Risk Pooling in SC
Lect. delivered by
Prof. S P Sarmah
Concept of Risk Pooling
• Risk pooling suggests that demand variability is reduced if one aggregates
demand across locations
• When demand is aggregated across different locations, it becomes more
likely that high demand from one customer will be offset by low demand
from another.
• Reduction in variability allows a decrease in safety stock and therefore,
reduces average inventory
• Risk of carrying more inventory and obsolescence of product due to less
demand in the market or risk of stock out due to more demand in the
market.
Concept of Risk Pooling
• Critical points about risk pooling
• Centralized inventory reduces both safety stock and average inventory in the
system
• Process of reallocation of inventory is possible in centralized distribution system
• Higher the coefficient of variation, greater the benefit obtained from centralized
system i.e. from Risk Pooling
• The benefits from risk pooling depend on the behavior of demand from one
market relative to demand from another
• Benefits from risk pooling decreases as correlation between demand from two
market is +ve
Risk Pooling Concept
• Consider these two systems:
Warehouse One Market One
Supplier
Warehouse Two Market Two
Market One
Central
Supplier Warehouse
Market Two
Centralized distribution systems
Supplier
One Central
Warehouse for
distribution
Retailers
Decentralized distribution System
Supplier
Decentralized
Warehouses for
distribution
Retailers
The distributor holds inventory to
• Satisfy demand during lead time
• Protect against demand uncertainty
• Balance fixed costs and holding costs
Implications of Risk Pooling
• If one aggregates the demand across different locations it becomes more likely that
high demand from one customer will be offset by low demand from another
• As the number of retailers goes up this likelihood also goes up.
• Aggregate demands are easier to forecast.
• Reduction in variability of demand.
• Decrease in safety stock.
• Reduces average inventory.
• Cutting down the inventory holding cost for the warehouse.
Some key questions related to Risk Pooling
• For the same service level, which system will require more inventory?
Why?
• For the same total inventory level, which system will have better
service? Why?
• What are the factors that affect these answers?
Example of Risk Pooling
Let us illustrate this with an example of a Noida based company ABC that produces
certain type of products and distributes them in the Southern parts of India. The
current distribution system partitions south Indian region into two markets each of
which has a warehouse.
❖One warehouse is located in Pune
❖Another one located in Chennai.
Alternative strategy of centralized distribution system replaces two warehouses by a
single warehouse located between the two cities in Bangalore that will serve all
customer orders in both the markets.
Consider these two systems:
Pune Warehouse Market
Market one
One
ABC company
Noida
Chennai Warehouse MarketTwo
Market two
Market One
Market one
Central
ABC company warehouse
Noida
Market two
Two
Given data and assumptions
• Manufacturing facility has sufficient capacity to satisfy any warehouse
demand
• Lead time for delivery to each warehouse is about one week and is
assumed to be constant.
• Delivery time does not change significantly if we adopt a centralized
distribution system.
• Service level is 97% i.e. the probability of stocking out 3% is maintained.
• Ordering cost, S = $60 per order
• Inventory holding charges = $0.27 per unit per week
Data Analysis
• Now with analysis of weekly demand for two different products, product
A and product B produced by ABC company for last 8 weeks in both
market zones, we will examine which distribution strategy will be more
efficient and cost effective.
Historical Demand Data for PRODUCT A
WEEK 1 2 3 4 5 6 7 8
Pune 33 45 37 38 55 30 18 58
Chennai 46 35 41 40 26 48 18 55
TOTAL 79 80 78 78 81 78 36 113
Historical Demand Data for PRODUCT B
WEEK 1 2 3 4 5 6 7 8
Pune 0 3 3 0 0 1 3 0
Chennai 2 4 0 0 3 1 0 0
TOTAL 2 7 3 0 3 2 3 0
Question?
How much can the ABC company reduce the
inventory if it decides to switch to the centralized
system but maintaining the same 97% service level?
Analysis
• In order to answer the question, we need to carry out an analysis from
the give data.
• We calculate average weekly demand , standard deviation of demand
and coefficient of variation.
• Standard deviation measures the absolute variability of customer
demands, while the coefficient of variation measures variability
relative to average demand.
Sample calculations
• Product A, warehouse - Pune
Week 1 2 3 4 5 6 7 8
Demand 33 45 37 38 55 30 18 58
• Average demand = (33+45+37+38+55+30+18+58)/8= 39.25
N
• Standard deviation of sample = ( X − )2
where, is the
average, N- sample size S = n=1
d (N −1)
S = ((33 − 39.25)2 + (45 − 39.25)2 + (37 − 39.25)2 + (38 − 39.25)2 + (55 − 39.25)2 + (30 − 39.25)2 + (18 − 39.25)2 + (58 − 39.25)2)
d 7
S =13.1773
d
• Coefficient of variance = standard deviation/ average = 13.1773/
39.25 = 0.3357
Summary of Historical DATA
Product Average Standard Coefficient
Demand Deviation of
Variation
Pune A 39.25 13.1773 0.3357
Chennai A 38.625 12.04 0.3117
Pune B 1.25 1.488 1.1904
Chennai B 1.25 1.5811 1.2648
CENTRAL A 77.875 20.7118 0.2659
CENTRAL B 2.5 1.9226 0.8095
• Average demand for product A is much higher than product B which is
a slow moving product.
• The Standard deviation for product A is higher but on the other hand,
coefficient of variation of product B is higher.
• For centralized distribution, average demand is simply the sum of the
demand faced by each of existing warehouse
• However the variability of demand as measured by STD or COV faced
by central warehouse is lower than that faced by the two existing ones.
Sample Calculation of inventory parameters
• Product A , warehouse Pune
• Average weekly demand = 39.25 units
• Lead time = 1 week
• Demand during lead time, DDLT = 39.25 units
• Safety stock = Z *S ' = Z *S LT =1.88*13.1773* 1 = 25.82units
d d
• ROP = DDLT + safety stock = 39.25 + 25.82 = 65.07 units
Q * = 2DS = 2(39.25)(60) =132.07 or 132 units
IC 0.27
• AIL = Q*/2 + safety stock = 132/2 + 25.82 = 91 units
SUMMAREY OF INVENTORY LEVELS FOR DECENTRALIZED SYSTEM
Product Average Safety Reorder Order Average
Demand Stock Point Quantity Inventor
During (SS) (s) (Q*) y
Lead
time
Pune A 39.25 25.82 65 132 91
Chennai A 38.625 22.63 62 131 89
Total average inventory for product A 180
Pune B 1.25 2.797 4.04 24 15
Chennai B 1.25 2.972 4.22 24 15
Total average inventory for product B 30
For the centralized system
Product Average Safety Reorder Order Average
Demand Stock Point quantity Inventory
During (SS) (s) (Q*)
Lead time
A 77.875 38.93 116 186 132
B 2.5 3.61 6 33 20
% Reduction in Inventory
REDUCTION IN AVERAGE INVENTORY
PRODUCT A = (180 −132)*100 = 36.36%
180
PRODUCT B = (30 − 20)*100 = 33.33%
30
Ideal Situation
Risk pooling works best for situation where
• High coefficient of variation, which reduces required safety stock.
• Negatively correlated demand as in such a case the high demand from
one customer will be offset by low demand from another
Concluding Comment
Risk pooling is an important concept in supply chain management. The
idea of risk pooling is executed by a centralized distribution system
which caters to the requirements of all the markets in a given region
instead of separate warehouse allocated for different markets.
THANKS