Operations and Supply Chain Management

Week 4: Managing Inventory across the Supply Chain

Video 1: Module Overview - Managing Inventory Across the

Supply Chain

In this module, we are going to talk about 'Inventory'. Especially, our

objective will be to understand, what is the role being played by inventory
in supply chain management? And we will also try to understand how
inventory strategies are designed and developed. So especially, we will
cover about not only the role of inventory in supply chain management,
but we will also try to understand what are inventory costs; what are the
trade-offs involved; the different inventory control systems; the decision
models. We will specifically focus on the Q system which is continuous
review models. We will learn there the calculation of Economic Order
Quantity and the Reorder Point, as well as we will learn how to calculate
Safety Inventory or Buffer Inventory.
Then we will also talk about P system, where we will try to understand how
order-up to-levels are calculated. Then my colleague, Professor Arqum will
talk about newsvendor model, which is a single-period model.

Video 2: What is Inventory?

What is Inventory? That would be the focus of this presentation. We will
primarily try to understand, what is the role of inventory in supply chain
management. To define formally, inventory are all materials that are
recorded in the book of ledger of any organisation and kept in the stocks
for future use. So, that means that inventory refers to any stocks that has a
future use and has a monetary value attached to it. To give some examples
of inventory; it can be raw materials, it can be work-in-process, it can be
finished goods. So, on your screen you can see some examples of
inventory.
Maybe, fabrics coming from fabric manufacturers for an apparel
manufacturer. It can also be for a food processing unit, the finish tomato
ketchup bottles ready to be shift to the customers. It can be work-in-
process inventory for a printed circuit board manufacturing company
where the printed circuit boards move along the manufacturing process
and workers are working on the PCBs. It can also be consumables, like the
worker's hand gloves used by the workers while working on machines. So,
from an accounting point of view inventory can be raw material inventory,
it can be finished goods inventory, it can be work in process inventory, it
can be consumables, it can be spare parts and others.
Why do we need inventories? When we are facing the demand in a future
period, we do not know what the demand is. So therefore, we anticipate

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the demand, or we estimate the demand. This estimated demand is used
for planning the supply quantities or the production quantities. And this
production quantity or the supply quantities that will be finally available for
meeting the demand may not match. And as a result, there may be
occasions where there may not be enough supplies or inventory to meet
the demand.
The inventory plays an important role in this mismatch. When there are
shortages or the demand is more than the supply or whatever is being
produced, then the excess demand can be met from inventory. Therefore,
the inventory plays he role of a cushion where there are mismatches
between demand and the supply, so that stockouts situations or shortage
situations are minimised. From an inventory management point of view,
we may classify the inventory into cycle inventory, safety inventory,
anticipated inventory, for the seasonal demand and pipeline inventory. The
cycle inventory is the amount of inventory that is utilised or that is required
for meeting the regular demand for a period.
The safety inventory or buffer inventory is used for taking care of the
uncertain demand. The anticipated seasonal inventory is the inventory
that is required where demand goes up during a peak season and the
demand will be lower during off-peak season. So, to take care of these
seasonal variations in demand, the seasonal stocks or anticipated seasonal
inventory is utilised. The pipeline inventory is the portion of the inventory
which have been ordered by the buyer but have not been yet received by
the buyer. So, that means this inventory is in transit. That portion of
inventory is referred as pipeline inventory.

Video 3: What are Inventory Costs and Demand?

Now, we are going to talk about the various costs involved in taking
invented decisions and how these costs are traded off while taking
inventory decisions. Now, when we talk of inventory, the primary cost
associated with stocking goods or with inventory, are the amount of
money or the amount of capital that is locked with the inventory. So, for
this capital locked, either we pay interest, or we lose some opportunities,
and therefore, the interest cost or the opportunity cost of the capital
locked in the inventory becomes the important part of inventory cost.
Additionally, we will also have to install and handle the inventory.
There are taxes, insurance costs, shrinkage costs. So, all these costs
becomes part of inventory costs. And these costs are calculated as a
variable cost, per unit of inventory or as a percentage of inventory value.
The second important costs are the inventory stockout costs. That means,
when that demand is more than the inventory on hand, there will be
shortages. So, the stockout costs are also an important cost that has to be
included while taking inventory decisions. Another important cost in
inventory decision is the fix cost of ordering. However, let us first start with

