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    SPECIAL REPORT ~ PRODUCTION AND INVENTORY CONTROL Physical Distribution: The Analysis of Inventory and Location LEROY. B. SCHWARZ ‘Krannert Graduate Schoo! of Management Purdue University West Lafayets, Indiana 47907 Abstract: The cost and service level performance of a manufacturing system or a distribution system depend heavily on the interaction between the physical system design and the inventory control system. This paper examines that interaction and provides some general analytical guidelines for (1) the determination of total system inventory and its distribution within a fixed system design, and (2) the determination of system design as suggested or favored by inventory considerations. ‘© This paper is concerned with the physical distribution of inventory within a multi-activity manufacturing and/or distr bution system. (See Ballou [4, Chap. 1] for a more compre- hensive description of the Key elements and supporting activities of physical distribution.) In a manufacturing system the physical distribution of inventory involves the determination of total system inventory, the partition of system inventory into raw, work.in-process, and finished ‘goods categories, and the allocation of these categorical stocks to specific manufacturing, processing, assembly, or warehousing sites. In a distribution system the physical distribution of inventory involves the determination of total system inventory, the partition of system inventory into retail, warehouse, and manufacturing finished-goods inven- tories, and the allocation of these categorical stocks 10 specific inventory sites ‘The physical distribution of inventory is an extremely important problem for any multiactivity organization. According to a recent survey [27], physical distribution costs consume about 14% of the sales dollar for the average manufacturing firm and about 26% of the sales dollar for the average merchandising firm. The National Council of Physical Distribution Management (NCPDM) estimates that Paper was handled by the developers ofthe Special Report on Pro- Auction and laventory Control, Professors Wiliam L. Berry and Vincent A. Mabert the physical distribution of goods from producer to con- sumer accounts for about 20% of the US Gross National Product (GNP). For many firms, inventory costsalone are approximately as large as before tax operating profits [25] And all these estimates ignore the costs resulting from weaknesses or inadequacies of the physical distribution system;eg,,lost sales, loss of customer good will, expediting costs, ote Obviously the profit potential for improved system design andjor inventory control is considerable. However, the challenges are also considerable. One such challenge is posed. by the uncertainties inherent in these systems, principally ‘customer demand uncertainties and supplier performance uncertainties (e.g., delivery times and quantities). Another challenge to improved system design and inventory control is cost estimation: sometimes important cost components (ea., the cost of a lost sale) are literally unknown; some- times “variable” costs with respect to physical distribution are buried in “overhead” cost categories. Yet another challenge-and perhaps the most important one—is the fact that system performance and cost depend in large part on the interaction between the physical system design and the inventory control system. For example, the location of warehouse facilities and the allocation ‘of customers to warehouses has a significant effect on the alternatives for and constraints on total inventory investment, inventory distribution, and customer service. On the other hand, the 138 (0569-5554/81/0600-0138/82.00/0 © 1981 AUE ALE TRANSACTIONS, Volume 13, No.2 production/inventory policies used to operate a system can hhave 4 significant effect on the design parameters of the physical system. For example, the use of different lot-size heuristics in a material requirements planning (MRP) system ‘can significantly affect the size and distribution of system inventories, and through them, the desited production and storage capacities of system sites. Despite the considerable cost or profit implications of these interactions, there has been no systematic study of them, This paper is a step toward that goal. We shall be concerned with two general questions: 1, Given the design of a multilevel production or distribu. tion system, what is the appropriate amount of total system inventory, and how should that inventory be distributed within the system? 2. How should production or distribution system design be influenced by inventory considerations and costs? ‘These questions are intentionally broad ones. They are ‘broad because itis my hope that their ultimate answers will be correspondingly broad. We are far from complete answers. However, in what follows f will outline my recommenda tions for what Wagner (43, p.290] has prescribed as “some rules of thumb, developed from analytical studies, to guide the basic design of @ production. and inventory-planning system.” It is possible, of course, to ask much more specific questions (subject to specific assumptions about demand rates, costs, system structures, etc.). Unfortunately, the answers to these questions, when available, are correspond- ingly specific, and seem to bear no common characteristics In what follows I will identify the common characteristics seen in the existing literature. See [19] end [23] for general reference and [18] for a research bibliouraphy in location analysis. See [1], [9], and [42] for surveys of single and multilevel inventory control models. 