2 Inventory Management

Inventory and (Yield) Management
Inventory Management - Victor Araman
Best Buys Lesson

In the 1990s, Eric Morley, Best Buys director of transportation, remembers $15 million worth of personal computers were on the way to stores in time for the holidays when chip maker Intel Corp. unexpectedly announced it was going to introduce a new Pentium processor, which wouldnt be available until after the New Year. We were stuck, Morley says. It became the Christmas without a PC. Thats when we learned that you dont
buy inventory just in case - you buy it just in
time
Inventory Management Victor Araman
Agenda
A First Look at Inventory Management
Motivation
Continuous Replenishment Model

Economic Order Quantity (EOQ) EOQ variants
Periodic Review Model

News Vendor LL Bean (see other slides)
Supply Chain Inventory
Agenda
Motivation


What Is Inventory?
Inventory is the stock or store of an item or a resource used by an organization. Different types of inventory Finished Goods (FGI) | Work in Process (WIP) | Raw Material Examples Cash in an ATM/bank Half assembled engines in a car manufacturing plant Phones in a retail store Silicon in a semiconductor manufacturing plant Seats in a plane Advertising slots for a TV broadcaster
Period Ending Assets Current Assets Cash And Cash Equivalents Short Term Investments
2-Mar-12 25-Feb-11 26-Feb-10
1,199,000
1,103,000
1,826,000
22,000
90,000
Net Receivables
2,288,000
2,348,000
2,020,000
Inventory Inventory
5,731,000 5,731,000
1,079,000
5,897,000 5,897,000
1,103,000
5,486,000 5,486,000
1,144,000
30-36% of Total Assets

Total Current Assets
Other Current Assets
10,297,000 140,000 3,471,000 1,335,000 359,000 403,000 -
10,473,000 328,000 3,823,000 2,454,000 336,000 435,000 -
10,566,000 324,000 4,070,000 2,452,000 438,000 452,000 -
Long Term Investments Property Plant and Equipment Goodwill Intangible Assets Accumulated Amortization Other Assets Deferred Long Term Asset Charges
Total Assets
16,005,000
17,849,000
18,302,000
Importance of Inventory
Importance of Inventory
Inventories represent a major commitment of monetary resources Inventories affect virtually all aspects of a companys daily operations Inventories represent a lethal weapon Example: Dell, Wal-Mart, Zara
Why Do Companies Hold Inventory?

To meet anticipated customer demand To protect against stock-outs To take advantage of economic order cycles To maintain independence of operations To allow for smooth and flexible production operations To hedge against inflation and price increases To take advantage of quantity discounts
Inventory Sales Ratio
Inventory Sales Ratio
Impact of Inventory on Valuation

Abnormal inventory growth vs. On year ahead earnings
Why Do Companies Hold Inventory?
WSJ-09-09-04
Inventory Measures
Average aggregate inventory value: Average of the total value of all items held in inventory Weeks of supply =
Average aggregate inventory value Cost of Goods Sold per week
Cost of Goods Sold per week
Inventory turns = Average aggregate inventory value Some of these measures can be customized for specific settings/industry Retail: sales per sqm of shelf space Restaurant: sales per available seat-hour Media: sales per slot per impression
Inventory Turns
Common industry benchmark Example (K-Mart: 2002)
Inventory value = 4.825 B $ Cost of Goods Sold = 26.258 B $/year Average time to turn a dollar (cost) to a dollar = 4.825/26.258 year = 0.183 years = 67 days. (Littles law) What is the financial significance of this time? Kmart improved this figure from 88 days in 1998.
Kmart Inventory Turns in 2002 = (1/0.183) = 5.44 Turns/year
Example (Walmart: 2002)

Inventory value = 22.75 B$, COGS = 171.56 B $ Time to turn a dollar = 43 days Inventory Turns = 7.7
Inventory Turns: Importance

Consider a retailer whose inventory holding cost is 0.3 $/$/year (we will discuss the components of inventory costs later) That is, incur 30 cents to hold one unit of a good that costs 1 $ for 1 year Say, this retailer turns inventory 4 times per year So, on average, each unit stays in inventory for (1/4) of a year So, the cost that the retailer incurs just due to holding inventory is 30/4 = 7.5 cents per dollar In other words, when we buy a product for $100 at this retailer, $7.5 are paid towards the retailers inventory holding costs
Inventory Turns: Importance