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understanding what the inventory cost is, and how it affects business
performance.
To measure the inventory consequences, a common measure that is used
is inventory turnover ratio, which is defined as cost of goods sold over the
average inventory. The cost of goods sold numbers can be obtained from
the profit and loss account of the company, and the average inventory is
generally considered as the closing inventory that is available in the
balance sheet of the company. We can also calculate days of inventory by
considering the number of working days and dividing those working days
number by the inventory turnover ratio. This will give us an idea of the days
of inventory that I have to keep for getting the sales.
Now, we will take some examples of make-to-stock supply chains of few
major companies in India, for example, Tata Steel, Hindustan Unilever
Limited, Maruti Suzuki Limited, and Tata Motors. We can see in the fourth
column of the spreadsheet, the inventory numbers corresponding to the
year as well as corresponding to the company. In the fifth column we can
see the share of inventory as a percentage of sales. And if I take inventory
cost at 20% of the inventory value, then in the sixth column, we can also
see the costs involved for these companies.
And in the seventh column, we can see that if, by better management
practises, if we can reduce the inventory by only 1%, we can see in the
second last column the potential savings that we can have by saving or
reducing inventory by 1%. Similarly, we have few examples from the oil
industry, and we have also tried to see the inventory performance of some
make-to-order system. In this example, for the make-to-order system, if I
compare this with the make-to-stock system, we see that the average days
of inventory shown in the last column are relatively higher than the make-
to-stock system.
The higher days of inventory for the make-to-order system is actually a
sign of poor management practises or inefficiencies in their project
management practises. This basically highlights that, whatever was
planned could not be followed at the time of execution, and as a result,
goods may be lying on the shop floors, or the inventory may not be
moving. However, at the same time, we would naturally find that they will
also have a very higher missing deadlines, and in fact the missing
deadlines or in short insufficient inventory can be quite serious.
This we have seen with the example of the retail industry in module 1, that
in the retail industry we have an estimated stock out cost of $1.1 trillion for
year 2014, which is equal to the size of the Australian economy. And this
highlights that stock out costs can also be quite significant for a firm. And
therefore, when taking inventory decisions, we need to take a trade-off or
we need to do a trade off between the inventory cost on one side, as well
as the inventory stockout cost or the consequences of stockouts on the
other side.

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There is also another important costs that are associated with taking
inventory decisions, that is the fixed cost of ordering or fixed cost of
production. In order to reduce inventory, I can produce more, I can order
frequently. However, this will increase the cost of ordering, which includes
the fixed cost of processing the orders, the administrative cost of taking
decisions, the transportation cost, the receiving cost, the inspection cost;
these are fixed in nature which are incurred every time an order is placed.
In case of production, the ordering in smaller lots to reduce inventory will
lead to more changeovers, more set up changes that increases the fixed
cost.
Therefore, to take inventory decisions, we have to trade-off these three
costs: inventory ordering costs, inventory costs which is also known as or
referred as inventory carrying costs, and the consequences or the cost of
stockouts.

Video 4: Inventory Control Systems and Deterministic

Models - Part A
Now, we are going to talk about the various inventory control systems that
are usually used. We will primarily try to understand, for what context
which type of control systems are more suitable. For understanding or
deciding which model to be applied for what context, we have to
understand the nature of demand. Demand can be deterministic; demand
can be uncertain. Demand can be dependent demand; demand can be
independent demand. So, let us first understand what independent
demand is. When we talk of finished goods inventory, the demand is faced
from the customers who are independently placing orders for the finished
goods.
So, such demands are referred as independent demand. Even for spare
parts, whose demand is generated by random failures of machines or due
to maintenance requirements, may also be treated as independent
demand.
However, for parts and components which are assembled to make the
finished product are slightly different than the demand for the finished
products or the demand for spares. Take the example of a car. The
demand for car is independent. However, the demand for the wheels is
dependent on the demand that is realised for the end product, that is the
car. So, for every unit of demand for a car, we will require four wheels. So, in
that case the demand for the part, wheels is a dependent on the demand
for the finished cars.
Now when we are talking of inventory systems, in this video we are
basically talking about independent system. For the dependent demand,
we have in earlier videos have learned how organisations prepare plans in
the form of sales and operations plan as well as material requirements
plan for managing the inventory of such parts and components. In terms

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of inventory control system, we will primarily talk about the continuous
review system, assuming that the demand is deterministic. The
deterministic refers to demand not varying, which we will refer to the
average demand of any finished goods or spares. Then we will realise this
assumption and then we will try to see how the inventory can be managed
when the demand is random or uncertain.
One of the specific points that is to be noted about continuous review
system is that, the monitoring of the inventory has to be done on a
continuous basis. And whenever the inventory level drops down to a point,
we place an order. Because the inventory has to be continuously
monitored, the review system or the inventory system is referred as
continuous review system. This system is generally used for products that
are costly or that have high inventory value or the value of conjunction is
higher or even for critical parts for which the stock outs can have very high
consequences.
But there are also many products whose inventory consequences maybe
moderate. In such cases, rather than monitoring the inventory on a
continuous basis, we may look at the inventory or we review the inventory
at some specific intervals of time on a regular basis or periodically. So, such
inventory systems are referred as periodic review system. Imagine a store
selling cooldrinks or beverages. Generally, these stores places their orders
maybe once in a week or twice in a week. So, every week or every alternate
week, the retailer places an order. In this example, the order is placed after
a fixed interval of time.
So, the placement of the order or the timing of the placement of order is
pre-decided. But at the time of placing the order, how many units to be
ordered? That is decided based on the inventory that is remaining in the
stock. Such a system is referred as periodic review system. We will also talk
about single period model or most popularly known as Newsvendor
model. This model will be discussed by my colleague, Professor Arkham
Martin.