1 will also. present some new ideas and discuss guidelines derived from them. However, all of the guidelines below are, zt best, only partial answers to the questions raised above. Perhaps this paper will stimulate the publication of additional guidelines. ‘This is my sincere hope. Inventory Considerations in a Fixed Production/ Distribution System In this section we will consider general guidelines affecting inventory determination within the confines of a fixed production or distribution system. There are two fundamen- tal questions: (1) What should be the size of total system inventory investment? @) How should that inventory be distributed within the system? I shall examine these questions in two different settings. fone in manufacturing and one in distribution. in the manu facturing setting we will consider the manufacture of a single product with a fixed production design (eg. fixed product engineering, fixed bill of material, fixed manufacturing operation, etc.) and examine considerations affecting inven- tory investment and its distribution with respect to raw ‘material, work in process(WIP), and finished goodsinventory. In the distribution setting we will consider the distribution of a single product with 2 fixed distribution channel and examine considerations with respect to total system inven- tory snd its geographical distribution within the system, Inventory System Criteria and Costs ‘The proper choice of an inventory control system requires ‘an understanding of (1) the measures of inventory system performance, and (2) the “variable” costs of inventory ‘management. In addition, a veriety of other factors should be considered, Inventory System Performance Measures Inventory system performance, or service level, may be measured in a variety of ways. The principal measures are Fill Rate — the average fraction of unit demand which 4 given stocking location can satisfy, or “fil,” from on- hand inventory. Fill rar is also the probability that the stocking location has no backorders at a random point in time. Fills [15], a closely related measure, is the average number of unit demands per unit time that can be filled from onshand inventory. Fills = (Fill Rate) x (Demand Rate) Fxpected Back Orders — the time-weighted average number of back orders (including zero) outstanding at a stocking location. Expected Delay — the demand.weighted average time (Gncluding zero) that a unit demand must wait before being filled by a stocking location. It is easily shown that Expected Delay = (Expected Back Orders) + (Expected Demand); see [28] Very specil consideration must be given tothe meaning of these measures in the context of a mualevel production) inventory system. For example, in a distribution system consisting of one or more warehouses supplying N retailers, system performance from a customer standpoint depends solely on retailer fill rates or back orders (or some retail- demand.veighted average thereof), not on warehouse fill rates, back orders, etc. In such a system, out-of-stock condi tions at a warehouse affect system performance only in- directly, by increasing retsiler lead times. Such delays only affect system performance if lst sales or back orders at one or more retailers are a consequence (see (31]). In a manu- facturing setting, say the assembly of single end product June 198 1, AUIE TRANSACTIONS 139 from independent components, the component fill aes, Fi 1... ai, only indicate the probability. I1Y,F;, of being able to assemble one unit ofthe end product Inventory Costs We shall confine our attention only (0 those costs (out: ofpocket and opportunity costs) whose magnitude is af fected by the inventory plan—and which, in turn, affect the inventory plan for a fixed production/inventory system: Inventory Holding Cost includes the cost of capital fon purchased goods and labor value added, taxes, in- surance, storage costs (heat, light, rftigeration),shrinkage, spoilage, and related costs, Order or Setup Cost includes those clerical and other processing costs associated with ordey preparation or receipt which are independent of the quantity ordered or produced, This cost includes order writing, pricing, shop- order scheduling, expediting, postage, etc Penalty Cost includes all of those costs which occur directly or indirectly as a consequence of an out-of-stock condition at an inventory location. If an out-of-stock condition occurs at an inventory location servicing custo- mer demand, a lost sale may occur; alternatively, the customer may agree to accept a delivery delay, or back onder. Lost sales and back orders may result in immediate costs (eg, the lost contribution to profit and overhead, explicit contract penalties, etc.) and delayed costs (eg. loss of future business, loss of goodwill, etc.). In an attempt {0 avoid or minimize the cost consequences of a lost sale or back order, the system may attempt to expedite production or delivery from its supplier, trans- ship from an alternative location, or substitute a more costly or less profitable item in stock, All of these tactics have associated costs. Cost estimation is an extremely difficult and often frustrating process for the inventory analyst, Many of the components of order cost and inventory holding cost are literally “buried” in overhead cost categories. Further, many ‘of the costs associated with outof'stock conditions are extremely difficult to estimate; ¢g., what is the cost of @ Tost sale, 0:, wnat is the longsun cost of goodwill loss? Although “better” cost accounting should allow the analyst better estimates of “buried” variable costs, the difficulty of, precisely estimating