Importance of the Level of Product
Availability
• Product availability (also referred to as the customer service
level) measured by cycle service level or fill rate.
• Product availability affects supply chain responsiveness.
• Trade-off:
◦ High levels of product availability
◦ increased responsiveness and higher revenues
◦ increased inventory levels and higher costs
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Importance of the Level of Product
Availability (Cont.)
• Product availability is related to profit objectives, and strategic and
competitive issues
◦ Nordstrom (a department store chain): focused on providing a high level of
product availability and gained its reputation for responsiveness. But the
prices are higher.
◦ Power plants: a shut down is extremely expensive; some try to maintain
several month of fuel supply’s to avoid the chance of running out.
◦ Supermarkets: most carry only a few days’ supply of product; stockout do
occur with some frequency.
• What is the optimum level of fill rate or cycle service level that will result
in maximum supply chain profits?
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Factors Affecting the Optimal Level
of Product Availability
• Cost of overstocking (Co): the loss incurred by a firm for each unsold unit at the
end of selling season.
• Cost of understocking (Cu): the loss of margin lost by a firm for each lost sale
because there is no inventory on hand. Cost of understocking should include
the margin lost from non-returning customers.
• Possible scenarios:
◦ Seasonal items with a single order in a season
◦ One-time orders in the presence of quantity discounts
◦ Continuously stocked items
◦ Demand during stockout is backlogged
◦ Demand during stockout is lost
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L.L. Bean Women’s Red Ski Parka: Demand Distribution
Demand (Di) (in 100s) Probability (pi) Prob(x ≤ Di) Prob(x > Di)
4 0.01 0.01 0.99
5 0.02 0.03 0.97
6 0.04 0.07 0.93
7 0.08 0.15 0.85
8 0.09 0.24 0.76
9 0.11 0.35 0.65
10 0.16 0.51 0.49
11 0.20 0.71 0.29
12 0.11 0.82 0.18
13 0.10 0.92 0.08
14 0.04 0.96 0.04
15 0.02 0.98 0.02
16 0.01 0.99 0.01
17 0.01 1.00 0.00
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L.L. Bean (Cont.)
• Expected demand = Dipi =1,026
• If ordering 1,000 parkas (Q), cycle service level (probability of not running out
of stock) = 51%
• Cost (c) = $45; Price (p) = $100
• Any unsold parka at the end of the season are sold at the outlet store for $50.
• Costs of holding the parka in inventory and transporting it to the outlet store
= $10.
• Thus, a salvage value (s) = $50 - $10 = $40 per parka
• Profit = p – c = $100 - $45 = $55
• Loss = c – s = $45 - $40 = $5
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Seasonal Items with a Single Order in
a Season
• Often called “the newsvendor problem”
• If the newspaper seller does not buy enough papers to
resell, sale opportunities are lost.
• If the seller buys too many, the overage cannot be sold.
• This decisions are for items such as fashion goods and some
seasonal goods.
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Seasonal Items with a Single Order in
a Season (Cont.)
•
• CSL* = optimum CSL = the probability that demand during
the season will be at or below the optimal order size Q*
• CSL* = Prob(D ≤ Q*)
• Probability that demand during the season will be greater
than Q* = Prob(D > Q*) = 1 – CSL*
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Seasonal Items with a Single Order in
a Season (Cont.)
• At the optimal CSL, the expected marginal contribution must be 0.
• Thus, Expected benefit of purchasing an extra unit
= Expected cost of purchasing an extra unit
• Expected understocking cost = Expected overstocking cost
• CSL* = Prob(D ≤ Q*) = (p – c)/(p – s) = Cu/(Cu+Co)
• CSL* is also referred to as the “critical ratio”.
• The Optimal Q (or Q*) is the quantity that satisfies
[ (1 – CSL*)(p – c) ] = [ CSL*(c – s) ]
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Example: Mrs. Kendall's Christmas
Tree Business (Sipper and Bulfin, 1997)
f(D) = Probability density function of demand
f(D) = Prob(demand = D)
F(D) = Cumulative probability function of demand
F(D) = Prob(demand ≤ D)
F(Q) = Prob(demand ≤ Q)
Cu = Cost of understocking per unit
(lost profit, loss of good will)
Co = Cost of overstocking per unit
Unit cost + Disposal cost – Salvage value
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Example: Mrs. Kendall's Christmas
Tree Business (Cont.)
Critical Ratio:
Prob(D ≤ Q*) = CSL* = F(Q*) = Cu/(Cu+Co)
F(Q*) = the probability of satisfying the demand during the
period if Q* is purchased for the period.
Q > D: Co = $40 for the tree & its disposal
D > Q: Cu = $40 for lost profits
F(Q*) = Cu / (Cu + Co)
= 40 / (40 + 40)
= 0.50
Q* = 28
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Example: Sportmart
• Decide on the number of skis to purchase of the winter season.
• Demand is normally distributed, with a mean () of 350 and a standard
deviation () of 100.
• Each pair of skis costs (c) = $100 and retails for (p) = $250.
• Any unsold skis at the end of season are disposed for $85.
