SUPPLY CHAIN MANAGEMENT UNIT 3

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UNIT: 3 PLANNING DEMAND, INVENTORY AND SUPPLY

INVENTORY:

The term inventory refers to the raw materials used in production as well as the goods produced that
are available for sale.

Inventory means the stock of the product of a company and components thereof that makes up the
product. It includes the raw materials, work in progress and finished goods.

The function of an inventory is as mentioned below:-

1. Managing demand and supply
2. Knowing about the demand of customers and goods finished
3. Component and raw material availability.
4. The major requirements for processing and its output
5. Knowledge of materials needed for production

Reasons for Inventories:

1) Improve customer service
- Provides immediacy in product availability
2) Encourage production, purchase, and transportation economies
a) Allows for long production runs
b) Takes advantage of price-quantity discounts
c) Allows for transport economies from larger shipment sizes
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3) Act as a hedge against price changes

- Allows purchasing to take place under most favourable price terms

4) Protect against uncertainties in demand and lead times

- Provides a measure of safety to keep operations running when demand levels and
lead times cannot be known for sure

5) Act as a hedge against contingencies

- Buffers against such events as strikes, fires, and disruptions in
Supply

Types of Inventories:

In general, there are six main categories of inventories: cycle stock, safety stock, pipeline stock,
seasonal stock, decoupling stock, anticipation inventory and dead stock.

i) Cycle stock is inventory, i.e., highly predictable in its turnover and need to be replenished .
ii) Safety stock is inventory, i.e., concerned with short-range variations in either demand or
replenishment. It protects against the uncertainty of demand and lead time.
iii) Transit inventory or pipeline inventory is composed of products that are in transit
between producer and purchaser locations and are not ready to use or be sold. This stock is
equal to the expected demand over the lead time (the time between issuing an order and
receiving it).
iv) Speculative stock is inventory kept in case of material shortages, price increases, or
unexpected changes in demand rather than to satisfy current demand .
v) Seasonal stock is one form of speculative stock that is held for anticipated demand for a
specific time period—e.g., increasing chocolate demand on Valentine’s Day.
vi) Dead stock is inventory for which there is no longer demand. These inventories impose tax
costs on a firm, so they should be moved out as appropriate.

Inventory Management objectives:

i) Good inventory management is a careful balancing act between stock availability and the cost
of holding inventory
Customer Service Inventory Holding costs

i.e., Stock Availability

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ii) Service objectives: Setting stocking levels so that there is only a specified probability of running
out of stock

iii) Cost objectives: Balancing conflicting costs to find the most economical replenishment quantities
and timing

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ROLE OF INVENTORY IN SUPPLY CHAIN:

Average Inventory = Cycle Inventory + Safety Inventory

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MANAGING CYCLE INVENTORY IN SUPPLY CHAIN:

Definition of Cycle Inventory: Cycle Inventory or Cycle stock or working stock or lot size stock is an
essential part of the total inventory. It is that part of the entire inventory that helps the company to
meet the usual demand for the product. It is essential because this is what a company uses first to
fulfil the customer’s order.

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Cycle inventory exists because producing or purchasing in large lots allows a stage of the supply chain
to exploit economies of scale and thus lower cost. The presence of fixed
costs associated with ordering and transportation, quantity discounts in product pricing, and short-
term discounts or promotions encourages different stages of a supply chain to exploit economies of
scale and order in large lots.

Importance of Cycle Inventory:

Cycle stock also plays an integral part in the firm’s operations. This stock converts into sales and
generates cash flows, which the company then uses to pay creditors. Moreover, it is also part of the
firm’s total assets on the balance sheet. A company can value the cycle stock using the LIFO (last-in,
first-out) or FIFO (first-in, first-out) method. The same value then goes into the balance sheet.

Cycle inventory exists in a supply chain because different stages exploit economies of scale to lower
total cost. The costs considered include material cost, fixed ordering cost and holding cost.

The trade-off between ordering cost and inventory costs can be represented mathematically by using
the following notations:

D = annual demand of item, d = daily demand

A = fixed cost of order (cost of set-up in manufacturing environment)
C = cost per unit of item
i = inventory-carrying cost per rupee of inventory per year
Q = order size
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H = inventory-carrying costs per unit per year = C × i

We assume that the supplier does not offer any quantity discounts, irrespective of the size of the
orders, so the total annual cost of items is not relevant from the inventory management point of view
and will be C × D, irrespective of the order size. So the only relevant supply chain costs are cost of
carrying and cost of ordering. The inventory in a system will behave as shown in Figure.

At the beginning of every cycle (just after the replenishment from the supplier), the retailer has stock
equal to Q and the same will reduce to zero by end of the cycle (just before the next replenishment).
So, on an average, the retailer will carry cycle inventory of Q/2 throughout the year. So the retailer
will be incurring an annual inventory-carrying cost Q/2 × H. Since the annual demand is D, the retailer
will have D/Q such cycles in a year and in every cycle the retailer incurs an ordering cost of A, thus
incurring a total annual ordering cost of amount A × D/Q. As can be seen in Figure, the inventory-
carrying cost increases linearly with order size Q, while the annual ordering cost decreases
exponentially with order size Q.

Behaviour of inventory level with time (Graph)

Impact of order size on inventory-related cost (Graph)

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Optimal order quantity will be at a point where the total inventory-related cost will be lowest at a
point given by Q*. This is also known as EOQ, that is, economic order quantity:

Apart from ordering quantity, we also need to specify when the decision maker should
place an order from the supplier. Let us assume that the decision maker gets his material from the
supplier who is reliable but has a lead time of L days. During this lead-time period, the quantity of
demand faced by the retailer is equal to L × d. So the decision maker should place an order every time
his stock reaches the level of L × d and we will call this point the reorder point R. So the retailer has to
follow a simple inventory policy and has to continuously monitor the inventory and whenever it
reaches the reorder point R the retailer has to place an order for quantity Q*.