Video 5: Inventory Control Systems and deterministic models

- Part B
Now for understanding, how actually operationally these three inventory
systems play out, we actually take a simple example of a retailer who is
selling one fashion product in the form of handbags. Assume that this
retailer faces a demand of 100 units every week on an average. However,
the retailer to meet the demand, places an order of 600 units every three
weeks. So, in this example, there are two decisions that we can see. One
decision is that every three week, or every third week, the retailer places an
order of 600 units. So, there is a decision to be made on the part of the
retailer, when to place the order and how much to place the order.

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Now if I look at, or if I try to draw the inventory balance or on-hand
inventory of the retailer and plot it against time over different weeks, then
it will look like the graph that is in front of you. At time zero, that means
the beginning of the first week, assume that we start with an on-hand
inventory of 600 units. Every week, 100 units are consumed and gradually
the inventory is depleted. And at some point, in time, inventory will reach
zero. And we can design a system such that exactly at that point in time,
another supplies arrive. Exactly at the point of time when the inventory
level is supposed to be zero. And immediately the inventory level goes up
to 600 again, and the cycle repeats. So here, on this diagram you can see
that, when the inventory level drops down to a point called R, which is
generally referred as re-order point, we are placing an order. And the
supply from the supplier arrives after L. Or the supply lifetime is L, so at
time T, when the inventory level drops down to zero, the supply from the
supplier arrives and inventory level again goes up.
So, in this example or on this diagram, R is the point when we are placing
the order. And an order of size Q, is being placed L periods before the
inventory level goes down to zero. So, that the supply of quantity Q exactly
arrives after L periods. However, in periodic review system, the timing of
the order is fixed. And every time whenever the inventory is reviewed, one
looks at or the inventory manager looks at the present inventory level, and
then places enough to raise the inventory level to a prefixed number,
which is generally referred as 'order-up-to' level.
So, the continuous review system is also referred as Q system, and we will
discuss subsequently and try to calculate how much to order and when to
order for continuous review system. We will also discuss how the field rate,
or the service level can be used to calculate the safety stock when the
demand is uncertain. Then, we will learn how to calculate order-after level
for P-system.

Video 6: Continuous Review Systems

Now we will try to calculate, how much to order and when to order for a
continuous review system when the demand is considered to be equal to
the average demand. For understanding the calculations, we will go back
to the same example of the retailer selling handbags and sourcing the
handbags from a supplier. Observe the on-hand inventory diagram. So, the
inventory starts at 600 and then gradually gets depleted as the demand is
being realised at the rate of 100 units every week. As inventory is being
consumed to meet the demand on an average at 100 units per week, the
inventory level drops gradually.
Because the demand is constant, we can represent the on-hand inventory
with a straight line because consumption is happening at uniform rate.

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Assume that the supply lead time is L that means when the retailer places
an order, the supplies arrive after L weeks. So, at some point in time as
inventory is getting depleted, the inventory level will be dropping down to
zero. It will be natural for the retailer that it places an order L periods in
advance. Here additional assumption is that L is fixed that means that
supplier delivers within exactly L periods. On receiving the supplies, the
inventory level again goes up to 600.
Now we will try to understand whether this 600 units of order quantity
given L weeks of lead time, whether it is optimal. To arrive at the
calculation, suppose D is the average annual demand. The product is
being procured at a unit cost of C, h represents the holding cost as a
fraction of the product cost. It is generally expressed as percentage of C. S
is the the fixed cost of ordering incurred every time an order is placed. And
Q represents the order quantity. If we go back to the diagram again and
suppose say we reduce the order quantity from 600 to 300 in our previous
example, we will see that the number of orders that will be made in a year
will go up.
So, that means if I reduce the order quantity, my average inventory will go
down. However, it will increase the frequency of order. So, reducing the
average inventory will reduce the inventory cost. However, increasing the
frequency of orders will increase my ordering cost. So, in this case I have to
trade-off the inventory cost with the inventory ordering cost. Now let us try
to calculate the costs. The first cost is the material cost. Because the
annual demand is D and the unit cost is C, so the total material cost is D*C.
The number of orders that will be made every year or annually, if every
time we place an order of quantity equal to Q will be D/Q.
The ordering cost will be incurred every time an order has been placed and
the unit fixed cost of order is capital S.
So, number of times of order into capital S will be the total ordering cost
for the year. The average inventory, every inventory cycle would be Q/2 and
the inventory holding cost is h percentage of C. So therefore, the total
annual inventory holding cost will be Q/2 * h * C. So therefore, the total cost
that is involved in taking the decision is DC is the material cost, then the
fixed ordering cost, then the total inventory cost. Now, we have to decide
the order quantity Q that will minimise the total cost. As Q increases, the
holding cost will increase. However, the frequency of order will go down.
So, is ordering cost. The material cost is same because we are meeting an
annual demand of D. So, the total cost line will be a convex function. And
we can see on the diagram that there is a minimum cost point shown or
marked as EOQ. So, that means that when we are placing an order equal
to EOQ, our total costs will be minimum. That answers the question- How
much we will place orders? And the answer is equal to EOQ. EOQ stands
for Economic Order Quantity.

