Risk Pooling

- HP Deskjet -
Prof. Daniel Corsten

Acknowledgements: Hau Lee, Laura Kopzak,

Eric Johnson, Beril Toktay
Key Messages

– The objective of a risk pooling strategy is to

• redesign the supply chain, the production
process or the product to
• either reduce the uncertainty the firm faces
• or to hedge uncertainty so that the firm is in a
better position to mitigate the consequence of
uncertainty.

– Four versions of risking pooling:

 location pooling
 product pooling
 lead time pooling
 delayed differentiation (HP case)
 consolidated distribution
 capacity pooling
Inventory-Service Crisis at HP

– The Crisis: Inventory Imbalance

• excess inventory in some product options
• shortages in other product options
– Contributing Causes
• product options due to geography
• long DC replenishment lead time
• highly uncertain market
• inflexible design: difficult to rework one option
• out of control inventory system
• uncoordinated functional interests; conflicting incentives
Mapping Supply Chain and Product Structure

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 Postponement - Delayed Product Differentiation
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the factory.
Estimation of Inventory Required: Base Case
Basic conditions:

5 weeks
Lead time (Europe) (l)
Carrying cost .12
(*based on HP Case p. 12)
Review period (p) 1 week
Line item fill rate .98

Safety stock calculations from basic conditions and case data:

Monthly Monthly Std Weekly Weekly Std Dev Safety Safety L(z) z
Europ Mean Std Dev Dev/ Mean Std Dev over p+l Stock Stock
e Mean in
Option Weeks
s
A 42.3 32.4 .77 10 16 38 83 8.5 .0051 2.18
AA 420.2 204.9 .49 97 98 240 484 5.0 .0081 2.02
AB 15,830.1 5,625.6 .36 3,653 2,702 6,618 12,577 3.4 .0110 1.90
AQ 2,301.2 1,168.5 .51 531 561 1,375 2,798 5.3 .0077 2.03
AU 4,208.0 2,204.6 .52 971 1,059 2,594 5,309 5.5 .0075 2.05
AY 306.8 103.1 .34 71 50 121 228 3.2 .0117 1.88
Total 23,108.6 5,333 21,479 4.0

Results:
$127,992
Holding cost of cycle stock
Holding cost of safety stock $1,043.952
Holding cost of pipeline inventory $1,279,920
Total supply chain holding cost $2,451.864

Note: Monthly means and standard deviations (including Total) in this table are taken
from case Table 1. Safety stocks are calculated from that data using Garrett van Ryzin:
"Analyzing Inventory Cost and Performance in Supply Chains"
The inventory required is calculated as the sum of the safety stocks required of the individual options.
Efficiency Frontier (Inventory vs Service):
Sea Freight

Safety stock - fill rate trade-off when shipping by sea

28000
safety stock

23000

18000

13000
97.00% 97.50% 98.00% 98.50% 99.00% 99.50% 100.00%
fill rate
 Step-by-Step Calculation (1): European AB

The safety stock inventory model calculates safety stocks required to achieve a
given line item fill rate (LIFR) goal for any item at any location.
It takes into account average demand, the standard deviation of demand
(more precisely, forecast error variability), the replenishment lead time,
the review period (one week), and the average order quantity
(one week’s worth of demand).

Assumptions:
μ (weekly demand): 15,8300/4.33 weeks = 3,653 units
σ (weekly demand): 5,625/SQRT(4.33 weeks) = 2,703 units
Lead time (l): 5 weeks
Review period (p): 1 week
Target LIFR: 98% (given)

Safety Stock:
L(z): (1-.98)(3,653*1)/2,702*(5+1)½ = 0.011 with (5+1)½=2.4495
z: (from statistical tables): 1.90
σ *SQRT(p+l): (2,703)(5+1)½ = 6,618 units
Safety stock (1.90)(6,618) = 12,576 units
Safety stock in weeks of supply: 12,576/3,653 = 3.4 weeks’ supply
Step-by-Step Calculation (2): Overall Inventory

Assumptions:
Holding Cost 12% p.a.
Printer cost $400

Inventory (Units)
Total Cycle stocks Σμ(A, ...,AY) *p/2 5.333*1=5.333 (from table)
Total Pipeline stocks Σμ(A, ...,AY) *l 5.333*5=26.665
Total Safety stocks Σ(A, ...,AY) z σSQRT(p+l) 21.479 (from table)
Total Stock Holding 53.747

Inventory Holding Cost ($)

Total Cycle Stock Holding Cost: 5,333 (.12)(400)/2=$127,992

Total Pipeline Stock Holding Cost: 26,665(.12)(400) =$1,279,920

Total Safety Stock Holding Cost: 21,749(.12)(400) =$1,043.952
Total Inventory Holding Cost: $2.451.864
Estimation of Inventory Required: Air Freight
Basic conditions:
1 weeks
Lead time (Europe) (l)
Carrying cost .12
Review period (p) 1 week
Line item fill rate .98

Safety stock calculations from basic conditions and case data:

Monthly Monthly Std Weekly Weekly Std Dev Safety Safety L(z) z
Europ Mean Std Dev Dev/ Mean Std Dev over p+l Stock Stock
e Mean in
Option Weeks
s
A 42.3 32.4 .77 10 16 22 44 4.5 .0089 1.98
AA 420.2 204.9 .49 97 98 139 250 2.6 .0140 1.81
AB 15,830.1 5,625.6 .36 3,653 2,702 3,821 6,425 1.8 .0191 1.68
AQ 2,301.2 1,168.5 .51 531 561 794 1,449 2.7 .0134 1.83
AU 4,208.0 2,204.6 .52 971 1,059 21,498 2,752 2.8 .0130 1.84
AY 306.8 103.1 .34 71 50 70 116 1.6 .0202 1.66
Total 23,108.6 5,333 11,037 2.1

Results:
$127,986
Holding cost of cycle stock
Holding cost of safety stock $529.784
Holding cost of pipeline inventory $255,972
Total supply chain holding cost $913.742

* Airfreight not considered

Postponement: Statistical “Trick”

– Statistical Puzzle: How do you sum up means and

standard deviations of independent demand
distributions?

– For means: Easy - just add them up! 

– For Standard Deviations: The standard deviation of a

series of random events equals the square root of the
sum of the variances
 12 
2
2
 
2
1 2

– Example: σ1=3, σ2=4 => σ12=5

Estimation of Inventory Required: Distribution
Center Localization of a Generic Printer
Basic conditions:
5 weeks
Lead time (Europe) (l)
Carrying cost .12
Review period (p) 1 week
Line item fill rate .98

Safety stock calculations from basic conditions and case data:

Monthly Monthly Std Weekly Weekly Std Dev Safety Safety L(z) z
Europ Mean Std Dev Dev/ Mean Std Dev over p+l Stock Stock
e Mean in
Option Weeks
s
A 42.3 32.4 .77 10 16 22 44 4.5 .0089 1.98
AA 420.2 204.9 .49 97 98 139 250 2.6 .0140 1.81
AB 15,830.1 5,625.6 .36 3,653 2,702 3,821 6,425 1.8 .0191 1.68
AQ 2,301.2 1,168.5 .51 531 561 794 1,449 2.7 .0134 1.83
AU 4,208.0 2,204.6 .52 971 1,059 21,498 2,752 2.8 .0130 1.84
AY 306.8 103.1 .34 71 50 70 116 1.6 .0202 1.66
Total 23,108.6 5,333 11,037 2.1

Generi 23,108.6 6244.0 .27 5,333 3,000 7,347 13,175 2.5 .0145 1.79
c
Results:
$127,986 *The standard deviation of a series of random events
Holding cost of cycle stock
equals the square root of the sum of the variances
Holding cost of safety stock $632,393 σ(16,..50)=SQRT Σ()162, ..., 502).
Holding cost of pipeline inventory $1,279,860
Total supply chain holding cost $2,040,239

*indirect effects (e.g. lead time) not considered

Inventory Benefits from Localization
(Postponement)
Inventory benefits of postponement when shipping by sea

28000

Vancouver
Postponement
safety stock

23000

18000

13000
97.00% 97.50% 98.00% 98.50% 99.00% 99.50% 100.00%
fill rate
Comparison of Scenarios
Sea Freight L=5 Generic Localized Solution L=5
$127,986
$127,992 Holding cost of cycle stock
Holding cost of cycle stock
Holding cost of safety stock $632,393

Holding cost of safety stock $1,043.952 Holding cost of pipeline inventory $1,279,860

Holding cost of pipeline inventory $1,279,920

Total supply chain holding cost $2,040,239
Total supply chain holding cost $2,451.864

Air Freight L=1

$127,986
Holding cost of cycle stock

Holding cost of safety stock $529.784

Holding cost of pipeline inventory $255,972

Total supply chain holding cost $913.742

 What Really Happened …

– Deskjet re-designed to be DC-localizable (postponement).

Implementation in early 1992.
– Millions of dollars saved from inventory reduction, service
improvement, and freight reduction.
– Innovative packaging won patents.
– All Vancouver products now DC-localizable
(postponement).
– Vancouver as showcase for “Design for
Localization/Postponement” -- Best practices spreads to
other HP divisions.
Reactions to DPD Proposal
– Manufacturing: blessing

– Engineering: changes mean disasters to great products

– Finance: calculate duties and customs

– Marketing: check for benefits of increased local presence

– European distribution: add non-value-added activities

• who pays?
• who trains?
• procurement problems
• Vancouver stockouts now
• too much Vancouver inventory now
When is Localization/Postponement appropriate?

– High uncertainty in demand mix

– Long lead times
– Short product life cycle
– High inventory /stock out costs
– Not too costly/time consuming to customize
– High value to core component
– Low variable cost of differentiating components
Epilogue: HP - Shift Away from Postponement?
HP Supply Chain Today
Epiloque: Framework for Supply Chain Design
Risk Pooling Summary

– Risk pooling strategies are most effective when total

demand uncertainty is lower than the uncertainty for
individual products/locations.
– A little bit of risk pooling goes a long way:
• With location pooling the biggest bang is from pooling a
few locations
• With capacity pooling a little bit of well designed flexibility
is very effective.
– Risk pooling strategies do not help reduce pipeline
inventory.
– Risk pooling allows a firm to “have its cake and eat it too”
• It is possible to lower inventory and increase service
simultaneously.