Let us go back to the case of the retailer. The product is purchased at `30 and the inventory- carrying
cost is 20 per cent. The ordering cost for the retailer is estimated to be `256 per order. The supplier
takes 15 working days to supply the item at the retailer’s warehouse.

The optimum order quantity is 1,600 and the average inventory is 800 units. So on an average the
retailer carries cycle stock of 8 days of demand and has an inventory turnover of 37.5.
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MANAGING SAFETY INVENTORY IN A SUPPLY CHAIN

Definition of Safety Inventory : Safety stock (also called buffer stock) is a term used by supply chain
managers to describe a level of extra stock that is maintained to mitigate risk of stock-outs (shortfall
in raw material or packaging) due to uncertainties in supply and demand.

Safety inventory is inventory carried to satisfy demand that exceeds the amount forecast.

Safety inventory is required because demand is uncertain, and a product shortage may result if actual
demand exceeds the forecast demand.

Reasons/Importance of maintaining safety stock:

 Safety stock protects against unforeseen variation in supply and/or demand
 To compensate forecast inaccuracies (only in case demand is bigger than the forecast)
 Its purpose is to prevent disruptions in manufacturing or deliveries
 Avoid stock outs to keep customer service and satisfaction levels high

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There is a
formula for the safety stock that helps you determine the optimal number of products you should
keep in the buffer. The calculation is relatively simple, and all it needs is that you have purchase and
sales records.

Safety stock = (Maximum daily usage * Maximum lead time in days) – (Average daily usage *
Average lead time in no of days).

Role of safety stock:

 Average inventory is therefore cycle inventory plus safety inventory
 There is a fundamental trade off:
i) Raising the level of safety inventory provides higher levels of product availability and
customer service and thus the margin captured from customer purchases.
ii) Raising the level of safety inventory also raises the level of average
inventory and therefore increases holding costs. However, both the
increased variety of products and the greater pressure for availability push firms to
raise the level of safety inventory they hold.
a) Very important in high-tech or other industries where obsolescence is a significant
risk, where the product life cycles are short and demand is very volatile (where the
value of inventory, such as PCs, can drop in value).
b) Compaq and Dell in PCs

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Inventory level with safety inventory (Graph)

While determining the cycle stock we assumed that the demand was constant, that is, every day the
decision unit faced a demand for d units consistently. Similarly, we assumed that the supplier was
reliable, which means that we get exactly the quantity we ordered in exactly L days. Unfortunately,
customers do not behave in a predictable way and suppliers also work with production and
transportation systems that have some degree of unreliability. As a result, actual demand may be
either more or less than 100 per day. Similarly, the actual time taken by the supplier may be either
more or less than 15 days.

Consequently, all inventory points end up keeping safety stock. In the case of our retailer, when there
is no uncertainty, it is optimal to place an order when stock on hand is exactly 1,500 units. At the end
of 15 days, stock on hand will be zero because the supplier will take exactly 15 days, and during those
15 days every day
customers will demand exactly 100 units per day. If we consider the uncertainty in demand, then, we
can only say that the average daily demand is 100 units but it could vary.

Similarly, the supplier will take, on an average, 15 days but it could take more time or less. Intuitively,
therefore, we can figure that if one works with a reorder point of 1,500 units, 50 per cent of the time
one runs out of stock and faces a stock out situation. In most real-life situations, stock out costs are
quite high and such high levels of stock out situations are very costly for the supply chain. So, to take
care of this demand and supply uncertainty, we carry safety stock so as to reduce chances of stock out
situations. As shown in Figure, one can visualize the system as adding a foundation level of safety
stock to take care of this uncertainty. In general, safety stock is the average inventory on hand when
the replenishment lot arrives. The average inventory carried by a firm is the average cycle stock plus
safety stock.
In this section, we examine the trade-off that the supply chain manager must consider

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while planning the safety stock inventory. On the one hand, increasing safety stock inventory reduces
the chances of stock out situations, but, on the other hand, increasing safety stock increases inventory-
carrying cost for the firm. Demand uncertainty in the service sector is managed through safety
capacity because unlike product firms they cannot keep finished goods inventory. Safety capacity in
terms of human inventory (idle people capacity) is known as people on bench in the software
industry.

For firms that are in high-end technology industry these issues are very important
because higher safety stock inventory could result in obsolescence. The central question we need to
answer is, “How much safety stock should be carried in the supply chain?” This question can be
answered by capturing the uncertainty in demand and supply, and evaluating the consequences of a
stock out situation.

For any supply chain, three key questions need to be considered when planning safety
inventory:

1. What is the appropriate level of product availability?

2. How much safety inventory is needed for the desired level of product availability?
3. What actions can be taken to reduce safety inventory without hurting product availability?

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METHODS FOR CALCULATING SAFETY STOCKS:

A commonly used approach calculates the safety stock based on the following factors:

 Demand is the number of items consumed by customers, usually a succession of independent

random variables.
 Lead time is the delay between the time the reorder point (inventory level which initiates an
order is reached and renewed availability.
 Service level is the desired probability of meeting demand during the lead time without a stock
out. If the service level is increased, the required safety stock increases, as well.
 Forecast error is an estimate of how far actual demand may be from forecast demand.