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Now the next question: When shall we place the order? Because the lead
time is L, it is obvious that we will have to place the order L periods before
the inventory level drops down to zero. Corresponding to the lead time, we
can also see on the diagram that R is the amount of inventory that will be
left, L periods before the inventory level drops down to zero and this R is
referred as reorder point. And this R can be calculated as D/365 * L.
Because the annual demand is D and suppose say that total number of
working days is 365. In reality it will be lesser than that.
Then D/365 would be the per day consumption or per day demand. And in
L periods or L days, the total amount of inventory that will be required to
fulfil the demand during the lead time is D/365 * L that means the point at
which we place the order again. So, the reorder point answers the question
when to order. There may also be situations when the lead time is greater
than the inventory cycle or the inventory ordering cycle. Which means on
the diagram, we can see, or we can refer to the inventory ordering cycle as
the time duration between any two similar points.
That means we can look at the time between the placement of orders
subsequently. So, the inventory cycle in the diagram is lesser than the
supply lead time L. In such cases, the reorder point calculation may
change. For calculating the reorder point, we will have to do the
calculation for effective lead time shown as L_e. So, the effectively time can
be calculated using the formula which basically signifies that although I
may be placing an order in the diagram in the first ordering cycle and
receiving at the beginning of the fourth ordering cycle, I may be treating it
as that I am placing the order effectively just L_e period before. The cycle
length or the inventory cycle can also be calculated as shown. In the next
video, we will take one example to understand how these calculations can
be carried out in practice.

Video 7: Continuous Review Systems – Example

Welcome. Now, we will take one example how, for the continuous review
system, how much to order and when to order can be calculated. The
example that we are taking for understanding the calculations, we assume
an inventory system where the demand is 1,000 units every month. There
is also a fixed cost of order placement, transportation and receiving equal
to Rs. 4,000 every time an order is placed. The unit cost of the product or
the item is Rs. 500 and the holding cost is calculated at 20%. So, determine
the total number of items that the store manager should order.
So basically, what we have to calculate is Q. Now, it is given that D is equal
to 100 units per month. So, if I calculate the annual demand, it would be
1,200. Then the question comes why we are converting the monthly
demand into annual demand? The simple reason is that the inventory cost
of 20% implicitly we assume that that 20% is the that has to be paid every
year or is calculated annually. As a result, the demand to be considered
also has to be on annual basis. So, the annual demand is 1,200 units.

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The fixed cost S is Rs. 4,000, the unit cost of the item C his 500 units and
the holding cost H is 20%, that is 0.2. So, then I can use the economic order
quantity formula to calculate the economic order quantity, or what should
be the optimal order size that will minimise my cost. And we see that the
economic order quantity formula gives us the optimal order quantity to be
equal to 980. Then we can also calculate the optimal number of orders
which will be equal to annual demand by the economic order quantity
that we have calculated.
We get a value of 12.24 as the number of orders. Obviously, the question
comes how the number of orders can be a fractional number? It has to
mean integer. And the moment we round it off the number of orders there
may be a fear that my cost may not be the minimum cost. That is actually
correct. The moment I do the rounding-off, I may not remain at optimal
cost level. However, the interesting characteristic of the total cost function
is that it is relatively flat and the bottom, which means that minor
rounding-offs do not change the cost significantly, and therefore such
rounding-off is perfectly all right, because from a managerial decision
point that is the most feasible one.
Similarly, the cycle time can also be calculated by dividing the total
number of working days. Here, we are assuming 365 days divided by the
optimal number of orders, and we are getting a cycle time of equal to
29.82, which essentially means that every 30 days we are placing an order.
For calculating the reorder point, we need the lead time. The lead time
given is 12 days. However, we calculated the cycle time to be equal to 30.
So, the lead time is lesser than the cycle time.
So, we can use directly the reorder point formula to calculate the reorder
point, which we get as 395 units, which means that when the inventory
level drops down to 395 units, we place an order of equal to 980 units.
Suppose say the lead time is 38 days. In such case we find that the lead
time is greater than the inventory order cycle. In that case, we will have to
calculate the effective lead time, and effective lead time turns out to be
equal to eight days, and we get the reorder point to be equal to 263 units
when the lead time is 38 days.

