Inventory Management, Supply Contracts and Risk Pooling: Kaminsky@ieor - Berkeley.edu

Inventory Management,
Supply Contracts and Risk

Pooling
Phil Kaminsky
kaminsky@ieor.berkeley.edu
Issues
• Inventory Management
• The Effect of Demand Uncertainty

– (s,S) Policy
– Periodic Review Policy
– Supply Contracts
– Risk Pooling
• Centralized vs. Decentralized Systems
• Practical Issues in Inventory Management

Customers,
Field demand
Sources: Regional Warehouses: centers
plants Warehouses: stocking sinks
vendors stocking points
ports points
Supply
Inventory &
warehousing
costs
Production/
purchase Transportati
on Transportati
on
costs costs Inventory & costs
warehousing
costs
Inventory
• Where do we hold inventory?
– Suppliers and manufacturers
– warehouses and distribution centers
– retailers
• Types of Inventory
– WIP
– raw materials
– finished goods
• Why do we hold inventory?
– Economies of scale
– Uncertainty in supply and demand
– Lead Time, Capacity limitations
Goals:
Reduce Cost, Improve Service
• By effectively managing inventory:
– Xerox eliminated $700 million inventory from
its supply chain
– Wal-Mart became the largest retail company
utilizing efficient inventory management
– GM has reduced parts inventory and
transportation costs by 26% annually
Goals:
Reduce Cost, Improve Service
• By not managing inventory successfully
– In 1994, “IBM continues to struggle with shortages in
their ThinkPad line” (WSJ, Oct 7, 1994)
– In 1993, “Liz Claiborne said its unexpected earning
decline is the consequence of higher than anticipated
excess inventory” (WSJ, July 15, 1993)
– In 1993, “Dell Computers predicts a loss; Stock
plunges. Dell acknowledged that the company was
sharply off in its forecast of demand, resulting in
inventory write downs” (WSJ, August 1993)
Understanding Inventory
• The inventory policy is affected by:
– Demand Characteristics
– Lead Time
– Number of Products
– Objectives
• Service level
• Minimize costs
– Cost Structure
Cost Structure
• Order costs
– Fixed
– Variable
• Holding Costs
– Insurance
– Maintenance and Handling
– Taxes
– Opportunity Costs
– Obsolescence
EOQ: A Simple Model*
• Book Store Mug Sales
– Demand is constant, at 20 units a week
– Fixed order cost of $12.00, no lead time
– Holding cost of 25% of inventory value
annually
– Mugs cost $1.00, sell for $5.00
• Question
– How many, when to order?
EOQ: A View of Inventory*
Note:
• No Stockouts
• Order when no inventory
• Order Size determines policy
Inventory
Order
Size
Avg. Inven
Time
EOQ: Calculating Total Cost*
• Purchase Cost Constant
• Holding Cost: (Avg. Inven) * (Holding
Cost)
• Ordering (Setup Cost):
Number of Orders * Order Cost
• Goal: Find the Order Quantity that
Minimizes These Costs:
EOQ:Total Cost*
160
140
120
100 Total Cost
Cost
80
Holding Cost
60
40
20 Order Cost
0
0 500 1000 1500
Order Quantity
EOQ: Optimal Order Quantity*
• Optimal Quantity =
(2*Demand*Setup Cost)/holding cost
• So for our problem, the optimal quantity is

316
EOQ: Important Observations*
• Tradeoff between set-up costs and holding
costs when determining order quantity. In fact,
we order so that these costs are equal per unit
time
• Total Cost is not particularly sensitive to the
optimal order quantity
Order Quantity 50% 80% 90% 100% 110% 120% 150% 200%
Cost Increase 125% 103% 101% 100% 101% 102% 108% 125%
The Effect of
Demand Uncertainty
• Most companies treat the world as if it were
predictable:
– Production and inventory planning are based on
forecasts of demand made far in advance of the
selling season
– Companies are aware of demand uncertainty when
they create a forecast, but they design their planning
process as if the forecast truly represents reality
• Recent technological advances have increased
the level of demand uncertainty:
– Short product life cycles
– Increasing product variety
Demand Forecast
• The three principles of all forecasting
techniques:
– Forecasting is always wrong

– The longer the forecast horizon the worst is
the forecast
– Aggregate forecasts are more accurate
SnowTime Sporting Goods
• Fashion items have short life cycles, high variety
of competitors
• SnowTime Sporting Goods
– New designs are completed
– One production opportunity
– Based on past sales, knowledge of the industry, and
economic conditions, the marketing department has a
probabilistic forecast
– The forecast averages about 13,000, but there is a
chance that demand will be greater or less than this.
Supply Chain Time Lines
Jan 00 Jan 01 Jan 02