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FACTORS AFFECTING THE LEVEL OF SAFETY INVENTORY:

The appropriate level of safety inventory is determined by the following two factors:
o The uncertainty of both demand and supply
o The desired level of product availability

The uncertainty of both demand and supply:

As the uncertainty of supply or demand grows, the required level of safety inventories
increases. Demand for milk at a supermarket is quite predictable. As a result, supermarkets can
operate with low levels of safety inventory relative to demand. In contrast, demand for spices at the
same supermarket is much harder to predict. Thus the supermarket needs to carry high levels of
safety inventory for spices relative to demand. Whereas most of the milk inventory at a supermarket
is cycle inventory (with very little being safety inventory), most of the spice inventory is safety
inventory carried to deal with uncertainty of demand.

The desired level of product availability:

As the desired level of product availability increases, the required level of safety inventory also
increases. If the supermarket targets a higher level of product availability for a certain spice, it must
carry a higher level of safety inventory for that spice.
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DIFFERENCE BETWEEN CYCLE INVENTORY AND SAFETY INVENTORY:

Cycle stock is the goods allocated to meet regular customer demand over a certain amount of time.

Safety stock, on the other hand, is more like backup inventory.

Cycle stock = Total inventory on hand – Safety stock

Description Cycle Stock Safety Stock

Inventory planned to be used Buffer inventory to cover any
Definition
in a certain period unplanned issues
Used when demand outpaces
Replenishes old stock as it’s predicted sales, production output is
Intended use
sold less than planned or supplier orders
are late
New orders placed regularly
Reordering Only replaced on as-needed basis
after existing inventory is sold

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UNCERTAINTY IN SUPPLY CHAIN:

Uncertainties in supply, process and demand are recognized to have a major impact on the
manufacturing function. Uncertainty propagates throughout the network and leads to inefficient
processing and non-value adding activities. This uncertainty is expressed in questions such as:

i) What will my customers order?

ii) How many products should we have in stock? and

iii) Will the supplier deliver the requested goods on time and according to the demanded
specifications?
The presence of uncertainty stimulates the decision maker to create safety buffers in time, capacity or
inventory to prevent a bad chain performance. These buffers will restrict operational performances
and suspend competitive advantage. Those companies which cope best with uncertainty are most
likely to produce internationally competitive bottom-line performances.

Four types of supply chain uncertainty:

1. Process Uncertainty:

• Internal ability to meet a production delivery target

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• Understand each work process yield ratio and lead time estimates for operations

• Competition within company for resources for the product delivery process

2. Demand Uncertainty

How well companies’ meet customer demand- measured through lost sales.

3. Control Uncertainty

Associated with information flow. In demand-pull link between supply and demand is clear and there
is no control uncertainty. Customer orders to production schedule to supplier requests. With batch
and lot sizes, link between demand and true requirements is low and control uncertainty is high.

4. Supply Uncertainty:

Poorly performing suppliers not meeting buyer requirement and affecting value- added processes.
Measured through supplier delivery performance, order time series, lead time, raw material stock and
supplier quality

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IMPACT OF SUPPLY UNCERTAINTY ON SAFETY INVENTORY:

The impact of supply uncertainty is well illustrated by the impact of the grounding of MSC Napoli on
the south coast of Britain in January 2007. The container ship was carrying more than 1,000 tons of
nickel, a key ingredient of stainless steel. Given that 1,000 tons was almost 20 percent of the 5,052
tons of nickel then stored in warehouses globally, this delay in bringing nickel to market resulted in
significant shortages and raised the price of nickel by about 20 percent in the first 3.5 weeks of
January 2007. Supply uncertainty arises because of many factors, including production delays,
transportation delays, and quality problems. Supply chains must account for
supply uncertainty when planning safety inventories.

In this section, we incorporate supply uncertainty by assuming that lead time is uncertain and identify
the impact of lead time uncertainty on safety inventories. Assume that the customer demand per
period for tablets at Amazon and the replenishment lead time from the supplier are normally
distributed. We are provided the following inputs:

D: Average demand per period

: Standard deviation of demand per period
L: Average lead time for replenishment

: Standard deviation of lead time

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We consider the safety inventory requirements given that Amazon follows a continuous review policy
to manage tablet inventory. Amazon experiences a stock out of product if demand during the lead time
exceeds the ROP—that is, the quantity on hand when Amazon places a replenishment order. Thus, we
need to identify the distribution of customer demand during the lead time. Given that both lead time
and periodic demand are uncertain, demand during the lead time is normally distributed with a mean
of DL and a standard deviation , where

Given the distribution of demand during the lead time in Equation and a desired
CSL, Amazon can obtain the required safety inventory using Equation.

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ANALYSING IMPACT OF SUPPLY CHAIN REDESIGN ON THE INVENTORY :

Any supply chain redesign has a significant impact on the inventory and other components of supply
chain costs.

Since any major change of this kind has long-term implications, supply chain managers have to justify
the same with a rigorous cost–benefit analysis.