Video 8: Estimating Safety Inventory and Cycle Service Level

Welcome. Now, we will try to calculate the safety inventory or buffer
inventory when the demand is uncertain. As well as we will also talk about
what is Cycle Service Level. Coming back to the on-hand inventory level
diagram that we have used in our previous videos; we are placing an order
when we had R units on hand. After placing the order, we will consume R
units over the next L periods which is the lead time. And after lead time of
L periods, we will receive the supplies from the supplier. It may happen
that by the time we receive the supplies, I may be stocked out, that means
my demand during the next L periods, may be more than the R units that I
had when I have placed an order.

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Or I may also be having a situation of Surplus, when I am receiving the
supplies from the supplier after L periods.
So, that means because of uncertain demand, I may end up with surplus
or shortages. And that has a chance depending on the demand that we
are facing, or the uncertainty of the demand that we are facing. So, the key
point here is that when we placed an order, we had R units and until we
receive the orders, this R units should be sufficient enough to meet the
demand. If we do not meet the demand, then we stockout. So, the
demand during the next L periods becomes very, very important, and we
call it as lead time demand.
Again summarising, if the Lead time demand is more than the Re-order
point, then we will have Shortages. If the Lead time demand is lesser than
the Re-order point, we will have Surplus. So, that means when we are
facing an uncertain demand, there is a possibility of having stockout. We
want to minimise the adverse consequences of such stockouts by
deciding some buffer stock, or by keeping some extra units which are
called as buffer stock or safety stock. Now, our objective would be to
determine the quantity of this buffer stock. What should be the size of the
safety stock? Or the buffer stock? For understanding that, or for
calculating that, we have to understand the lead time demand.
So, the lead time demand is uncertain, and because of this uncertainty, we
have to understand, or we have to have the mean demand during the lead
time, as well as what is the uncertainty measured by standard deviation.
Suppose say, every period or every week, if the period is week, the demand
is having a mean of say 75 units, and the standard deviation of 15 units.
Similarly for week two, mean of 75 and standard deviation of 15 and so on.
If our lead time is three weeks, the mean of lead time demand, that is the
average demand during the next three weeks of demand would be 75 + 75
+ 75 which is equal to 225.
So, 225 would be the average of the lead time demand. For calculating the
standard deviation, the standard formula that is used assuming that the
demand during every period or every week are independent. Based on this
assumption, we can calculate the standard deviation of the aggregated
demand over the L periods as under root of L * the standard deviation of
one period, that is the weekly demand. Having calculated the average
demand during the lead time as well as the standard deviation of the lead
time demand, we will try to calculate the safety stock.
But while trying to calculate the safety stock, we cannot rule out the
possibility that there will never be a stockout. But what we try to do is that
we try to limit the possibility of stockout within certain range. And that is
where the notion of service level comes. Based on the industry, based on
the competitive nature in the market or looking at what is the service level
being achieved by your competitors, we will arrive at some service level

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which will be acceptable to the customers. Service level refers to the
chance that I will not have stockout during the inventory cycle.
The service level is a managerial decision that has to be taken based on the
market being served as well as how the competitors are performing in
terms of service level. Suppose say, the competitors are the average, or
most of your competitors are achieving a service level of 90%, it is
appropriate that we also have a service level around 90%, otherwise, the
customer satisfaction will go down. Given, we have the fill rate which is the
chance of not having stockout, as a target, we can calculate the safety
stock. Suppose say, we have to achieve a target service level of 80%, which
means that the possibility of a stockout is limited to 15 % only.
And suppose say, the lead time distribution has this shape, with a mean of
D_L and standard deviation of Sigma_L calculated as under root of L *
Sigma. Suppose the distribution of the lead time demand is as shown in
the diagram. Although we see that it appears to be a normal distribution,
but it is not necessary that always it will be a normal distribution. Suppose
that I do not have any safety stock, so my reorder point was calculated
considering the average demand only. So, that means my R level matches
with the average line on this diagram.
And we can see on the diagram that in such a case, there is a 50 % chance
that the lead time demand will be more than the average demand during
the lead time.
However, our target service level is 85%, which will essentially mean that I
cannot keep the R value at a level which was calculated based on the
average demand. So, I have to shift the R from the average point towards
the right, such that the area on the right-hand side of the point R on this
graph is 85%. The moment we shift the R from the mean demand point,
we are basically increasing the quantity of R, from the value that we have
calculated when we have assumed average demand. This extra quantity
that we are keeping increasing the service level is referred as the safety
stock, and that can be calculated by calculating the Z value corresponding
to 85% of the service level. Z value can be calculated for normal
distribution, by simply looking at the normal table or using the NORM.INV
function of the Spreadsheet or MS Excel, and the safety stock can be
calculated simply as Z times of the standard deviation of the lead time
demand.

