Risk Pooling

Concept

 In a centralized distribution, whenever

demand from one region is higher than
average while demand from another market
area lower than average, items in the
warehouse that were originally allocated for
one market can be reallocated to other. It is
not possible in decentralized system
Example

Warehouse
North Market
-north

Plant

Warehouse-
South market
south
ABC Ltd

 The company have one plant and two

warehouses
 The retailers are the customers
 Lead time from factory to warehouse is one
week
 It provides 95% service level
 It handles 1500 products and 10,000
accounts.
ABC

 It is considering replacement of two

warehouses with single warehouse located in
between two markets
 Same service level should be maintained
 It is called centralized distribution system
Features of old system

 Warehouses are more near to market

 Lead time to customers are low
 Warehouse Costs are high
 Inventory kept at two different places
Features of new system

 Lead time will increase

 Warehouse cost will come down
 Transportation cost will increase
Product A-demand

Week 1 2 3 4 5 6 7 8
North 33 45 37 38 55 30 18 58
South 46 35 41 40 26 48 18 55
Total 79 80 78 78 81 78 36 113
Product B-demand

Week 1 2 3 4 5 6 7 8
North 0 2 3 0 0 1 3 0
South 2 4 0 0 3 1 0 0
Total 2 6 3 0 3 2 3 0
Summary

Product Ave. SD of demand Co-efficient of

demand variation

North A 39.3 13.2 0.34

North B 1.125 1.36 1.21

South A 38.6 12.0 0.31

South B 1.25 1.58 1.26

Central A 77.9 20.71 0.27

Central B 2.375 1.9 0.81

Inventory levels

Product Ave. SS Reorder

demand point Q
in LT

North A 39.3 25.08 65 132

North B 1.125 2.58 4 25

South A 38.6 22.8 62 131

South B 1.25 3 5 24

Central A 77.9 39.35 118 186

Central B 2.375 3.61 6 33

SD and co- efficient of variation

 Co-efficient of variation=SD/Ave. demand

 SD measures the absolute variability of
demand
 Co-efficient measures variability relative to
average demand
 A has much larger SD
 B has larger co-efficient
Important observations

 Average demand at central warehouse= sum

of individual ave. demand
 But variability is much smaller in central
warehouse compared to combined variability
of individual warehouses
Important observations

 Take average inventory of Product A

 At north warehouse= SS + Q/2=91
 At south warehouse= SS + Q/2= 88
 Average inventory at central warehouse is
132 units
 It is less than combined ave. inventory by
26%
OUTCOMES

 It suggests that demand variability is reduced

if one aggregates demand across locations
 It is because, as we aggregate demand
across different locations, it becomes more
likely that high demand from one customer
will be offset by low demand from another
 This reduction in variability allows us to
reduce safety stock and thus average
inventory
OUTCOMES

 Higher the coefficient of variation, the greater

the benefit obtained from centralized
systems.
 The benefit from risk pooling decrease as the
correlation between demand from the two
markets becomes more positive.