Think about profit margins for two Retailers (A and B) in the same market (selling the same products) If Retailer A turns 4 times per year, 7.5 cents is the inventory cost/$. If Retailer B turns 8 times per year, only 3.75 cents is the inventory cost per $ (by better Inventory management) All else being the same, the profit margin of B is 3.75 % higher than A! Typically, net profits in the retail industry can be as low as 2 % !
Inventory Turns in the Retail Sector

Gross Margin
Compare: Wal-Mart : 7.54 turns per year K-Mart : 5.44 turns per year
45% 40% 35% 30% 25% 20% 0 5 10 Inventory Turns 15
10
ABC Analysis
Divides on-hand inventory into 3 classes A class, B class, C class Basis is usually annual $ volume $ volume = Annual demand x Unit cost Policies based on ABC analysis Develop class A suppliers more Give tighter physical control of A items Forecast A items more carefully
Classifying Items as ABC

80-20 rule % Annual $ Usage
100 80 60 40 20 0 0 50 100 Class A B C % $ Vol 80 15 5 % Items 15 30 55
A B C
% of Inventory Items
11
Inventory Decisions Driven by Cost

Ordering cost. (per order/transaction) cost incurred each time an order is placed with a supplier or production is ordered with its own shop Holding cost. (per unit of inventory per unit time) cost associated with maintaining an item in inventory until it is used or sold Stockout or shortage cost. (per unit of lost sale) occurs when the demand for an item exceeds its supply Item cost. (per unit of inventory) Under constant demand: becomes relevant if a quantity discount is available
Inventory Holding Costs

Category Housing costs Material handling costs Labor cost from extra handling Investment costs Pilferage, scrap, and obsolescence Cost as % of Inventory Value 6% (3 - 10%) 3% (1 - 3.5%) 3% (3 - 5%) 11% (6 - 24%) 3% (2 - 5%)
(Approximate Ranges)
12
Agenda
Motivation


Economic Order Quantity - EOQ
Inventory Level
Time
13
Economic Order Quantity (EOQ)

Model Assumptions Single product or item Demand rate known and constant
Item produced in lots, or purchased in orders

Each lot or order received in single delivery Lead time known and constant Ordering, or setup costs are constant No backorders are allowed No quantity discounts are allowed
Data & Costs Formulation
Demand = D units per year Ordering cost = S dollars per order placed Holding cost = H dollars per unit per year Order quantity = Q units

Holding Cost = H Q/2 per year Ordering Cost = S D/Q per year Total Cost = H Q/2 + S D/Q
14
EOQ Model: How Much to Order?

Annual Cost
H Q/2
Order (Setup) Cost Curve
S D/Q
Q* Optimal Order Quantity
Order Quantity (Q)
EOQ: When to Order?
Inventory Level Average Inventory
Q* / 2
ROP Reorder Point LT Lead Time
Time
15
Solution of the EOQ Problem
Total Cost
TC(Q )
DS QH Q 2
Optimal Quantity
Q*
2DS (EOQ solution) H
EOQ Model Equations

D = Demand per year S = Setup (order) cost per order H = Holding (carrying) cost d = Demand per day LT = Lead time in days Optimal Order Quantity Q* = 2DS H Reordering Point ROP = d LT d = D Working days / Year
Expected Number of Orders D N = Q* Expected Time between orders T = Working Days per year N
16
What if?
What if management is concerned by costs of emissions?
What if there are discounts based on the order quantity? What if demand or/and lead times are NOT deterministic?
EOQ Adjusted Costs of Emissions

Cost of reducing emissions
17
Out of Stock At Supermarkets
EOQ Adjusted Demand Uncertainty

Frequency
Service Level
P(Stockout)
Inventory Level
Q
SS Avg dLT
ROP
dLT
ROP
Avg dLT
SS
Safety Stock
Time
Lead Time Place order
Receive order
18
Service Level & Safety Stock

How much & when to order ? Uncertain demand (and possibly uncertain lead time)
Lead Time Demand: Demand during leadtime Leadtime demand follows normal distribution (forecasting) Continuous replenishment
What is a service level? What is the differ

What is the difference between a service level and a fill rate?
How is the service level linked to the Safety Stock?