Video 9: Estimating Safety Inventory and Cycle Service level –

Example
For understanding how safety stock can be calculated in practise, we take
a simple hypothetical example. We assume that the demand is normally
distributed, and the weekly demand has an average value of 2500 with the
standard deviation of 500. So, we have to calculate the cycle service level
resulting from an inventor system that is being already implemented,

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whereby we are placing an order of 10,000 units whenever the inventory
level is dropping down to 6000. In this example, the reorder point is 6000.
For calculating the safety stock, first we will calculate the lead time
demand average which can be calculated as 2500 into the lead time of
two weeks.
So, the average lead time demand is 5000 units. We have placed an order
when we had 6000 units. So, that means we have placed an order when
our inventory level was 1000 more than the average lead time demand
which was the reorder point when we assumed average demand in earlier
model. The standard deviation of the lead time demand is calculated as
under root of two into 500 and we get the value of standard deviation as
707. Now for 1000 units of safety stock, we will calculate the service level by
using the MS Excel formula NORMDIST.
The NORMDIST function asks for the value of hour which is currently equal
to 6000. The mean demand of the lead time demand which is equal to
5000 and the standard deviation of the lead time demand which we have
calculated as 707. The NORMDIST function returns a value of 0.92 which
represents the service level, which essentially means that there is a chance
of only 8% for the stock out. That means 92% of the time we are able to
fulfil the demand. And that is how the safety stock level and the cycle
service level are related to each other.

Video 10: Fill Rate

Welcome. In the previous video, we have tried to understand the
relationship between cycle service level and the safety stock. In practice, a
more common measure of service level is fill rate which is the percentage
fulfilment by quantity. The field rate can be calculated using the formula, 1-
ESQ/Q. Expected shortage quantity here represents the expected shortage
quantity, every inventory cycle. Now how do I calculate the expected
shortage quantity? Expected shortage quantity can be calculated using
the formula that is shown on your screen. The formula appears to be little
complicated or confusing, but we do not want to look at the formula.
However, the same formula can be converted into a spread sheet formula
which can be given as on your screen. Using the formula, once we
calculate the expected shortage quantity, we can easily calculate the fill
rate. In the formula, we have some input numbers that we have to feed.
One is the SS, which is the safety stock. Then, we have the sigma_L which
is the standard deviation of the lead time demand. For understanding how
fill rates are calculated, we will take a very simple example which is a
continuation of the previous example that we have considered while
calculating the safety stock.
The calculation for average lead time demand and the standard deviation
of the lead time demand remains same. By using the formula for expected
shortage quantity that we just described,

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we get a value of 25.13. Given that the expected shortage quantity of 25
and an order quantity of 10,000, we can use the formula for fill rate to
calculate the fill rate to be equal to 99.75%, which essentially means that
99.75% of the quantities we were able to fulfil following the inventory policy
of ordering 10,000 units when we have 6000 units on hand. In all our
previous discussions on safety stock, we have assumed the lead time to be
fixed. Now let us try to understand what the effect on safety inventory
would be if the lead time is also uncertain.
Assume that S_L is the standard deviation of the lead time with L as the
mean lead time or the average lead time. All the previous calculations
remain same, except that the safety inventory calculation or rather the
standard deviation of the lead time demand will change.

Video 11: P-System

Welcome. Now we will try to understand, how in the P-system we
determine how much to order and how do we calculate the safety stock.
Imagine a retailer who places order every week. And there is a vehicle with
goods come from the supplier every week, say every Tuesday and visits the
retailer to take orders and fulfil the orders immediately from the goods
that is being carried in the vehicle. Now the retailer checks his stock level
and after checking the stock, he places an order quantity that raises
enough to take care of the demand until the vehicle or the supplies arrive
next Tuesday.
So, in this case the order is being placed once every week, every Tuesday.
So, when to order is already determined, it's Tuesday every week. Now
then, the other aspect that is remained to be determined is how much to
order and the retailer does so, by raising enough so that it can take the
demand during the period until the vehicle arrives next Tuesday. And this
order and the existing inventory level together constitute or forms
something called as order-up to-level. So, effectively, the retailer has to just
determine the order-up to-level and we can calculate the order quantity
equal to the order-up to-level minus whatever is the inventory that is on
him right now.
In this example, the retailer receives the deliveries immediately on placing
the order. However, on other cases, the time between the placement of
orders and the receiving of the supply can be substantial. We represent
that lead time as 'L' and the inventory cycles that means the time between
the placement of orders or in the retailer's example, the time between
from this Tuesday to the next Tuesday is referred as the review period of
capital 'T'. The order-up to-level should be good enough, to cover the
demand for the period T + L.
Therefore, the order-up to-level will be equal to the average demand
during the period (T + L) plus the amount of safety inventory that we will
keep, so that the stock out levels or the safety stock level are within the

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Operations and Supply Chain Management
targeted filled red values. So, the order-up to-level can be calculated as the
average demand during the period (T + L) which is equal to (T + L) into the
average weekly demand plus the safety stock which can be calculated as Z
times of the standard deviation of the demand during the period (L + T).
And this is how we can calculate the order up-to-level for a P-system.