This is illustrated using two specific examples in this section on centralization versus decentralization
and choice of mode of transport. These examples, apart from analysing the impact on inventory, also
illustrate the trade-offs between inventory and transportation cost. The centralization versus
decentralization example also illustrates the concept of risk pooling.

i) Centralization Versus Decentralization:

Let us take the case of a company that currently has 16 regional stock points and has been serving its
dealers from the stock point that is closest. This firm wants to explore the possibility of centralizing its
stock holding. This will mean that stocks will be held only at one central point and all the dealers will
be served from this central point. Obviously, this is going to increase the time that the firm will take to
service dealers or customers. As this will result in higher inventory at the dealer’s end, the firm will
have to use a faster mode of transport so as to provide more or less the same delivery time as in the
decentralization case. Since the firm cannot force dealers to hold higher inventory, it will have to work
with a faster and more expensive mode of transport to maintain the same service level. As a result, the
company will reduce inventory-related costs but will have to pay higher transport cost. For simplicity,
we assume that each region has similar demand distribution with mean daily demand as 100 and

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standard deviation of demand being 30. Each of the stock points (in both centralization and
decentralization cases) gets served from the plant and that takes a lead time of exactly 15 days. In the
decentralization case, the average transport cost was Re 1 per unit, and in centralization case, the
transport cost will increase by 10 per cent to `1.10 per unit. Let us assume that all other relevant data
will be similar to the case of retailer (ordering cost, `256; inventory-carrying cost per unit, `6; required
service level, 97.7 per cent). So in the decentralized case, each stock point will be carrying cycle stock
inventory of 800 units and safety stock of 232 units. Let d1, d2, …, dn, represent the daily demand
faced by individual regional stock points and let σd1, σd2, ..., σdn represent the standard
deviation of demand at the respective stock points. The daily demand (dc) and the standard deviation
of demand (σdc) at the central stock point will be as shown below:

The average demand faced by the centralized stock point is the sum of the average demand faced by
the existing 16 stock points. However, the standard deviation of demand in the centralized case will
not be simply additive. In general, whenever we pool demand across locations, the phenomenon
called risk pooling may be observed. Risk pooling suggests that demand uncertainty is reduced when
one pools demand across demand locations. This happens because higher demand at one regional
market will get offset by lower demand at another regional market. Lower uncertainty results in
lower safety stock in the centralization case.

Details of cycle stock, safety stock and transportation cost implications have been worked out in Table
4.6. As can be seen in Table 4.6, cycle stock in centralization gets the benefit of economies of scale and
the cycle stock in the system reduces to 25 per cent of the current level. The safety stock reduces
because of lower uncertainty faced by the centralized system compared to the decentralized system.
But transport costs go up because a firm will like to maintain the same level of customer service
(delivery lead time in this case). As we can see in this case, moving to centralization will reduce the
cost by `26,304. Of course, apart from inventory costs, the company will also make savings in terms of
facility and establishment costs as it has to manage fewer establishments.
In general, the higher the demand uncertainty, the higher the savings in safety stocks. Similarly, the
higher the number of stock points involved in risk pooling, the higher the savings in cycle stock
because of economies of scale. However, to provide the same level of service, if the organization has to
increase transportation costs substantially, the firm may want to work with a decentralized system.
For example, in the current case, if transportation costs increased by 25 per cent decentralization may
be a better option. So for goods (products like salt, wheat flour, etc.), which are fast moving, that have
low demand variability and have high transportation costs, centralization will not make sense. But
where transportation is not a significant part of the cost and demand variability is high (slow-moving
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items, service items), it will be better to centralize. Many firms have used this approach while
redesigning their supply chains. IBM (in the service industry) and Reliance (in the manufacturing
sector) have redesigned their operations and moved to centralization of resources to achieve the
benefits of risk pooling.

ii) Choice of Mode of Transport:

The choice of mode of transport can significantly alter the performance of the supply chain. In many
firms, while redesigning the supply chain, have to change the mode of transport for optimum
efficiency within the chain.

Consider a computer marketing firm that serves its market from one central depot and the demand
observed is 100 PCs per day, with the standard deviation of demand being 30. The company has a
policy of maintaining a service level of 97.8 per cent. Currently, it sources its PCs from Europe and has
to allow six weeks (36 days) of lead time: 1 week to manufacture at its Europe plant and five weeks
for shipping. The company is exploring the possibility of airlifting the material, which will reduce the
lead time to two weeks (12 days). This will result in increase in transportation cost from `100 to `400
per unit of PC. Inventory-carrying cost for PC is `6,000 per unit per year.

Since there is no change in demand structure and ordering costs, the cycle stock will not
change but this decision will affect the safety stock and the pipeline cost. Details of inventory cost and
transportation costs have been worked out in Table.

As can be seen in Table, shipping PCs by air will lower the overall annual cost by `7.3
million. As can be seen, most of these savings are achieved because of reduction in pipeline inventory
costs in the above case. Normally, one will lift high-value items by air and low-value items by sea.

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To sum up, different categories of inventories, which get affected by supply chain decisions, should be
identified, and appropriate models for quantifying the costs and benefits of the proposed supply chain
redesign initiative should be used.

Analysis of choice of mode of transport example (Table)

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RISK POOLING OR INVENTORY CONSOLIDATION:

Risk pooling is the practice of consolidating facilities in fewer locations, by using a consolidated
distribution strategy that will reduce supply and demand risk.

Supply chain risk pooling refers to the practice of consolidating as much of a business's supply chain
as possible into one flow. In other words, it's putting all your eggs in one basket.

Risk Pooling involves using centralized inventory instead of decentralized inventory to take
advantage of the fact that if demand is higher than average at some retailers, it is likely to be lower
than average at others.

The basic principles of risk pooling are as follows:

 Use of fewer warehouses or DCs to supply customers by consolidating customer regions
 Aggregating customer demands reduces demand risk
 Reduction in demand risk reduces total inventory in the supply chain

To understand Risk pooling, one needs to understand the following two principles in relations to
demand (Simchi-Levi, 2009):

 Standard Deviation (SD) – a measure of how much demand tends to vary around average.
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 Coefficient of Variation (CV) – the ratio of standard deviation to average demand

Coefficient of variation = SD / Average Demand

While both the SD and CV provide the measure of variability, the difference between two is that SD
measures absolute variability of demand and CV measuring variability relative to average demand.