Service level = 1 - Probability of stockout Higher service level means more safety stock More safety stock means higher ROP ROP = Avg of leadtime demand + safety stock
Safety Stock Computation

Leadtime demand is a normal distribution with an average and standard deviation Decide on your TARGET Service Level
Likelihood that leadtime demand is smaller than ROP is a service level Example: SL = 99% means that you leave a 1% chance of stock-out during any cycle
Find the corresponding level of inventory: ROP

ROP = Avg dLT + Safety Stock
Normal
Service Level Avg dLT ROP
Using Excel the ROP is ROP = NORMINV(SL, Avg dLT, stdev)

Leadtime Demand
19
Probabilistic Model: Examples

Demand during lead-time for one brand of TV is normally distributed with a mean of 36 TVs and a standard deviation of 15 TVs. What safety stock should be carried for a 90% service level? What is the appropriate reorder point?
Based on available information, the daily demand for CD-ROM drives averages 10 units (normally distributed), with a standard deviation of 1 drive. The lead-time is exactly 5 days. Management wants a 97% service level. What safety stock should be carried? What is the appropriate reorder point?
Agenda
Motivation


20
Inventory Management: The Newsvendor model

Demand Uncertainty Fixed Price
Single Order Too many?
Selling Newspapers
Economic parameters
buy at w = 1 sell at r = 1.5 salvage at s = 0.05
Random demand
a distribution is available (with an average 300 and a standard deviation 100 units)
The too much/too little problem

Order too much and there is a loss due to unsold newspapers Order too little and you lose potential sales (and profits)
21
Market Uncertainty & Ex-Ante Bet

There are consequences of getting this bet wrong
The expected profit maximization balances the too much too little costs
Brief Comparative Analysis

EOQ Long lifecycle products with stationary demand No demand uncertainty Tradeoff between setup and holding costs, driven by the frequency of ordering The Newsvendor model Short lifecycle products One shot items
can be stocked only once at the beginning of the selling season)
Considerable demand uncertainty Tradeoff between

costs of excess leftover inventory (overstocking, holding or disposal costs) excess demand (stockout costs)
Examples
fashion clothing | toys | computer games | music albums | books, consumer electronics
22
The Newsvendor Concept

Overage cost per unit Co is the (opportunity) cost of one unit of excess inventory (over ordering)
What if you had ordered one fewer unit? Overage cost = Cost Salvage value = w s What if additional cost is required to dispose of a leftover inventory? Co = 0.95
Underage cost per unit Cu is the (opportunity) cost of one unit of lost sales (under ordering)
What if you had ordered one additional unit? Underage cost = Price Cost = r w what if a goodwill cost or penalty cost is incurred in addition to the lost margin? Cu = 0.50
The Newsvendor Order Quantity Q

We define the critical ratio CR =
CR measures the balance of power between marginal costs of shortage and leftover
how worse or better is too little compared to too much
Probability Distribution Risk of leftover
Risk of shortage Critical Ratio CR
Avg Dmd
Demand
23
Expected Profit
Penalty cost = p = 0 If Q < D : Revenues = r Q ; If Q > D : Revenues = r D ; Salvage value = s (Q D ) Profit = r min{D , Q} + s (Q D )+ w Q
r
x
Sales
s x Leftover
News Boy Victor F. Araman
Cost of Demand Uncertainty

The mismatch Cost Gr(Q) = (r - w) E(D - Q)+ + (w S) E(Q - D)+
Cu : under-ordering x Expected Lost cost or lost margin Sales Co : over-ordering cost x Expected leftover or the overage cost
Profit = r min{D , Q} + s (Q D )+ - w Q
Expected Profit Pr (Q) = (r w) ED Gr (Q)

Risk free profit
Simple manipulations
Mismatch Cost
24
Marginal Analysis: Balancing the Risks

Ordering one more unit
D>Q Q+1 X Cu
X Cu Prob{D > Q } + Co Prob{D Q } + (X + Co) x Prob{D Q } DQ X+C

o
(X Cu) x Prob{D > Q }
Q+1 is better than Q if Co Prob{D Q } < Cu Prob{D > Q
Q
80
X
Expected marginal benefit of understocking
70
60 50 40
Expected gain or loss
As more units are ordered the average benefit from ordering one unit decreases (it becomes more likely to be left with inventory) while the average loss of ordering one more unit increases (it becomes less likely to be short in inventory)
30
20
Expected marginal loss of overstocking
10
0 0 800 1600 2400 3200 4000 4800 5600 6400
Newsvendor Cost Tradeoff