Design Production Retailing
Feb 00 Sep 00 Feb 01 Sep 01

Production
SnowTime Demand Scenarios
Demand Scenarios
Probability
30%
25%
20%
15%
10%
5%
0%
0
0
0
0
0
0
0
0
0
8
0
6
8
1
Sales
SnowTime Costs
• Production cost per unit (C): $80
• Selling price per unit (S): $125
• Salvage value per unit (V): $20
• Fixed production cost (F): $100,000
• Q is production quantity, D demand
• Profit =
Revenue - Variable Cost - Fixed Cost + Salvage
SnowTime Scenarios
• Scenario One:
– Suppose you make 12,000 jackets and demand ends
up being 13,000 jackets.
– Profit = 125(12,000) - 80(12,000) - 100,000 =
$440,000
• Scenario Two:
– Suppose you make 12,000 jackets and demand ends
up being 11,000 jackets.
– Profit = 125(11,000) - 80(12,000) - 100,000 +
20(1000) = $ 335,000
SnowTime Best Solution
• Find order quantity that maximizes
weighted average profit.
• Question: Will this quantity be less than,
equal to, or greater than average
demand?
What to Make?
• Question: Will this quantity be less than,
equal to, or greater than average
demand?
• Average demand is 13,100
• Look at marginal cost Vs. marginal profit
– if extra jacket sold, profit is 125-80 = 45
– if not sold, cost is 80-20 = 60
• So we will make less than average
SnowTime Expected Profit
Expected Profit
$400,000
$300,000
Profit
$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity
Expected Profit
$400,000
$300,000
Profit
$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity
SnowTime:
Important Observations
• Tradeoff between ordering enough to meet
demand and ordering too much
• Several quantities have the same average profit
• Average profit does not tell the whole story
• Question: 9000 and 16000 units

lead to about the same average
profit, so which do we prefer?
Expected Profit
$400,000
$300,000
Profit
$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity
Probability of Outcomes
100%
80%
Probability
60% Q=9000
40% Q=16000
20%
0%
-1 0
0
00
00
00
00
00
00
00
00
00
00
10
30
50
-3
Revenue
Key Insights from this Model
• The optimal order quantity is not necessarily
equal to average forecast demand
• The optimal quantity depends on the relationship
between marginal profit and marginal cost
• As order quantity increases, average profit first
increases and then decreases
• As production quantity increases, risk increases.
In other words, the probability of large gains and
of large losses increases
SnowTime Costs: Initial
Inventory
• Production cost per unit (C): $80
• Selling price per unit (S): $125
• Salvage value per unit (V): $20
• Fixed production cost (F): $100,000
• Q is production quantity, D demand
• Profit =
Revenue - Variable Cost - Fixed Cost +
Salvage
Expected Profit
$400,000
$300,000
Profit
$200,000
$100,000
$0
8000 12000 16000 20000
Order Quantity
Initial Inventory
• Suppose that one of the jacket designs is a
model produced last year.
• Some inventory is left from last year
• Assume the same demand pattern as before
• If only old inventory is sold, no setup cost
• Question: If there are 7000 units remaining, what

should SnowTime do? What should they do if
there are 10,000 remaining?
Initial Inventory and Profit
500000
400000
300000
Profit
200000
100000
0
00
00
00
00
0
00
50
00
50
50
65
80
95
11
12
14
15
P roduc tion Qua ntity
500000
400000
300000
Profit
200000
100000
0
00
00
00
00
0
00
50
00
50
50
65
80
95
11
12
14
15
500000
400000
300000
Profit
200000
100000
0
00
00
00
00
0
00
50
00
50
50
65
80
95
11
12
14
15
500000
400000
300000
Profit
200000
100000
0
5000
6000
7000
8000
9000
13000
10000
11000
12000
14000
15000
16000
P ro d u ctio n Qu an tity
Supply Contracts
Fixed Production Cost =$100,000
Variable Production Cost=$35
Wholesale Price =$80
Selling Price=$125
Salvage Value=$20
Manufacturer Manufacturer DC Retail DC
Stores
Demand Scenarios
Demand Scenarios
30%
Probability
25%
20%
15%
10%
5%
0%
00
0
0
0
00
00
00
00
00
80
10
14
16
18
12
Sales
Distributor Expected Profit
Expected Profit
500000
400000
300000
200000
100000
0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity
Distributor Expected Profit
Expected Profit
500000
400000
300000
200000
100000
0
6000 8000 10000 12000 14000 16000 18000 20000
Order Quantity
Supply Contracts (cont.)
• Distributor optimal order quantity is 12,000
units
• Distributor expected profit is $470,000
• Manufacturer profit is $440,000
• Supply Chain Profit is $910,000
–Is there anything that the distributor