It is best to describe that with an example:

Comparing 3 markets (shown in Table 1) and their demand structure for 5 weeks, gives results of
dramatic difference in standard deviation among all 3 markets with Market A at 15.25 and Market
B and C at 24.85 and 46.31 respectively. This shows the higher spread of data and may lead to the
thinking of higher inventory level. However if we look at the coefficient of variation, the variation for
Market C is actually slightly lower than Market A.

Method of Risk Pooling :

Risk pooling, is also referred as centralized and the opposite as decentralised system. The figures 4
and 5 below present both the decentralized and centralized system of supply chain. It is often
assumed that the having decentralized system will increase the efficiency of demand fulfilment
and reduce the possibility of stock out. Moreover locating the warehouse closer to market would
result in shorter lead time.

While this is true, that having more warehouses and being closer to market definitely brings
shorter lead time and better demand fulfilment but at the same time it also means that the more
safety stock is being kept and any dramatic demand variability will result in either stock out or over
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stock of products – with former resulting in increasing the demand from supplier and will most
likely cause bullwhip effect or the latter resulting in higher cost of holding. Bullwhip effect occurs
when a slight seasonal increase in demand at the consumers’ end, increases the demand
variability throughout the whole supply chain (Mitch Kirby, 2015), shown in figure 5 below.

Instead the Risk Pooling method of having a centralized or few centralized stores to serve
different nearby markets is more efficient – as the demand variability from one store/market can
be balanced by the demand variability in the other. The same is applied to the demand variability
of products. The demand for Product A being high and resulting in profit can offset the poor
performance of product B in a certain market. This will lead to reduced safety stock while managing
the same and/or higher service level.

Refer to our example above with Markets A, B, and C. If to manage warehouses for three of them
separately, then the cost for holding safety stock at each warehouse, as well as the capital stuck in
inventory will be quiet high. Whereas with risk pooling, aggregation of demand will reduce the need
for safety stock and thus the cost. And any demand variability in one market would be offset by the
variability of the other – unless if all the markets present demand variability in positive at the same
time.

Four types of risk pooling:

i) Location pooling
ii) Product pooling
iii) Lead time pooling
-Delayed differentiation
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-Consolidated distribution
iv) Capacity pooling

1) Location Pooling :

 Can be used to decrease inventory while holding service level constant, or increase service
level while holding inventory costs.
 Ex. Nordstrom:
• Pooling in-store and online inventories across the entire company using IT systems and
inventory trans-shipments
• Sales increased by 39% due to stock-out reduction and reduced delivery lead times
Pros.
• Reduces demand uncertainty therefore reducing inventory.
• Increases service levels
Cons:
• May move inventory away from customers
• May increase delivery lead time / transportation costs

2) Product Pooling :
 Ex. Hewlett-Packard (Europe)
 Deskjet-Plus printers manufactured in Vancouver
 Three DCs in N.A., Europe, and Asia
 Different power-supply modules/manuals needed to accommodate local
requirements
 One month delivery lead time
 Solution:
• Build one generic printer
• Add power-supply modules/manuals for different counties only in response to demand
Limitations:
• A generic design may not provide key functionality to customers with special needs
• A generic design may be more expensive to produce as it may require additional components
• A generic design may eliminate brand/price segmentation opportunities

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3) Lead Time Pooling

 Consolidated Distribution

 Delayed Differentiation

Why Pooling?
 Reduces uncertainty
• Demand amount
• Demand location
• Lead time
 Uncertainty reduction
• Results in reduction of safety stock!

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MANAGING INVENTORY FOR SHORT LIFE CYCLE PRODUCTS:
 Many high-technology products are characterized by a "short" product life cycle (PLC) a short
life on the market, a steep decline stage and the lack of a maturity stage.

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 The product life cycle model is not only important to marketing teams and product managers,
it's also critical to any inventory planner that manages demand forecasting and stocking
policies
 Some of the most important stages through which product life cycle passes are as follows:
l. Introduction
2. Growth Stage
3. Maturity Stage
4. Saturation Stage
5. Decline Stage.

1. Introduction
The product is developed keeping in view a particular need of a set of consumers and introduced in
the market by initiating its commercial production. At this stage product is new in the market,
consequently its demand is low and requires dynamic sales efforts. The promotional costs are,
therefore, high at this stage and the production costs are also not fully recovered due to low volume of
sales.

2. Growth Stage
There is a fast expansion in sales as the cumulative impact of the promotional expenditure helps in the
market acceptance of the product as well as the reputation of the product gains around. But this rapid
expansion can be sustained only by the maintenance of product quality.

[Link] Stage
When the product enters the maturity stage the rate of growth of its sales declines, though the volume
of sales keeps on increasing. This is so because most of the peoples needing the product-had; already
adopted it during the growth stage and now when the product enters its maturity stage, it faces a
small and declining number of potential buyers. Consequently, the firm has to spend relatively
increasing amount of sales promotion.

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[Link] Stage
At this stage, the sales volume of the product comes to an end to grow. The only additional demand for
the product happens to be its replacement demand.