Optimal Rule
Expected cost of ordering one extra unit = Expected cost of ordering one less unit So, the optimal quantity solves for C0 P(D Q) = Cu P(D > Q)
P{Demand Q} Underage Cost Overage Cost Underage Cost
The quantity
is known as the critical ratio.
In the newspaper example: critical ratio = 0.5/(0.95+0.5) = 0.345

25
Newsvendor: Optimal Quantity to order

Probability Distribution
Risk of leftover
Risk of shortage Critical Ratio
Average Demand
Demand
A Normal Distribution
If demand distribution is normal Use Excel
s =100
Q* = Norminv(CR, m , s) = Norminv(0.345,300,100)
CR 0.345
= 260
m =300
26
Financial Performance
If seller orders the newsvendor quantity Q*
What should the seller expect in terms of profits ? What about averages sales? How many units will be discounted on average (salvage)? How much money is left on the table? (i.e. What is the fraction of demand unmet?)
Once lost sales are evaluated the rest follow trivially For normal distribution lost sales is known
tables that provide the values of lost sales excel functions that give the exact value of lost sales
If demand is not normal. Harder to get (need simulation)

Average Lost Sales
Suppose demand can take one of these values D belongs to {0,10, 20,190, 200} Suppose Q=120 What is the average lost sales? If D<=Q : No lost sales = 0 If D = 130, lost sales = D - Q= 10 If D = 140, lost sales = D - Q = 20 Average Lost Sales = 10 x P(D=130) + 20 x P(D=140) + + 80 x P(D=200)
27
Average Lost Sales for Normal Dist.

Available information Demand (D) is Normal with avg: ED = 300 and stdev sD = 100 Assuming the previous economic parameters then CR = 0.325 and Q = 260 Formula for Average Loss Sales
sD x L(z)
s is the standard deviation (given) z = (Q ED) / sD e.g. z = (260-300)/100 = 0.4 L(z) = normdist(z, 0, 1, 0) z x (1 - normdist(z, 0, 1, 1)) e.g. L(-0.4) = 0.63 and Average Lost Sales = 100 x 0.63 = 63
The Rest Indeed Follows

Sales + Lost Sales = Demand
Avg Sales = Avg Demand Avg Lost Sales = 300 63 = 237units
Leftover Inventory + Sales = Q

Avg leftover inventory = Q Avg Sales = 260 237=23units
Average Profit
Price x Avg Sales + Salvage x Avg Leftover Inv. Cost * Q = (Price Cost) x Avg Sales (Cost Salvage) x Avg Leftover Inv. = (1.5-1)*237-(1-0.06)*23 = $96.88 ~ $97
28
Yield Management in Action

Fare: New York - Chicago
Wednesday to Friday
1400 1200 1000 US$ US$ 800 600 400 200 0 August September October 1400 1200 1000 800 600 400 200 0 August September October
Fare: New York - Chicago

Thursday to Saturday
Wednesday-Friday fares are 15-20% higher than Thursday-Saturday fares!
Yield Management
Yield Management: term used in many service industries to describe techniques to allocate limited resources, such as airplane seats or hotel rooms, among a variety of customers, such as business or leisure travelers.
By adjusting this allocation a firm can optimize the total revenue or "yield on the investment in capacity Since these techniques are used by firms with extremely perishable goods, or by firms with services that cannot be stored at all, these concepts and tools are often called perishable asset revenue management. American Airlines credits yield management techniques for a revenue increase of $500 million/year and Delta Airlines uses similar systems to generate additional revenues of $300 million per year.
29
Yield Management
Marriott Hotels credits its yield management system for additional revenues of $100 million per year, with relatively small increases in capacity and costs Broadcasting companies use yield management to determine how much inventory (advertising slots) to sell now to the "upfront market" and how much to reserve and perhaps sell later at a higher price to the "scatter market The core logic is similar to the newsvendor model
Agenda
Motivation


30
A Simple Supply Chain

m Manufacturer w, Q Retailer r, D End consumer
The manufacturers profit is given by Pm = (w m) Q*

where, m is the production unit cost incurred by the manufacturer and Q* is the optimal quantity ordered by the retailer
Supply Chain Inventory Insights

Double marginalization effect Postponement strategies Risk sharing and supply chain maximum value
Refer to Newsvendor Problems
31
Supply Contracts: Real Options