and manufacturer can do to increase
the profit of both?
Supply Contracts
Selling Price=$125
Salvage Value=$20
Stores
Retailer Profit
(Buy Back=$55)
600,000
500,000
Retailer Profit
400,000
300,000
200,000
100,000
0
00
00
00
00
0
0
0
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Order Quantity
Retailer Profit
(Buy Back=$55)
600,000
$513,800
500,000
Retailer Profit
400,000
300,000
200,000
100,000
0
00
00
00
00
0
0
0
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Order Quantity
Manufacturer Profit
(Buy Back=$55)
600,000
Manufacturer Profit
500,000
400,000
300,000
200,000
100,000
0
00
00
00
00
0
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Production Quantity
Manufacturer Profit
(Buy Back=$55)
600,000
$471,900
Manufacturer Profit
500,000
400,000
300,000
200,000
100,000
0
00
00
00
00
0
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Production Quantity
Supply Contracts
Wholesale Price =$??
Selling Price=$125
Salvage Value=$20
Stores
Retailer Profit
(Wholesale Price $70, RS 15%)
600,000
500,000
Retailer Profit
400,000
300,000
200,000
100,000
0
0
0
00
00
00
00
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Order Quantity
Retailer Profit
600,000
$504,325
500,000
Retailer Profit
400,000
300,000
200,000
100,000
0
0
0
00
00
00
00
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Order Quantity
Manufacturer Profit
700,000
600,000
Manufacturer Profit
500,000
400,000
300,000
200,000
100,000
0
00
00
00
00
0
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Production Quantity
Manufacturer Profit
700,000
600,000
Manufacturer Profit
500,000 $481,375
400,000
300,000
200,000
100,000
0
00
00
00
00
0
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
13
14
15
16
17
18
Production Quantity
Supply Contracts
Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700
Supply Contracts
Selling Price=$125
Salvage Value=$20
Stores
Supply Chain Profit
1,200,000
Supply Chain Profit
1,000,000
800,000
600,000
400,000
200,000
0
00
00
00
00
0
0
00
00
00
00
00
00
00
00
00
60
70
80
90
10
11
12
14
16
17
18
13
15
Production Quantity
Supply Chain Profit
1,200,000
$1,014,500
Supply Chain Profit
1,000,000
800,000
600,000
400,000
200,000
0
00
00
00
00
0
0
0
00
00
00
00
00
00
00
00
00
60
70
80
90
11
12
13
10
14
15
16
17
18
Production Quantity
Supply Contracts
Strategy Retailer Manufacturer Total

Sequential Optimization 470,700 440,000 910,700
Buyback 513,800 471,900 985,700
Revenue Sharing 504,325 481,375 985,700
Global Optimization 1,014,500
Supply Contracts: Key Insights
• Effective supply contracts allow supply
chain partners to replace sequential
optimization by global optimization
• Buy Back and Revenue Sharing contracts
achieve this objective through risk
sharing
Contracts and Supply Chain
Performance
• Contracts for Product Availability and Supply
Chain Profits
– Buyback Contracts
– Revenue-Sharing Contracts
– Quantity Flexibility Contracts
• Contracts to Coordinate Supply Chain Costs
• Contracts to Increase Agent Effort
• Contracts to Induce Performance Improvement
Contracts for Product Availability
and Supply Chain Profits
• Many shortcomings in supply chain performance occur
because the buyer and supplier are separate
organizations and each tries to optimize its own profit
• Total supply chain profits might therefore be lower than if
the supply chain coordinated actions to have a common
objective of maximizing total supply chain profits
• Double marginalization results in suboptimal order
quantity
• An approach to dealing with this problem is to design a
contract that encourages a buyer to purchase more and
increase the level of product availability
• The supplier must share in some of the buyer’s demand
uncertainty, however
Contracts for Product Availability and
Supply Chain Profits: Buyback Contracts
• Allows a retailer to return unsold inventory up to a
specified amount at an agreed upon price
• Increases the optimal order quantity for the retailer,
resulting in higher product availability and higher profits
for both the retailer and the supplier
• Most effective for products with low variable cost, such as
music, software, books, magazines, and newspapers
• Downside is that buyback contract results in surplus
inventory that must be disposed of, which increases
supply chain costs
• Can also increase information distortion through the
supply chain because the supply chain reacts to retail
orders, not actual customer demand
Contracts for Product Availability and Supply
Chain Profits: Revenue Sharing Contracts
• The buyer pays a minimal amount for each