Video 12: Single Period Problem (Newsvendor Problem)

Having understood the periodic review and the continuous review
systems, let's look at a very different class of inventory problems.
Historically, by virtue of the fact that they were first observed in the case of
newspapers, they have been called newsvendor models. As you would
have realised by now that demand is uncertain and frequently, we make
sense of demand uncertainty using probability distributions. And normal
distribution by virtue of it's very fact, is one of the most used distributions
in the world. Specifically, we're focusing the case of single period inventory
model. How does it work is, consider the case of a newsvendor.
They are trying to sell newspapers.
You would notice that a newspaper is a perishable product, and the
newsvendor faces a very fundamental issue. Newspapers, unlike other
products like FMCG or consumer durables cannot really be inventoried.
Today's newspaper is practically useless tomorrow. So, in that sense the
choice of how many newspapers to order brings forth a very fundamental
trade-off that organisations in the perishable space face. If you bring too
few newspapers, the opportunity to generate more profits is lost because
today's demand will not happen tomorrow. If you bring too many
newspapers, then you face a different kind of a trade-off. The excess
newspapers that you have brought will end up getting wasted and you
would again have a sub-optimal problem.
So, within the domain of these two extreme situations; too few and too
little, we have to arrive at the optimal solution for this classic newsvendor
model. Let's look at the newsvendor model in a bit more detail. Suppose
we specify that the demand for the newspaper is spread normally with
some mean and some standard deviation. If you decide to bring mean
number of newspapers, you realise that half the time there will be stock
out and half the time there will be excess because the normal distribution
is spread evenly around the mean. If you order more than the mean, the
chances of having excess stock go up.
If you order less than the mean, the chances of stock outs go up.
So, within these two extremes, our attempt will be to identify the optimal
number of newspapers that should be brought in order to maximise
profitability for the newsvendor. As we know this decision is risky; having
excess as well a shortage, both have problems. So, that is why under such
decision criteria, it is best to use an expected value approach. As all of you

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know, the expected value is the payoff * probability of payoff which allows
us to come up to the expected value. Let's take a small example. Imagine I
am buying a newspaper for ₹3 and selling it for ₹5.
And let me also assume that if I am not able to sell the newspaper, I do not
have any salvage value.
In this background, allow me to introduce two new terms. The first, is what
we like to call the cost of understock or C_u as it sometimes called. The
other is cost of overstock or C_o as it is sometimes called. The cost of
understock is the loss of opportunity if I am not able to satisfy the item. The
cost of overstock, on the other hand, is the loss of investment that happens
if I am not able to sell the product. As you would realise under conditions
when the prices are kept fixed, if we go on ordering more and more of the
item.
One copies, two copies, 10 copies, 50 copies, 100 copies. The fact that on
every newspaper I make some margin, or I lose my investment if I don't sell
it, remains fixed. But the probability that whether I would be able to sell
the newspaper is contingent on how many newspapers I order. I might be
happy to sell 1, 10, 15, 20 but there will definitely come a time where I would
feel that on account of the riskiness inherent in the enterprise, it is better
for me to stop ordering at that point. We call that point the critical fractile.
How does it work? We take an expected virulence and if we assume that P
is the probability that an item will be sold given that there are only two
scenarios here; sold or unsold. 1 - P will be the probability that the item is
unsold. We use the two probabilities and the two payoffs of C_u and C_o.
We identify an equation which balances these trade-offs. Basically, we're
looking at the point at which the expected value of underselling and
overselling both are balanced. That point is what we call a critical fractile
which is given as the ratio of C_u / (C_U + C_o).
It is that point where given the dynamics of the product in terms of the
probability distribution as well as the economics of the product, the
riskiness on account of overselling and underselling; both of these things
are balanced.
Critical fractile becomes the optimal point which we should try to cover if
we have to maximise our profit in the long run. Once we have the critical
fractile we would estimate the optimal ordering quantity corresponding to
the critical fractile. This process will be demonstrated to you using a small
Excel file.

Video 13: Demo: Newsvendor Model

Now let's take a look at a small example to help understand the
newsvendor model. Consider the data in front of us. As you can see, we're
assuming that the daily demand for the newspapers, spread over a mean
of 100 at a standard deviation of 10. We're also provided some pricing data.