5. Decline Stage
Ultimately the product enters a stage of decline where its sale volume starts shifting down. The
competitors have by then entered the market with substitutes and imitations and the product
distinctiveness starts diminishing. Consequently, the sale of the product also starts declining. The
product life cycle, changes occur in price elasticity of demand and promotional elasticity. There are
also continuous changes in the production and distribution costs over the product life-cycle. This
necessitates continuous adjustments in the pricing policy over the various phases of the product life-
cycle so as to get the best return in each case. It can be analysed from the Product life cycle that as the
product moves to the next stage of its life-cycle, the sellers control over prices keeps on further
reducing. So, in order to save itself from the stage of saturation and decline, the firm makes a fresh
innovation just at a time when the existing product is about to enter the saturation stage.
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MULTIPLE-ITEM, MULTIPLE-LOCATION INVENTORY MANAGEMENT:

In actuality, managing the inventory in a supply chain involves dealing with a large number of items,
often stocked at multiple stock points at various stages in the supply chain. So far we have only looked
at the problem of managing inventory for a single item at a single stock point.

The supply chain can rarely be managed by a single decision maker. Complex supply chains are
decomposed into multiple decision-making units managing individual stock points, which in turn
connect various production and transportation activities within a chain. For each stock point, one can
identify relevant supply and demand processes. However, the optimal way of dividing the supply
chain into decoupled stock points is by no means a trivial exercise. Similarly, parameters for the
supply and demand processes do not remain static at all times. These get affected by various supply
chain integration initiatives taken by the firm. But once the supply chain design is completed, for a
given level of supply chain integration, the performance at each stock point can be improved using the
concepts discussed in this chapter. Finally, supply chain improvement involves working on structure
(optimal number of stock points), improving supply chain integration (altering parameters of supply
and demand processes)and simultaneously optimizing performance of individual stock points.

For multiple items, theoretically, supply chain analysis can be carried out for each and every item
using the approach outlined in this chapter. But the supply chain manager cannot be expected to focus
on all items with the same energy and time because he or she has limited resources and the energy

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spent all on all the items do not result in the same kind of benefits. For this purpose, we discuss
selective inventory control techniques that help managers in dividing items into multiple categories
and handle different categories of items in different ways.

Selective Inventory Control Techniques:

When dealing with a large number of items, the management may not be in a position to
focus attention on all items. For example, a large company like IndianOil will have lakhs of SKUs to
handle; similarly, a grocery chain like Foodworld has to manage thousands of [Link], not all
items are likely to be of equal importance. So it makes sense for a company to classify items so that
managers can pay suitable attention to different categories of items.

There are several classification schemes for categorizing SKUs:

i) ABC classification. Items are classified into three categories based on the value of the
consumption. A-category items contribute significantly to the value of inventory and consumption and
are controlled tightly and get more managerial attention. ABC classification is discussed in greater
detail at a later stage.
One of the most popular methods of classification of items is the ABC classification. It is a common
practice to use three ratings: A (very important), B (moderate importance) and C (little importance).
SKUs in A categories can be given higher priority in terms of allocation of management time. To carry
out the ABC analysis, all the items are rank-ordered based on the sales in value terms. Cumulative
percentages of the total sales (in rupee) and the total number of items are computed and these
percentages are plotted.

The company has 126 SKUs, but the top three SKUs (2.4 per cent of items) accounted for about 60 per
cent of the sales volume. The format of the ABC analysis is illustrated in Table. The same data have
been plotted in Figure. As can be seen, 75 per cent of the items constitute less than 5 per cent of value,
so the firm has to find a method for the Delhi sales manager to prioritize his time. That is, he should
have very simple systems for these 75 per cent of items and spend most of his time and attention on
A-category items.

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ABC categorization has been used with success in following areas:

a) Allocation of managerial time: An A-category item should receive the bulk of managerial
attention and C category items should receive very little.

b) Improvement efforts: The improvement effort should be directed at A-category items only.
For example, supplier relationships, lead time reduction, reduction in uncertainty in lead time,
etc.

c) Setting up of service levels: According to one philosophy, the A category should receive 99
per cent service level, the B category should receive 95 per cent and the C category should
receive 90 per cent service level so that the overall weighted service level for the company will
be around 97 per cent. Some firms do exactly the opposite. They provide 99 per cent of service
level to C-category items, 95 per cent to B-category items and 90 per cent to A-category items.
It is not that the firm actually allows 10 per cent of stockouts in A-category items, but during
the replenishment cycle, the firm monitors closely all the A-category items in terms of actual
demand as well as the status of supply.

d) Stocking decision in the distribution system: A-category items are kept at all regional
distribution points, but C-category items are kept at a central warehouse only. B-category
items are kept only at a few regional hubs but not at all regional stock points.

Some firms use a similar concept, called the 80–20 rule, that is, 80 per cent of the sales is taken care of
by 20 per cent of the items. In this system, items are classified in just two categories.

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ii) FSN classification. Items are classified based on volume of usage: fast moving (F), slow moving (S)
and non-moving (N). Fast-moving items are usually stocked in a decentralized fashion while slow-
moving items are stocked centrally. Non-moving items are candidates for disposal and the firm will
like to make sure that non-moving items do not take up a significant share of inventory investment.
This classification is quite popular in the retail industry.
iii) VED classification. Items are based on criticality: vital (V), essential (E) and desirable (D). This
classification is quite popular in maintenance management. Based on the VED classification, one can
fix different service levels for different items. Of course, a firm prefers to work with a very high service
level for V category of spare items. For example, Reliance industry maintains a 99.995 per cent service
level for V category of spares. While deciding the inventory level for a D category product, one will fix
relatively lower levels of service requirements.