unit purchased from the supplier but shares
a fraction of the revenue for each unit sold
• Decreases the cost per unit charged to the
retailer, which effectively decreases the
cost of overstocking
• Can result in supply chain information
distortion, however, just as in the case of
buyback contracts
Contracts for Product Availability and
Supply Chain Profits: Quantity Flexibility
Contracts
• Allows the buyer to modify the order (within limits)
as demand visibility increases closer to the point of
sale
• Better matching of supply and demand
• Increased overall supply chain profits if the
supplier has flexible capacity
• Lower levels of information distortion than either
buyback contracts or revenue sharing contracts
Contracts to Coordinate
Supply Chain Costs
• Differences in costs at the buyer and supplier can
lead to decisions that increase total supply chain
costs
• Example: Replenishment order size placed by the
buyer. The buyer’s EOQ does not take into account
the supplier’s costs.
• A quantity discount contract may encourage the
buyer to purchase a larger quantity (which would be
lower costs for the supplier), which would result in
lower total supply chain costs
• Quantity discounts lead to information distortion
because of order batching
Contracts to Increase Agent
Effort
• There are many instances in a supply chain where an agent
acts on the behalf of a principal and the agent’s actions affect
the reward for the principal
• Example: A car dealer who sells the cars of a manufacturer,
as well as those of other manufacturers
• Examples of contracts to increase agent effort include two-
part tariffs and threshold contracts
• Threshold contracts increase information distortion, however
Contracts to Induce
Performance Improvement
• A buyer may want performance improvement from a
supplier who otherwise would have little incentive to
do so
• A shared savings contract provides the supplier with
a fraction of the savings that result from the
performance improvement
• Particularly effective where the benefit from
improvement accrues primarily to the buyer, but
where the effort for the improvement comes primarily
from the supplier
Supply Contracts: Case Study
• Example: Demand for a movie newly released
video cassette typically starts high and
decreases rapidly
– Peak demand last about 10 weeks
• Blockbuster purchases a copy from a studio for
$65 and rent for $3
– Hence, retailer must rent the tape at least 22 times
before earning profit
• Retailers cannot justify purchasing enough to
cover the peak demand
– In 1998, 20% of surveyed customers reported that
they could not rent the movie they wanted
Supply Contracts: Case Study
• Starting in 1998 Blockbuster entered a revenue
sharing agreement with the major studios
– Studio charges $8 per copy
– Blockbuster pays 30-45% of its rental income
• Even if Blockbuster keeps only half of the rental
income, the breakeven point is 6 rental per copy
• The impact of revenue sharing on Blockbuster
was dramatic
– Rentals increased by 75% in test markets
– Market share increased from 25% to 31% (The 2nd
largest retailer, Hollywood Entertainment Corp has
5% market share)
(s, S) Policies
• For some starting inventory levels, it is better to
not start production
• If we start, we always produce to the same level
• Thus, we use an (s,S) policy. If the inventory
level is below s, we produce up to S.
• s is the reorder point, and S is the order-up-to
level
• The difference between the two levels is driven
by the fixed costs associated with ordering,
transportation, or manufacturing
A Multi-Period Inventory Model
• Often, there are multiple reorder opportunities
• Consider a central distribution facility which orders from a

manufacturer and delivers to retailers. The distributor
periodically places orders to replenish its inventory
Reminder:
The Normal Distribution
Standard Deviation = 5
Standard Deviation = 10
0 10 20
Average
30
=4030 50 60
The DC holds inventory to:
• Satisfy demand during lead

