 220 500 x 0.96 = 480 -260
800 0.09 0.24 0.76 1600 5500 x 0.02 = 110 500 x 0.98 = 490 -380
900 0.11 0.35 0.65 1700 5500 x 0.01 = 55 500 x 0.99 = 495 -440
1000 0.16 0.51 0.49 (1 – CSL)(p – c) CSL(c – s)
1100 0.2 0.71 0.29
1200 0.11 0.82 0.18
1300 0.1 0.92 0.08
What is the optimal order quantity?
1400 0.04 0.96 0.04
1500 0.02 0.98 0.02
1600 0.01 0.99 0.01
1700 0.01 1 0
Optimal Level of Product Availability

• Expected marginal contribution of raising the

order size from O* to O*+1
(1 – CSL*)(p – c) – CSL*(c – s)

p–c Cu
CSL* = Prob(Demand  O*) = =
p–s Cu + Co

O* = F-1(CSL*, , ) = NORMINV(CSL*, , )
Example 12-1: Evaluating the optimal
service level for seasonal items
• The manager at Sportmart, a sporting goods store, has
to decide on the number of skis to purchase for the
winter season. Based on past demand data and weather
forecasts for the year, management has forecast
demand to be normally distributed, with a mean 350 and
a standard deviation of 100. Each pair of skis costs $100
and retails for $250. Any unsold skis at the end of the
season are disposed of for $85. Assume that it costs $5
to hold a pair of skis in inventory for the season. How
many skis should the manager order to maximize
expected profits?
Example 12-1: Evaluating the optimal
service level for seasonal items
Average demand (mean) = 350
Standard deviation of = 100
demand (stdev)
Material cost c= $100
Price p= $250
Salvage value s= 85 – 5 = $80
Cost of understocking Cu = p – c = 250 – 100 = $150
Cost of overstocking Co = c – s = 100 – 80 = $20
Optimal cycle service level CSL* = Cu/(Cu + Co) = 150/170 =
0.88
Optimal order size
NORMINV(CSL*, , ) =
O* =
468