Cummins India is a classic example of a firm that has applied ideas of selective inventory control
techniques in managing its spares inventory.
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PRICING & REVENUE MANAGEMENT: :

 Short-term price promotions could be an effective tool to more profitably meet seasonal
demand.
 supply chain profits by better matching supply and demand, especially when there are multiple
customer types willing to pay different prices (based on attributes such as response time) for
an asset.
 Revenue management is the use of pricing to increase the supply chain surplus and profit
generated from a limited availability of supply chain assets.
 Supply chain assets exist in two forms that are capacity and inventory. Capacity assets in the
supply chain exist for production, transportation, and storage.
 Inventory assets exist throughout the supply chain and are carried to improve product
availability.
 In the presence of multiple customer types, revenue management aims to grow profits by
selling the right asset to the right customer at the right price.
 Besides varying capacity and inventory, revenue management suggests varying price to grow
profits by better matching supply and demand. Pricing is a factor that gears up profits in
supply chain through an appropriate match of supply and demand.
 Revenue management can be defined as the application of pricing to increase the profit
produced from a limited supply of supply chain assets

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 Ideas from revenue management recommend that a company should first use pricing to
maintain balance between the supply and demand and should think of further investing or
eliminating assets only after the balance is maintained.
 Revenue management is defined as the application of differential pricing on the basis of
customer segment, time of use and product or capacity availability to increment supply chain
surplus.
 Revenue management plays a major role in supply chain and has a share of credit in the
profitability of supply chain when one or more of the following circumstances exist:
 The product value differs in different market segments,
 The product is highly perishable or product tends to be defective.
 Demand has seasonal and other peaks.
 The product is sold both in bulk and the spot market.
 The strategy of revenue .management has been successfully applied in many streams that we
often tend to use but it is never noticed. For example, the finest real life application of revenue
management can be seen in the airline, railway, hotel and resort, cruise ship, healthcare,
printing and publishing.
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VARIOUS SITUATIONS IN WHICH REVENUE MANAGEMENT IS EFFECTIVE AND THE TECHNIQUES
USED IN EACH CASE:

Conditions under which Revenue Management Has the Greatest Effect:

 The value of the product varies in different market segments (Example: airline seats)
 The product is highly perishable or product waste occurs (Example: fashion and seasonal
apparel)
 Demand has seasonal and other peaks (Example: products ordered at [Link])
 The product is sold both in bulk and on the spot market (Example: owner of warehouse who
can decide whether to lease the entire warehouse through long-term contracts or save a
portion of the warehouse for use in the spot market)

i) Pricing & Revenue Management for Multiple Customer Segments:

 If a supplier serves multiple customer segments with a fixed asset, the supplier can improve
revenues by setting different prices for each segment
 Prices must be set with barriers such that the segment willing to pay more is not able to pay
the lower price
 The amount of the asset reserved for the higher price segment is such that the expected
marginal revenue from the higher priced segment equals the price of the lower price segment

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pL = the price charged to the lower price segment
pH = the price charged to the higher price segment
DH = mean demand for the higher price segment
σ H = standard deviation of demand for the higher price segment
CH = capacity reserved for the higher price segment
RH(CH) = expected marginal revenue from reserving more capacity
= Probability(demand from higher price segment > CH) x pHRH(CH) = pL
Probability(demand from higher price segment > CH) = pL / pH

ii) Pricing and Revenue Management for Perishable Assets

 Any asset that loses value over time is perishable
 Examples: high-tech products such as computers and cell phones, high fashion apparel,
underutilized capacity, fruits and vegetables
 Two basic approaches:
 Vary price over time to maximize expected revenue
 Overbook sales of the asset to account for cancellations
 Overbooking or overselling of a supply chain asset is valuable if order cancellations occur and
the asset is perishable
 The level of overbooking is based on the trade-off between the cost of wasting the asset if too
many cancellations lead to unused assets and the cost of arranging a backup if too few
cancellations lead to committed orders being larger than the available capacity

p = price at which each unit of the asset is sold

c = cost of using or producing each unit of the asset
b = cost per unit at which a backup can be used in the case of asset shortage
Cw = p – c = marginal cost of wasted capacity
Cs = b – c = marginal cost of a capacity shortage
O* = optimal overbooking level
s* = Probability(cancellations < O*) = Cw / (Cw + Cs)

If the distribution of cancellations is known to be normal with mean mc and standard deviation σ
c then

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If the distribution of cancellations is known only as a function of the booking level (capacity L +
overbooking O) to have a mean of m(L+O) and std deviation of σ (L+O), the optimal
overbooking level is the solution to the following equation:

iii) Pricing and Revenue Management for Seasonal Demand:

 Seasonal peaks of demand are common in many supply chains
 Examples: Most retailers achieve a large portion of total annual demand in December
([Link])
 Off-peak discounting can shift demand from peak to non-peak periods
 Charge higher price during peak periods and a lower price during off-peak periods

iv) Pricing and Revenue Management for Bulk and Spot Customers
 Most consumers of production, warehousing, and transportation assets in a supply chain face
the problem of constructing a portfolio of long-term bulk contracts and short-term spot market
contracts
 The basic decision is the size of the bulk contract
 The fundamental trade-off is between wasting a portion of the low-cost bulk contract and
paying more for the asset on the spot market
 Given that both the spot market price and the purchaser’s need for the asset are uncertain, a
decision tree approach as discussed in Chapter 6 should be used to evaluate the amount of
long-term bulk contract to sign

For the simple case where the spot market price is known but demand is uncertain, a formula can
be used
cB = bulk rate
cS = spot market price
Q* = optimal amount of the asset to be purchased in bulk
p* = probability that the demand for the asset does not exceed Q*

Marginal cost of purchasing another unit in bulk is cB. The expected marginal cost of not
purchasing another unit in bulk and then purchasing it in the spot market is (1-p*)cS.