time
• Protect against demand
uncertainty
• Balance fixed costs and
holding costs
The Multi-Period Continuous
Review Inventory Model
• Normally distributed random demand
• Fixed order cost plus a cost proportional to amount
ordered.
• Inventory cost is charged per item per unit time
• If an order arrives and there is no inventory, the
order is lost
• The distributor has a required service level. This is
expressed as the the likelihood that the distributor
will not stock out during lead time.
• Intuitively, how will this effect our policy?
A View of (s, S) Policy
S
Inventory Position
Inventory Level
Lead
Time
0
Time
The (s,S) Policy
• (s, S) Policy: Whenever the inventory
position drops below a certain level, s, we
order to raise the inventory position to
level S.
• The reorder point is a function of:
– The Lead Time
– Average demand
– Demand variability
– Service level
Notation
• AVG = average daily demand
• STD = standard deviation of daily demand
• LT = replenishment lead time in days
• h = holding cost of one unit for one day
• K = fixed cost
• SL = service level (for example, 95%). This implies that
the probability of stocking out is 100%-SL (for example,
5%)
• Also, the Inventory Position at any time is the actual
inventory plus items already ordered, but not yet
delivered.
Analysis
• The reorder point (s) has two components:
– To account for average demand during lead time:
LT× AVG
– To account for deviations from average (we call this safety stock)
z × STD × √LT
where z is chosen from statistical tables to ensure that the probability of
stockouts during leadtime is 100%-SL.
• Since there is a fixed cost, we order more than up to the reorder point:
Q=√(2 × K × AVG)/h
• The total order-up-to level is:
S=Q+s
Example
• The distributor has historically observed weekly demand of:
AVG = 44.6 STD = 32.1
Replenishment lead time is 2 weeks, and desired service
level SL = 97%
• Average demand during lead time is:
44.6 × 2 = 89.2
• Safety Stock is:
1.88 × 32.1 × √2 = 85.3
• Reorder point is thus 175, or about 3.9 = (175/44.6) weeks
of supply at warehouse and in the pipeline
Example, Cont.
• Weekly inventory holding cost: 0.87=
(0.18x250/52)
– Therefore, Q=679
• Order-up-to level thus equals:
– Reorder Point + Q = 176+679 = 855
Periodic Review
• Suppose the distributor places
orders every month
• What policy should the distributor
use?
• What about the fixed cost?
Base-Stock Policy
r r
L L L
Base-stock
Level Inventory
Inventory Level
Position
0
Time
Periodic Review Policy
• Each review echelon, inventory position is
raised to the base-stock level.
• The base-stock level includes two
components:
– Average demand during r+L days (the time
until the next order arrives):
(r+L)*AVG
– Safety stock during that time:
z*STD* √r+L
Risk Pooling
• Consider these two systems:
Warehouse One Market One
Supplier
Warehouse Two Market Two
Market One
Supplier Warehouse
Market Two
Risk Pooling
• For the same service level, which system
will require more inventory? Why?
• For the same total inventory level, which
system will have better service? Why?
• What are the factors that affect these
answers?
Risk Pooling Example
• Compare the two systems:
– two products
– maintain 97% service level
– $60 order cost
– $.27 weekly holding cost
– $1.05 transportation cost per unit in
decentralized system, $1.10 in centralized
system
– 1 week lead time
Week 1 2 3 4 5 6 7 8
Prod A, 33 45 37 38 55 30 18 58
Market 1
Prod A, 46 35 41 40 26 48 18 55
Market 2
Prod B, 0 2 3 0 0 1 3 0
Market 1
Product B, 2 4 0 0 3 1 0 0
Market 2
Warehouse P
Market 1 A
Warehouse Product AVG STD CV s S Avg. %
Inven. Dec.
Market 1 A 39.3 13.2 .34 65 197 91
Market 2 A 38.6 12.0 .31 62 193 88
Market 1 B 1.125 1.36 1.21 4 29 14
Market 2 B 1.25 1.58 1.26 5 29 15
Cent. A 77.9 20.7 .27 118 304 132 36%
Cent B 2.375 1.9 .81 6 39 20 43%
Risk Pooling:
Important Observations
• Centralizing inventory control reduces both
safety stock and average inventory level for
the same service level.
• This works best for
– High coefficient of variation, which increases
required safety stock.
– Negatively correlated demand. Why?
• What other kinds of risk pooling will we see?
To Centralize or not to Centralize
• What is the effect on:
– Safety stock?
– Service level?
– Overhead?
– Lead time?
– Transportation Costs?
Centralized Systems*
Supplier
Warehouse
Retailers
• Centralized Decision
Centralized Distribution
Systems*
• Question: How much inventory should management
keep at each location?
• A good strategy:
– The retailer raises inventory to level Sr each period
– The supplier raises the sum of inventory in the
retailer and supplier warehouses and in transit to Ss
– If there is not enough inventory in the warehouse to
meet all demands from retailers, it is allocated so
that the service level at each of the retailers will be
equal.
Inventory Management: Best
Practice
• Periodic inventory reviews
• Tight management of usage rates, lead
times and safety stock
• ABC approach
• Reduced safety stock levels
• Shift more inventory, or inventory
ownership, to suppliers
• Quantitative approaches
Changes In Inventory Turnover
• Inventory turnover ratio =
annual sales/avg. inventory level
• Inventory turns increased by 30% from
1995 to 1998
• Inventory turns increased by 27% from
1998 to 2000
• Overall the increase is from 8.0 turns per
year to over 13 per year over a five year
period ending in year 2000.
Inventory Turnover Ratio
Indus
Factors that Drive Reduction in
Inventory
• Top management emphasis on inventory reduction
(19%)
• Reduce the Number of SKUs in the warehouse
(10%)
• Improved forecasting (7%)
• Use of sophisticated inventory management
software (6%)
• Coordination among supply chain members (6%)
• Others
Factors that Drive Inventory Turns
Increase
• Better software for inventory management (16.2%)
• Reduced lead time (15%)
• Improved forecasting (10.7%)
• Application of SCM principals (9.6%)
• More attention to inventory management (6.6%)
• Reduction in SKU (5.1%)
• Others
Forecasting
• Recall the three rules
• Nevertheless, forecast is critical
• General Overview:
– Judgment methods
– Market research methods
– Time Series methods
– Causal methods
Judgment Methods
• Assemble the opinion of experts
• Sales-force composite combines
salespeople’s estimates
• Panels of experts – internal, external, both
• Delphi method
– Each member surveyed
– Opinions are compiled
– Each member is given the opportunity to
change his opinion
Market Research Methods
• Particularly valuable for developing forecasts
of newly introduced products
• Market testing
– Focus groups assembled.
– Responses tested.
– Extrapolations to rest of market made.
• Market surveys
– Data gathered from potential customers
– Interviews, phone-surveys, written surveys, etc.
Time Series Methods
• Past data is used to estimate future data
• Examples include
– Moving averages – average of some previous demand points.
– Exponential Smoothing – more recent points receive more
weight
– Methods for data with trends:
• Regression analysis – fits line to data
• Holt’s method – combines exponential smoothing concepts with the
ability to follow a trend
– Methods for data with seasonality
• Seasonal decomposition methods (seasonal patterns removed)
• Winter’s method: advanced approach based on exponential
smoothing
– Complex methods (not clear that these work better)
Causal Methods
• Forecasts are generated based on data
other than the data being predicted
• Examples include:
– Inflation rates
– GNP
– Unemployment rates
– Weather
– Sales of other products
Selecting the Appropriate
Approach:
• What is the purpose of the forecast?
– Gross or detailed estimates?
• What are the dynamics of the system being forecast?
– Is it sensitive to economic data?
– Is it seasonal? Trending?
• How important is the past in estimating the future?
• Different approaches may be appropriate for different
stages of the product lifecycle:
– Testing and intro: market research methods, judgment methods
– Rapid growth: time series methods
– Mature: time series, causal methods (particularly for long-range
planning)
• It is typically effective to combine approaches.