penalty costs will likely never be relieved, Preliminary sensitivity analysis (see [34], pp. 85- 91) indicates that total inventory-related costs may be relatively insensitive to errors in estimating holding and order costs, However, more sensitivity analysis must be performed, particularly with respect (o penalty cost compo- One consequence of the difficulty of estimating penalty costs is that models of real-world inventory systems are almost universally cost/servicedevel models as opposed to costonly models, This fact underscores the importance of understanding what service-level measures really mean in multilevel production/inventory system. Other Considerations In addition ro costs and performance measures, the in ventory analyst must also consider other factors. For @ ‘multilevel system perhaps the most important of these other factors is system stability. Unfortunately, itis not well known that multistage decision systems can behave in un- stable, unexpected, nonintuitive ways when subjected to relatively minor changes in their environment (see [17] and [29]). Further, and perhaps as a consequence, there has been very little attention to the criterion of system stability in the management science literature, with two exceptions ([29, Chapter 8] and [41]). Consequently very title is Known about how to make multistage inventory control systems stable. in particular, the role of inventory in system stability/instability is unknown. Nonetheless, in the sense that instability can literally destroy an inventory system, stability must ultimately be regarded as the most important criterion of system operation, related factor is compati- Diicy of the inventory management system with the other management systems in the organization. For example, centralized inventory management may not be compatible with a general management philosophy of decentralized 0 per unit per unit time on its echelon inventory, j=1,2. Under continuous review with no back orders or lost sales, it can be shown that a policy which minimizes average system cost per unit time over an infinite time horizon ean be described by three Variables: Q3, the stationary lot size ordered by stage 2; Qs, the stationary lot size ordered by stage 1; and a positive integer n = Q2/Q1 (see (371). tl According tote system myopic heuristic, sand n must satisfy 2D(K, +nKi) 7 y= | , 1 ofa]. o where isthe smallest integer satsying ha Kil ninth) > @ Let us interpret these formulas: Q: is the basic EOQ formula provided that the fixed order cost is viewed as the sum of all fixed order costs incurred per lt size of 3 (one Kz plus m_ Ky’s), and provided that the marginal holding cost rate used isthe sum of all the incremental holding costs applicable to 3 (note that stage I's average echelon inven- tony is (I/n}th of stage 2's average echelon inventory). The formula for 1 has a less obvious interpretation. However, if we force equality in (2) and relax the integrality constraint fon n, we observe That is, n is approximately what would be obtained if one divided the simple EOQ at stage 2 by the simple EOQ at stage 1! In fact, m in (3) can be shown to be no more than fone unit from the smallest integer m satisfying (2). However, the relevant holding cost rates are the echelon holding cost rates Further support for the importance of echelon holding cost rates is provided by Blackburn and Millen [7] in their study of various sequential lot-size heuristics in a material requirements planning (MRP) setting. In particular, they provide an analytical demonstration of why the use of con- ventional single-stage heuristics (eg., Wagner and Whitin [44], Silver and Meal [39] , and Part-Period Balancing[20} ) can result in unsatisfactory results, They also demonstrate the relevance of echelon holding cost rates to these proce- dures and present a set of simple modifications—all using ‘echelon holding ratesand demonstrate that these modifica tions provide superior results in a simulated environment using rolling horizons and time-varying demand, ‘The Impact of Echelon Holding Cost Rates If'we make the reasonable assumption that, regardless ofall other considerations, the larger the estimated holding cost rate at a production/inventory site, the smaller and more frequent the orders placed (or production lots made) by it, ‘with resulting smaller average inventories, then the following generalities are suggested by the use of echelon holding cost rates versus conventional rates. In a Distribution System [see Fig. 1(a), for example] echelon holding rates will motivate the same size and frequency of orders by the highest level stocking point; e¢., the factory or national warehouse (e.g, stage 7) and the same total system inventory as conventional holding cost tates. This is because at such stages the echelon and con- ventional holding rates are identical. However, the geo: graphic distribution of this inventory within the system will be quite different. In general the effect of echelon versus conventional holding rates will be to shift system inventory towards the lowest level stocking points, eg. the retailers ae AIIE TRANSACTIONS, Volume 13, No.2 Ail stocking points below the highest one will be affected, tke size of the effect depending on the difference between stage’s conventional holding cost rate and that ofits supplier. However, in all cases lot sizes and average echelon inven- tories will be larger than analysis of conventional rates ‘would prescribe. For example, i(fotsizing decisions in the system in Fig. 1(@) were made using an BOQ model, then stage 5's order size and average echelon inventory would Jncrease by about 40% (by a factor