Retailer buys q call options at unit cost c
Call option: right to buy one unit at the exercise price x Options bought ahead of season, but exercised after demand is observed Induce the retailer to buy more units at the expense of sharing the risk (demand uncertainty)
Retailers Expected profit pr(q) = E[(R - x) min{D, q}] c q
Comparing to Original Newsvendor

Standard Newsvendor Max Expected Profit r min{D , Q} + s (Q D )+ - w Q Newsvendor with Options Max Profit (r - x) min{D, q} c q Set rrx |wc|s0 By analogy, solution must be given by Critical Ratio ku = r x c | ko = c CF =
+
Solution given by Critical Ratio Cu = r w | Co = w s CR =

+
P(D Q) = CR Q*= norminv(CF, Avg D, sD)
P(D q) = CF q*= norminv(CF, Avg D, sD)
Profit Manufacturer (w m) Q*
Profit Manufacturer E (c - m)q + x min{D, q} + S (q - D)+
32
Retailers Expected Profit

Retailers Expected profit pr(q) = E[(R - x) min{D, q}] c q Re-writing the profit pr(q) = (R - x - c) ED gr(q) gr(q) = (R - x - c) E[(D - q)+] + c E[ (q - D)+]
ku = R - x - c : opportunity cost (too few options) k0 = c : opportunity cost (too many options)
gr(q*) = s (ku + k0) Normdist(Normsinv(ku /(ku + k0)),0,1,false)

Manufacturers Expected Profit

Expected profit
Sales
Leftover
pm(q) = E[(c - M) q + x min{D, q} + S (q - D)+]

Net revenues from Revenues from exercised options selling q options Revenues from nonexercised options
See notes for an Excel formulation of this profit under normal demand!
33
Key Learnings
Inventory is the result of the imbalance between Supply and Demand It serves as a buffer to
Smooth seasonality Reduce risk/cost of stockouts Alleviate production scheduling Take advantage of economies of scale
Inventory is not free EOQ. Simple and Commonly used model

Tradeoff between setup and holding costs
Newsvendor. Commonly used for One Shot Items

Critical Ratio measures the imbalance between too much and too little

34

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Inventory and (Yield) Management

Inventory Management - Victor Araman

Best Buys Lesson

buy inventory just in case - you buy it just in

Inventory Management Victor Araman

Continuous Replenishment Model

Periodic Review Model

Supply Chain Inventory

Inventory Management Victor Araman

Continuous Replenishment Model

Periodic Review Model

Supply Chain Inventory

Inventory Management Victor Araman

Inventory Management Victor Araman

Inventory Management Victor Araman

2-Mar-12 25-Feb-11 26-Feb-10

30-36% of Total Assets

Other Current Assets

10,297,000 140,000 3,471,000 1,335,000 359,000 403,000 -

10,473,000 328,000 3,823,000 2,454,000 336,000 435,000 -

10,566,000 324,000 4,070,000 2,452,000 438,000 452,000 -

Inventory Management Victor Araman

Inventory Management Victor Araman

Inventory Management Victor Araman

Why Do Companies Hold Inventory?

Inventory Management Victor Araman

Inventory Sales Ratio

Inventory Management Victor Araman

Inventory Sales Ratio

Inventory Management Victor Araman

Impact of Inventory on Valuation

Inventory Management Victor Araman

Why Do Companies Hold Inventory?

Kmart Inventory Turns in 2002 = (1/0.183) = 5.44 Turns/year

Example (Walmart: 2002)

Inventory Turns: Importance

Inventory Management Victor Araman

Inventory Turns: Importance

Inventory Management Victor Araman

Inventory Turns in the Retail Sector

45% 40% 35% 30% 25% 20% 0 5 10 Inventory Turns 15

Inventory Management Victor Araman

Inventory Management Victor Araman

Classifying Items as ABC

Inventory Decisions Driven by Cost

Inventory Management Victor Araman

Inventory Holding Costs

Continuous Replenishment Model

Periodic Review Model

Supply Chain Inventory

Inventory Management Victor Araman

Economic Order Quantity - EOQ

Inventory Management Victor Araman

Economic Order Quantity (EOQ)

Item produced in lots, or purchased in orders

Inventory Management Victor Araman

Data & Costs Formulation

Inventory Management Victor Araman

EOQ Model: How Much to Order?

Order (Setup) Cost Curve

Q* Optimal Order Quantity

Order Quantity (Q)

Inventory Management Victor Araman

EOQ: When to Order?