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Inventory Management, Supply Contracts and Risk Pooling: Kaminsky@ieor - Berkeley.edu

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Inventory Management,

Supply Contracts and Risk

• The Effect of Demand Uncertainty

• Centralized vs. Decentralized Systems

• Practical Issues in Inventory Management

(2*Demand*Setup Cost)/holding cost

• So for our problem, the optimal quantity is

– Forecasting is always wrong

Jan 00 Jan 01 Jan 02

Feb 00 Sep 00 Feb 01 Sep 01

• Question: 9000 and 16000 units

• Question: If there are 7000 units remaining, what

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Manufacturer Manufacturer DC Retail DC

–Is there anything that the distributor

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$80

Manufacturer Manufacturer DC Retail DC

Fixed Production Cost =$100,000

Variable Production Cost=$35

Wholesale Price =$??

Manufacturer Manufacturer DC Retail DC

Strategy Retailer Manufacturer Total

Fixed Production Cost =$100,000

Variable Production Cost=$35

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Manufacturer Manufacturer DC Retail DC

Strategy Retailer Manufacturer Total

• The buyer pays a minimal amount for each

• Often, there are multiple reorder opportunities

• Consider a central distribution facility which orders from a

• Satisfy demand during lead

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(2DemandSetup Cost)/holding cost