of 2/1) and stage I's ‘otder size and average on-hand inventory would increase by about 70% (by a factor of V3) 1). The managerial mplica tions of these policy changes can be quite considerable: retailer lot sizes and average inventories will be increased, pethaps considerably, necessitating more retail shelf space but fewer, es frequent orders. Customer processing activity wii, of course, be unchanged. The larger tetall cycle inven tories will mean fewer opportunities for retail back order or lost sales, This will have the effect of increasing retailer fill rates and reducing customer delays and back orders. However, given that total system inventory is unchanged, there will be less system backup in the event of a stockout situation at a given retailer. The effect on the highest level stocking point i also considerable: lot sizes and ordering frequency are unaffected; however, average on-hand inven tories ae reduced, perhaps considerably, and, given that the highest level stocking points successors, or “customers,” are ordering in larger lot sizes (less frequently), there will bea reduction in order fling/shipping activity at this stage Intermediate stocking points have increased lot size, hence Jess ordering activity, and @ reduction in order filing! shipping. activity Jn a Manufacturing/ Assembly System (see Fig. 1b), for example} echelon holding rates will motivate the same size and frequency of orders for the highest level stocking points, such as raw materials and purchased components (4. stages 6 through 8), and the same echelon inventory for these items as conventional holding rates. Again, this is because at these stages the echelon and conventional holding rates are identical. However, the physical form of this inventory will be quite different. In general the effect of echelon versus conventional holding rates will be to shift system inventory towards finished goods, All manufacturing) assembly processes will be affected, the size of the effect depending on the difference between a given stage’s com ventional inventory cost rate and that of its components. In all cases, however, production lot sizes and average echelon inventories of the final and all intermediate manufacturing processes will increase. For exzmple, if lotsizing decisions in the system in Fig, 1(b) were made using an EOQ model, then stage 3's fot size and echelon inventory would increase about 145% (by a factor of 3/V.5); the production lot Size for stage I and the average finished-goods inventory ‘would increase about 125%, The managerial implications of these policy changes can be quite conskierable: finished s00ds inventories will increas, necessitating more space for finished inventory. The farger finished goods inventories will provide a better buffer against uncertainties in customer demand, However, in the event of a stockout, the average time to the next planned final assembly might be longer. Production lot sizes for all manufacturing and assembly ‘operations will increase. This implies fewer production set- ups and the potential for greater production efficiency (less down time for setups) {nventory Determination in System Subject to Uncertainty Uncertainty can affect an inventory system in two funda mental ways: through system demand and system supply ‘The specific effect in each case may be in aiming (e.g.,when a customer demand occurs er when @ raw material is delivered), in quantiy (e.g, how large a customer demand will be or how much ordered raw material is actually delivered), oF some combination of timing and quantity. In some instances management has some control or influence over uncertainty’ (eg. marketing); in some cases aot (€., randomness or unexpected events). See Betty and Whybatk {6} for a thoughtful classification of system uncertainty, a general discussion of alternative buffering alternatives (c.g, reducing uncertainty, excess capacity, quantity buffers, and time buffers), and a brief general discussion of consid erations affecting the choice ofa buffering alternative. Mathematical analysis of inventory determination for multilevel systems has, to date, yielded few useful analytical guidelines for managing uncertainty. The reason is simple ‘The problems are quite complex ones. For example, cons der a single retaller facing stationary unit Poisson demand aver time and using a (Q.7) policy, which requires that ‘whenever inventory position (the on-hand inventory plus al units on order less all outstanding back orders) falls tr, the retailer orders Q. This problem has been modeled exactly by Hadley and Whitin [22, hap. 4] under the assumptions of fixed lead times and back ordering. Now consider the demand process faced by the warehouse supplying V such ‘entical retailers: it isthe superposition, or overlay, of V identical Erlang.0 processes. This process has no convenient analytical form, a fact which virtually prohibits the exact analysis of even this simple system (see (35, Chap.8]). ‘Another complexity of multilevel system analysis is the transformation of system uncertainty. Thiscan be illustrated in a simple MRP environment: consider a two-stage manu- ‘facturing system (e.., Fig. 2) and ignore determination of buffer stocks for the end item: by selecting an EOQ lot sizing strategy for the end product (stage 1), end-product customer demand uncertainty, which may have both timing and quantity elements, is transformed into timing uncer- tainty for stage 2 (demand quantities on stage 2 will all be known to equal some [bill-of-materials] multiple of stage I's fixed lot size). By selecting a POQ lotsizing strategy at stage 1, end-product uncertainty is transformed