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Operations and Supply Chain Management
Let us assume that I am buying each copy of the newspaper for five rupees
and selling it for eight rupees. And just to understand it initially, we're
assuming that the salvage value of the newspaper is zero.
As the first step will calculate the cost of understock and the cost of
overstock. As you know, the cost of understock essentially relates to the
scenario of understocking, which means that even though demand for the
product is there but because of inventory shortage, I have to forgo the
opportunity which would essentially be the margin that I could have made
otherwise. In this case, it will be the difference between the price and the
cost, which amount to three rupees per copy. Similarly, we also have the
cost of overstocking, CO. As the name itself indicates, the overstock
corresponds to scenarios where in demand is not there but we have
excess inventory available.
Under such scenarios, essentially, whatever we invested goes to waste.
Again, remember these are all single period models so, the benefit of
keeping it in inventory and using it tomorrow does not exist. So, to
summarise, if their demand spread normally with the mean of 100 and
standard deviation of 10, the pricing data is be we purchase it for five, sell it
for eight leading to a cost of overstock of five and cost a fund of stock of
three. As we know the critical fractile can be expressed as Cu upon Co plus
Cu, which leads to a critical fractile value of 0.375.
What it means is given the underlying economics of the product, it is
optimal for us to cover 37.5% of the demand. Some of you might feel that
this is low, but remember, your choice of ordering should be contingent on
the size of the opportunity. We will do some basic What-If Analysis
afterwards. Obviously, when we have to place the order with our
distributors for the newspaper, we cannot express it in percentage terms.
That is why we will try to convert this critical fractile into an absolute
number.
The first step of this process is converted it into something called as Z
value. As part of this Z value, we take the NORM.INV Function which is in-
built in Excel and come up with a value of minus point three one. To help
you understand what it means basically, for this normal distribution which
if I remember is symmetric toward the mean we want to cover 37.5% of the
demand. What the Z value does, is essentially tell us that if you want to
convert 37.5% of the demand you should move Z sigma away from the
mean. In this case, because the critical fractile value is less than 50%,
obviously we'll have to move to the left of the mean, which is captured
with the negative Z value.
Or, in other words, if we want to capture 37.5% of the demand, we have to
move minus 0.3 sigma away from the mean, which leads to an ordering
quantity of and you can see from the formula tap that the optimal
ordering quantity will be, mean plus Z sigma. In our example, it will
effectively amount to 100 plus the Z value, which is negative into 10, which

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Operations and Supply Chain Management
finally amounts to an ordering quantity of 97 copies. Effectively, the
optimal ordering quantity can be rounded up to 97 copies. What it means
is when we're dealing with the scenario like this, with the following mean
demand and the given price, it will be optimal for us to order 97 copies of
this newspaper.
It is mathematically guaranteed under the set of assumptions that we
have, that this will be the profit maximising quantity. Any deviation from
this would lead to suboptimal outcomes. Some of you might feel that we
are ordering even less than the money but remember, the salvage value of
newspaper is zero in the above example. So, tomorrow if you order a larger
quantity say 120, the issue is that on some of the days definitely demand
would be high because demand is stochastic. But on majority of the days
you will end up with lot of excess newspapers, which would affect your
profitability.
Hence, the claim that 97 copies of the newspaper would maximise the
profit for this particular player. As always, let's try to understand through
doing a series of What-If Analysis. One obvious issue could be what if the
salvage value improves. Let's see the outcome. Suppose we're able to
dispose off excess newspapers at one rupee in the secondary market. You
can see that the critical fractile has improved, which also makes sense
because whenever the salvage value is attractive, the cost of overstock, the
riskiness of keeping more units has come down. In other words, we would
be more favorably predisposed to keeping more units.
Let us change the demand. Suppose the mean shifts from 100 to 150. You
would notice that the critical fractile which is dependent on the pricing
has not changed, but now it will be 42.8% of the revised demand
distribution and accordingly, the order quantity changes even though the
critical fractile has not changed. We can similarly experiment with
scenarios of high standard deviation or low standard deviation. We can
discuss scenarios in which prices have been increased and see the impact
on the optimal ordering quantity. It would worthwhile exercise for all of
you to engage with this basic model and see what impact do different
combinations of cost, prices, salvage values, means and standard
deviations have on the critical fractile as well as the optimal ordering
quantity.
A final note of reminder, critical fractile is independent of the distribution.
We have calculated critical fractile, solely on the basis of the pricing data.
Of course, the conversion of fractile into a number depends on the
demand distribution. For the normal distribution, this is the case which has
been illustrated. Now you have been fully briefed on the single period
newsvendor model. You would be interested to know that even though we
have taken the case of newspapers, similar conditions exist whenever
perishability is involved. This could be in the case of travel for example,
imagine aircraft taking off.

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Operations and Supply Chain Management
The moment the aircraft takes off, if it's having any seat as vacant, the
opportunity is gone. Frequently went up reading newspapers about
people being bumped off in spite of having confirmed tickets, because
airlines frequently resort to the practise of overbooking, because just like in
our case, they deal with scenarios of under and over where the people end
up cancelling and they're left with vacant seats. Similar conditions can be
applied for anything which is perishable in nature and the basic model
would hold. This helps you understand the power of the newsvendor
model and a variety of conditions under which it can be applied in the
practical world.

Video 14: Summary

Now, let's try to summarise what all we have learnt as part of the module.
We have learnt about, the importance of inventory in supply chain. We
have looked at the various costs associated with inventory in the supply
chain. We have also looked at multiple models that are used to handle
different scenarios, including single period as well as multi-period. We
have looked at continuous review as well as periodic review models. This
gives an overall picture of how inventory is managed in real-life supply
chains.

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Operations and Supply Chain Management