If the optimal amount of the asset is purchased in bulk, the marginal cost of the bulk purchase
should equal the expected marginal cost of the spot market purchase, or cB = (1-p*)cS

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Solving for p* yields p* = (cS – cB) / cS

If demand is normal with mean m and std deviation σ, the optimal amount Q* to be purchased in
bulk is

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THE ROLE OF IT IN PRICING AND REVENUE MANAGEMENT:
 Pricing of perishable assets
 Pricing of retail goods in the consumer packaged-goods category
 Mark downs of goods as the styles and seasons change
 Linking with other areas and applications

USING PRICING AND REVENUE MANAGEMENT IN PRACTICE

 Evaluate your market carefully
 Quantify the benefits of revenue management
 Implement a forecasting process
 Apply optimization to obtain the revenue management decision
 Involve both sales and operations
 Understand and inform the customer
 Integrate supply planning with revenue management
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REVENUE MANAGEMENT FOR INVENTORY ASSETS: MARKDOWN MANAGEMENT / DYNAMIC
PRICING

It is common practice in the fashion industry to procure the entire requirement for the season in one
lot, especially when one is procuring from long lead suppliers. In this section, we assume that the firm
is working with a traditional approach where the
entire lot is procured at the start of the season and the quality of forecast is likely to be poor when
goods are ordered before the start of the season.

In this section, we look at the use of markdowns so as to generate higher revenue

from the likely surplus stocks of the garments. In the speculative approach, in the designer garment
case, 82 per cent of the times we are likely to end up with surplus stocks. One will have the
information about the likelihood of surplus garments at the end of speculative period when forecast
updating takes place. Instead of waiting for the end of the season, one can influence demand during
the reactive part of the season by offering markdown. Markdown during the season is likely to fetch
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much higher value than the salvage value available at the end of season. Even in the responsive
approach, it is possible that likely demand for the season is going to be less than the inventory
available at the end of the speculative season. In such a case, again the firm can resort to markdowns
during the season itself rather than waiting till the end of the season for salvaging the leftover stocks
of garment.

In this section, we will just focus on designer shirts and we will also assume that for
a given scenario demand during the reactive period, part of the season is known with certainty. Let us
look at a situation where a firm has a stock of 694 shirts left at the end of month one, and it knows that
demand is going to be 150 shirts per month in the remaining three months of the season. So if the firm
does not offer any markdowns, it will have excess stock of 244 shirts at the end of season, which it will
have to salvage at the price of Rs 30 per unit only. Given that demand price is elastic, the garment firm
can offer markdowns during the remaining three months. Of course, as per industry practice, only
markdown is allowed, which means that once you do a markdown, prices in all subsequent months
have to be less than or equal to the price offered in the current month. In all subsequent months, the
price cannot go up. If the firm offers 20 per cent markdown in month 2, then in all subsequent months
during the season it has to offer at least 20 per cent markdown. Let us say the firm has two possible
markdown options, that is, 20 and 40 per cent, which results in demand increase by 30 and 70 per
cent, respectively. Of course, the firm has an option of 0 per cent markdown, which is no markdown
during the season.
Markdown options (Table)

The firm has to just optimize revenue as the cost incurred in acquiring shirts is a sunk cost at this
stage. We have 10 choices and firms can calculate revenue for each option and choose the option that
will result in the highest revenue for the firm. For example, monthly demand for 20 per cent
markdown will be 195 units and demand for 40 per cent markdown will be 255 units. At the end of
the season, all the leftover stock shirts will be sold at a salvage value of Rs 30 per unit. For any month
t, Price(t), Demand(Price(t)), Stock(t), Sales(t) are price, demand, stock and sales at the end of period
t, respectively. Revenue for any option can be worked out as follows:

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As can be seen from Table, option 7 is the optimal choice as it results in the highest
revenue of Rs 237,270, which is 2.1 per cent higher than option 1, which is no markdown policy. We
can also see that indiscriminate markdown policies can hurt the firm. For example, at a first glance
option 9 looks attractive because it ensures that all the garments will be sold during the season. Given
the fact that the price available at the end of season is Rs 30 only, one will be tempted to offer
markdown, which will generate at least revenue of Rs 300 per unit garment. But option 9 will actually
result in lower revenue than option 1, which is no markdown policy.

It is common practice for firms to work with standard markdown policies. For example,
a firm may have a policy that if it is likely to have surplus garments deep markdowns will be offered in
the last month of the season. Instead of a standard markdown policy, as suggested in this section, the
firm should decide optimal markdowns based on demand elasticity and estimate of the excess stock.

Markdown management discussed in this section is also known as dynamic pricing. Dynamic pricing
involves change in prices over a period of time. Dynamic pricing offers the potential to increase
revenues and profits. At the same time, it creates an incentive for consumers to strategize over the
timing of their purchases. That is, customers may anticipate the entire price path and try to optimally
time their purchases. In such cases, a firm should ideally use its pricing and stocking decisions to try
to profitably influence this strategic behaviour. One approach is to create a rationing risk by
understocking products. This will ensure that customers cannot take it for granted that the product
will be always available at the end of season at lower prices.
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THE ROLE OF PRICING AND REVENUE MANAGEMENT IN THE SUPPLY CHAIN:

 Revenue management is the use of pricing to increase the profit generated from a limited
supply of supply chain assets

 Supply assets exist in two forms: capacity and inventory

 Revenue management may also be defined as the use of differential pricing based on customer
segment, time of use, and product or capacity availability to increase supply chain profits

 Most common example is probably in airline pricing

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