into quan- tity uncertainty for stage 2 (variable demand quantities will ‘ccur every POO interval). These difficuities and others virtually prohibit the formulation of analytically derived suidelines forall but the simplest system structures. However, these guidelines are nonetheless useful: June 1981, AIIE TRANSACTIONS 143 Allocation of Distribution System Stocks ‘Simpson [40] has established two theorems with respect to the allocation of system inventory fora system consisting of m inventory locations, called warehouses, supplied and controlled by a central agency. A fixed quantity, Q,is to be alloeated among the warehouses as inventory to satisiy unknown customer demand over some specified period of time. Demand at warehouse i is given by a known proba- bility distribution Py, whereA(S,=/,) denotes the probability that demand at warehouse ,S,, equals its inventory, J, Two situations are considered. Inthe first situation, called “the emergency replenishment case,” warehouse i incurs a cost penalty (which may be thought of as an emergency expediting cost) whenever its inventory falls t0 a trigger level aj-Simpson proves that in this situation a necessary condition for minimum total expected system penalty cost, is that Q be allocated so that the weighted probabilities PIAS; >Q,—a,) be equal forall warehouses, BP 0, 0. Note that when p, = p and a; = 0 for all, this necessary condition equalizes the probability of a stockout at all warehouses. In the second situation, called the ease of “no emergency replenishment,” warehouse 1 incurs a penalty cost 1, for each unit of unsatisfied customer demand Simpson proves that in this situation a necessary condition for minimum total expected system penalty cos is thatthe weighted probabilities w,P(S,>Q,) be equal for all ware- houses Simpson's guidelines are to be found in the work of Eppen [14], Allen [2], [3], and others. For example, Allen [2] considers the redistribution of inventory in a situation identical to the no-emergeney-teplensiment case of Simpson except that mo outside stock is available. Instead, exiting system stock must be redistributed among the m warehouses at a unit cost ry from warehouse { t0 warehouse /. Allen proves that any postive redistribution bermeen ‘and equates the difference between the weighted shortage probability of the receiver and that ofthe shipper to the unit cost of transportation. Allocation of Production Distribution Stocks A littleknown paper by Hanssman [24] provides a conceptually useful framework for understanding the impact of inventory location on system profits. Hanssman considers a tworstage serial production system (one semifinished good and one finished product) facing normally distributed out- side end-product demand in a petiodic-review environment. Each stage uses a simple demand replenishment stocking rule. (In this rule, orders are placed each period to bring inventory position at each stage up to a predetermined target level each petiod.) Customer demand is assumed to be a function of the expected back orders (or delay) at the end-product level. The object is to determine the target ‘evel Jnventory at both stages in order to maximize expected system profits given a known contsibution margin for each unit sold and marginal holding costs A, for inventory on- hand at stage «Although the model is only approximate in some respects, its analysis does point out:(1) the relationship betiveen customer demand and service level expected back orders); and (2) the trade-offs involved in locating fixed system inventories (e.., the larger the semifinished inven- tory, the smaller stage I's supply uncertainty; the smaller the semifinished inventory, the larger stage I's safety stock but the larger its supply uncertainty.) ‘A Deterministic Model One model we have found useful in providing guidelines for the analysis of uncertainty in multilevel systems is a deterministic model as follows Consider a twosstage serial system (eg., Fig.2). Assume that stage 1 faces constant customer demand rate X and replenishes its inventory with orders of lot size Q, placed whenever its inventory postion falls to r,-Stage 1’ reorder point,r, is defined asr; =A, +5, where Ly is the fixed lead time between stage 1 and 2 provided that stage 2 has inventory to ship; S, is stage 1's safety stock. Stage 2 supplies stage 1, and thus faces the same average demand rate, Stage 2 replenishes its inventory with orders of lot size Q; placed whenever its inventory position fallsto rs r= Ny +S, where Lis the fixed lead time to receive orders at stage 2, and 5, is stage 2's safety stock. Stage 2 receives its supply from an unlimited source outside the system, The optimization problem of interest is to allocate a fixed system safety stock, 5, in order to maximize customer {ll ate, F, ,and minimize customer expected delay, Ty (Ot, equivalently, minimize customer expected back orders, Bs). Mathematically, Max Fy @ and Min 7, 6) subject 10 Si +52 <8 O) Under the assumptions that 5 is infinitely divisible (inte- srality ignored), and that thelumpy demand process at stage 2 may be approximated by a uniform demand process, it can be shown that for given values of S, and 5: the conresponding values for F and 7, may be determined as follows: First, determine 7; , the expected delay at stage 2 from Table 1. Second, given $, and Tz, find F, and 7 in Table 2. In some cases the solution is not unique (eg., for $ very large, Ft = | and 7 = Ofor almost any values S; and S). ‘Table 1: and Ts a6 a function of Sa S Fy th S20 1 ° S st - ~Qs, stage I's effective safety stock is increased by reducing S; and increasing Sy correspondingly. In