• Holding cost for a pair of skis for the season = $5
• Salvage value (s) = $85 – $5 = $80
• Cost of overstocking = Co = c – s = $100 – $80 = $20
• Cost of understocking = Cu = p – c = $250 – $100 = $150
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Example: Sportmart (Cont)
• CSL* = Prob(demand Q*) = Cu / (Cu + Co) = $150 / ($150 + $20) = 0.88
• Cu is much higher than Co, it is thus better off ordering more than expected value to
cover for the uncertainty of demand.
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One-Time Orders in the Presence of
Quantity Discounts
• p = a retail price per unit
• c = a cost to the retailer/buyer (without discount)
• cd = a discounted price if the buyer orders at least K units
• s = a salvage value
• Order size decision
◦ Using Co = c - s and Cu = p – c, evaluated the CSL* and Q* without a discount. Evaluate the
expected profit from ordering Q*
◦ Using Co = cd - s and Cu = p – cd, evaluated the CSLd* and Qd* with a discount.
◦ If Qd* K, evaluate the expected profit from ordering Qd*
◦ If Qd* < K, evaluate the expected profit from ordering K
◦ Select the order size which maximize the expected profit
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Managerial Levers to Improve Supply
Chain Profitability
• “Obvious” actions
◦ Increase salvage value of each unit
◦ Sell to outlet stores
◦ Sell the surplus in other region
◦ Decrease the margin lost from a stockout
◦ Arranging for backup sourcing (which may be more expensive) so that there are no
lost sales (and customers)
◦ Providing customer with a substitute product
• The optimal CSL (level of product availability) increases as the ratio of
Co/Cu decreases.
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Managerial Levers to Improve
Supply Chain Profitability (Cont.)
• Another managerial lever is the reduction of demand
uncertainty
◦ Improved forecasting
◦ Quick response: Reduce replenishment lead time
◦ Postponement: Postpone product differentiation until closer to
point of sale.
◦ Tailored sourcing: Use a low lead time, but perhaps an expensive
supplier as a backup for a low-cost, but perhaps long lead-time
supplier.
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Improved Forecasts
• Improved forecasts result in reduced uncertainty
• Less uncertainty results in either:
◦ Lower levels of safety inventory (and costs) for the same level of product
availability, or
◦ Higher product availability for the same level of safety inventory, or
◦ Both lower levels of safety inventory and higher levels of product
availability
• An increase in forecast accuracy decreases both the overstocked
and understocked quantity and increases a firm’s profits.
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Example: Impact of Improving
Forecasts
• Demand: Normally distributed with a mean of 350 units and standard deviation of
= 150 units
• Purchase price (c) = $100
• Retail price (p) = $250
• Disposal value (s) = $80
• How many units should be ordered as changes?
• Cost of overstocking = Co = c – s = $100 – $80 = $20
• Cost of understocking = Cu = p – c = $250 – $100 = $150
• CSL* = Prob(demand Q*) = $150 / ($150 + $20) = 0.88
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Impact of Improving Forecasts
Q* Expected Expected Expected
Overstock Understock Profit
150 526 186.7 8.6 $47,469
120 491 149.3 6.9 $48,476
90 456 112.0 5.2 $49,482
60 420 74.7 3.5 $50,488
30 385 37.3 1.7 $51,494
0 350 0 0 $52,500
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Example
Item % of Item $ Usage
A 20% 65%
B 30% 25%
C 50% 10%
• It is common to find a small
percentage of the items
accounting for a large
percentage of the annual cost
volume usage.
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Example: ABC Classification for Book Bindery
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Example: Book Bindery
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Multiple-Criteria ABC Analysis
• Non-Cost Criteria:
◦ Lead time
◦ Obsolescence
◦ Availability
◦ Substitutability
◦ Criticality
◦ How severity of the impact of running out
◦ How quickly the item could be purchased
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Cycle Counting
• Even though an organization may have made substantial efforts inventory
accurately, these records must be verified through a continuing audit (i.e.,
“Cycle Counting”).
• Cycle counting uses inventory classifications developed through ABC analysis.
• With cycle counting procedures, items are counted, records are verified, and
accuracies are periodically documented.
• The cause of inaccuracies is traced and appropriate remedial action taken to
ensure integrity of the inventory system.
◦ A items will be counted frequently, e.g., once a month
◦ B items will be counted less frequently, e.g., once a quarter
◦ C items will be counted perhaps once every 6 months
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Example
• A firm has 500 A items, 1,750 B items, and 2,750 C items.
• Company policy is to count
◦ all A items every month (every 20 working days)
◦ all B items every quarter (every 60 working days)
◦ all C items every 6 months (every 120 working days)
• The firm then allocated some items to be counted every
day.
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Example (Cont.)
Item Class Quantity Cycle Counting Policy Number of Items
Counted per Day
A 500 every month 500/20 = 25
(every 20 working days)
B 1,750 every quarter 1,750/60 = 29
(every 60 working days)
C 2,750 every 6 months 2,750/120 = 23
(every 120 working days)
Total 77
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