brief, this is why the optimal solution to conditions (4) — (6) is S¢=-0, and SP=S +03 Of course it is optimistic 10 imagine that mote compli- cated systems with stochastic demand yield such simple tradeoffs. However, it would not be surprising to find that analysis of more complicated systems yielded regions of policy space over which a given stages effective safety stock ‘was consistently increasing (or decreasing) depending upon Whether the incremental nit of system inventory was placed at { versus 7s predecesor. If $0, then the optimization problem reducesto determining or estimating the boundaries, of those regions, Verification ofthis possiblity ean be found in the Hadley/Whitin singledevel stochastic (Q, P) model [36]. In particular, it can be shown that, as indicated by the deterministic model, there i a tegion of space over which expected delay is approximately a second-order polynomial in its safety stock (a8 T> isin $; for -O2 <5 = © in Table 1), and a tepion of space over which expected delay isLnearinits safety stock (@s 73 isin, for S <-Qs). ‘This suggests that a two-stage stochastic system which was, modeled as two Hadley/Whitin models linked by the sup- pliers expected delay Would yield a policy space as described ‘This is indeed the case (see [36]}. Predecessor Safety Stock: Optimal policy in the deter- ministic system is obtained by setting stage 2°s safety stock, Sz, equal to -Q; and allocating stage 2's “extra” safety Tune 1981, AIIE TRANSACTIONS 145 stock to stage 1. (In fact, the analysis in the Appendix Indicates that all values of Sy <~Qz with corresponding values of 5;, 5, =5-Sz, yield the same desired results. This is because, for S, <~Qp, stage 1's effective safety stock is a constant.) This policy implies that stage 2 main- tains a policy of no uncommitted on-hand inventory. In other words, not only should stage 2 ignore holding positive safety stock, but it should set its safety stock so that every incoming order clears all outstanding back orders and leaves @ zero-on-hand (and net) inventory. This somewhat surprising result is consistent with con- ventional wiscom about safety stocks for multilevel systems. For example, Orlicky (33, p. 79] says of safety stock policy in an MRP system: “Safety stock is properly applied only to inventory items subject to independent demand” (¢., ‘end products). Otherwise it has litle intuitive appeal beyond the obvious view that a given stages effective safety stock is iectly affected by increasing its safety stock, but only indirectly affected if its predecessor's safety stock is in- creased. However, in their analysis of optimal safety stock policies for a one-warehouse Ndentical-retailer distribution system managed using (Q, r) replenishment policies and facing Poisson unit demand (36],, Schwarz er al. have been able to verify empirically the near-optimality of this policy. Is it possible that conventional wisdom has been correct all along? To be more precise: it possible that conventional wisdom is wrong in this instance only to the extent that itis not extreme enough? More research on this fascinating prospect is heatily encouraged. Other Studies ‘A variety of other studies are relevant to the location of inventory in a multilevel system facing stochastic demand. Miler er al, [30] compare alternative forecasting strategies for multistage production/inventory systems and provide some guidelines for when dependent versus independent forecasting strategies yield better forecasts for the demand on a given stocking location's inventory. In an independent strategy, the predecessor/successor relationships between stages are ignored and only the time series of agiven location's past demand is used for forecasting. In a dependent strategy, these relationships are exploited in a requirements planning fashion. There have also been a few very small scale empirical studies comparing the effectiveness of dif ferent buffering strategies in a simple MRP environment (see [8] and [45]). The Influence Inventory Considerations Should Have on System Design In this section we will consider the influence inventory considerations should have on system design. In a distribu- tion setting system design is concerned with the determina. tion of the number of inventory stocking points and their geographic location, the determination of which stocking points should serve which sector of customer demand, and the determination of the network of supply which links the stocking points into a distribution system. This i the wel: known “Jocation/allocation” problem. In 2 manufacturing setting system design is concerned with the determination of the number of components and their characteristics (.g the bill of material), the determination of the geographic or organizational sites for manufacture or purchase of these components, and the determination of the assembly net work used to combine components into a given end product. Of course a wide variety of factor affect system design. In a distribution setting, these factors include: transporta tion (usually divided into trunking cost, representing costs between system sites, and local deliery costs-see [13] fixed costs ofeach system ste (eg, administration, mainte: nance, and data processing); variable costs of each system site (eg., workforce, utilities); and a variety of marketing considerations (e4., convenience of customer acces), etc. In a manufacturing setting these factors include design, engineering and technological concerns, manufacturing ex: perience and expertise, resource utilization, fixed and vat able manufacturing costs, etc. We shall focus on the effects inventory considerations should have on system design ‘A number of facility location models are relevant 10 examining. the influence of inventory on system design Gross etal [35, Chap. 1] describe a framework for deter- mining the design of a multilocation distribution system and illustrate the use of this framework by embedding the Clark and Scarf [10] mulilocation inventory model in a ‘apacitated version of the fixed-charge location/allocation problem, Although this particular paper confines itself to Aistribution systems, the framework presented is equally applicable to manufacturing settings. Other published facility location models are relevant to the role of inventory to the extent that their cost structures reflect inventory cost behavior. Analysis of a variety of inventory polices suggests that inventory costs are generally approximately concave in demand (e4., the basic EOQ model) or throughput. Conse- quently, facility location models with concave costs are the most appropriate ones for review. Baumol and Wolfe [S] describe a model in which facility costs have a fixed component plus ¢ concave component, aV, where Vis the volume of demand served by the faclity and # and aare constants, a< 1. The value of @ may be chosen to best suit inventory cost considerations; e-. a= 5. They describe and illustrate a procedure to find local optima for this problem. Feldman er al. [16] examine a facility location model with continuous concave costs and present a heuristic algorithm similar to that of Kuehn and Hamburger [26]. Eilon et al, (13, Chap. 4] present a facility location model in which facility costs have a fixed component, linear component (in volume), and a square- root valume component.Their model also includes trunking and local delivery costs. They present a heuristic solution procedure One characteristic of concave facility costs in oeation/ allocation problems is that, in the absence of constraints on capacity, the optimal allocation for fixed locations isan extreme point. This implies that in a distribution setting all demand in a given location should be served by a single 146 AIIE TRANSACTIONS, Volume 13, No.2 source of supply. For example, a given customer demand should be entirely serviced by one retailer outlet; or @ given telailer should be supplied by only one supplier. In a manu- facturing setting this implies that a given processing stage receives @ given component pert or raw material from a single predecessor or supplier. This characteristic reflects the economic incentive to centralize inventories, This character- istic is examined below, Economic Incentives to Centralize Inventory From the standpoint of inventory cost and inventory space considerations alone, systems should be as centralized as possible. This characteristic can be obtained from a variety of models. Consider a siugle stocking ste managing inventory for # single product using a continvous-eview (Q, r > 0) model. Define D = Expected demand per unit time Fixed order cost Cn= (aventory holding cost per unit per unit time = Standard deviation of lead time demand SS = Safety stock =~, where sis the expected lead time demand. It can be shown that the expected ordering plus holding cst per unit time for this system is approximately TC(Q,r) GP TEO7) = —“-+ CoM + ColSS+ EB) » ©) where £(B) is the expected back orders per lead time, B)= fe-nowur, (a) and 6(+) is the density of lead time demand, If (+) is the normat density with mean y and standard deviation a, then i) where R() is the righthand unit normal linear fos integral IF we further assume the common practice of setting Q=[2C,D/Cn)%, the Wilson lot size, and setting safety stock to some multiple, k, of the standard deviation of lead time demand, 5 = ko, then (9) may be sizpliied to £1B)= 0R( ay TOD, = AC yCyD)* + Cy lk+ REDO. (12) ‘Now consider such stocking points (eg. retailers) in a decentralized system, each with expected demand time D, and lead time demand parameters yy, and 07, respectively The total decentralized system expected order plus holding cost per unit time, TC is TC, x x CECI Y DE + Gtk +O Do mt os 43) Alternatively, consider centralizing these inventories at a single geographic location with identical costs, The corres- ponding total expected order plus holding cast pet unit time, Toy is: Tle = (2C,Ch) 8 De" + Cy [k + RO) G0 a4) where = (Zopicd of, 0 na i! ie wo ((Z a) #25 won ed o. 06) where py is the correlation between lead time demands at i and From (15) and (16) it is clear that in all cases Moe Ty an This inequality is dictated by two separate effects: (I) the “portfolio” effect, under which the variance ofa sum is less tan or equal to the sum of the variances, and (2) the “EOO cost effect,” under which the total cost of holding and ordering per unit time under the optimal policy increases with the square rout of its parameters, To illustrate the potential for cost reduction through centralization assume D, and py; = O for alliand. i. Then Tp = N2C,CaDY#+ NC, ke + ROD (as) and Te =NAC,C.YPANAC, I+ ROJO. — (19) Consequently, Tp = NETC. 20) For example, if V=2, then TCp isapproximately 40% larger than TCg: for A’= 9, TCp is3 times larger! Similar incentives to centralization have been cited by Eppen [14] using an exact model of an infinite horizon, periodic review policy with normally distributed demand, ‘identical marginal holding costs, h, order penalty costs, p, and no fixed order cost. Dogramaci [12] provides similar analysis for yet another model, the “fundamental inventory model” of Naddor {32} June 1981, ANTE TRANSACTIONS 147 Similar arguments can be used to establish the inventory cost advantage of component commonalityin a manufactur- ing/assembly setting. In this setting the V retailers above represent the inventory sites for similar components in N separate end products. The centralized strategy above repre: sents. replacing the NV similar components by a single, ‘common component. Of course, it may be argued that the ‘common component will necessarily have to be a more costly one and, consequently, a more expensive one to carry in inventory. Although this 1s probably true, it is also possible that the large lot sizes for the common component provide greater production efficiencies, eg. ess setup time per unit, and the “learning curve” effect. In any event, in many cases the savings from centralization/commonality far outweigh the “extra” costs The Location of Inventory Storage Capacity _ ‘The analysis of inventory considerations in a fixed produc tion/distribution system provides some guidance with respect to the question of where inventory storage capacity should be provided in the design of a distribution or manufacturing system, It was shown that, all other things being equal, target inventories should increase or decrease not asa func: tion of conventional holding cost rates but asa function of the echelon holding cost rates. Further, in general, echelon inventory holding cost rates will shift inventory the system (eg. towards the retailers, and away from national warehouses, in a distribution’ system; towards finished goods, and away from raw materials, in a manu: facturing setting). As noted, the exact natute of the shift ‘depends on the relative values of the echelon and conven: ticnal cost rates. However, some further generalities may be outlined. For example, in those distribution settings in Which the conventional holding cost rates are largely inde- pendent of location (for example, suppose that conventional holding cost rates consist primarily of cost of capital and related charges), the echelon rates at all stages other than the highest one are likey to be small, perhaps quite smal, and the resulting echelon inventories quite large. Ifa retailer and the associated warehouse supplier are in the same approximate location (Le., subject to similar tax rates, ec.) then their respective inventory capacities should be inversely related to their relative costs of shelf space: the larger the differential the more inventory capacity should be provided at the warehouse. However, given the economic incentive to centralize inventories and the fixed costs associated with warehousing, unless the shelf space cost diferential is very considerable, serious consideration should be given to com- bining retail and warehouse sites. Interestingly, this practice is becoming a fairly common one. {As another example, consider a common manufacturing setting in which the differential in conventional holding cost rates between two successive production stages is largely attributable to the “value added” at the successor stage. In this setting the echelon holding rates will directly depend on the value added at the corresponding stage. From this it can be deduced that, al other things being equal, inventory should be physically held in component form as ‘opposed to “finished” form for a production stage with large value added (compared to its predecessor), and in “finished” ‘as opposed to component form for a production stage with small value added. Closing Remarks The broad questions raised in this paper are very important ‘ones. System design decisions (je., plant and equipment) and inventory control decisions usually involve an organi: tion’s largest and second-largest use of assets; itis vital that these decisions be coordinated in some manner. Of course it is possible, in principle, to construct a model for the simul- taneous determination of system design and inventory control (see (35, Chap. 1], for example). However, for the present, computational complexities prohibit the use of such general models in practice. For this reason and others, firms usually “solve” the design/inventory problem sequen- tially; eg., first, pick a design; second, determine inventory and other operating rules. It isin this context that guidelines of the type suggested above are invaluable decision aids. Appendix Consider a single-stage inventory mode! with constant demand rate A lt size Q, fixed lead time L,safety stock 5, and reorder point r = AL+5. When inventory” position reaches r an order is placed for Q units. Z. time units later, when Q is received, ner inventory (on-hand inventory less, back orders) will be Q + r= N= Q+ S. and on-hand inven tory wll be (Q +) where (x)= Max {0.x}. These values represent the maxima of these respective quantities: both values will decrease at the sate 2 until Q/A time units later, when net inventory will equal Q+5-Q=8 and on-hand inventory will equal S” (Se Fig. 3). We are interested in determining fll rate, F, expected back orders, 8, and expected delay, D, for this simple system. If § > 0, then the minimum onhand inventory per eydle is $°= $0. Consequently F= | and B= T=0. 17S <0, then the minimum on-hand inventory, 5°, is zero and minimum net inventory is negative. Consequently F-<1 and both Band Tare postive. Fig: Minima and maxima of net 148 AIIE T RANSACTIONS, Volume 13, No.2 1-Q ATs, Fy = 1 and 7, 0 for all values of (Sz, 5). In order to determine the optimizing values of S; and S, in each of the remaining six Tegions, it is necessary to compare OF/@S, with F/2 (or a7/aS, with 97/9S,)to determine the appropriate pol- icy. We will examine one such region to indicate the analysis, Consider -Q; <8;

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