Multi-Echelon

Inventory
Management
Prof. Larry Snyder
Lehigh University
Dept. of Industrial & Systems Engineering
OR Roundtable, June 15, 2006

Outline

Introduction

Overview
Network topology
Assumptions
Deterministic models

Stochastic models
Decentralized systems

Multi-Echelon Inventory June 15,

2006

Overview

System is composed of stages (nodes, sites, )

Stages are grouped into echelons
Stages can represent

Physical locations
BOM
Processing activities
Multi-Echelon Inventory June 15,
2006

Overview

Stages to the left are upstream

Those to the right are downstream
Downstream stages face customer demand

Multi-Echelon Inventory June 15,

2006

Network Topology

Serial system:

Multi-Echelon Inventory June 15,

2006

Network Topology

Assembly system:

Multi-Echelon Inventory June 15,

2006

Network Topology

Distribution system:

Multi-Echelon Inventory June 15,

2006

Network Topology

Mixed system:

Multi-Echelon Inventory June 15,

2006

Assumptions

Periodic review

Centralized decision making

Period = week, month,

Can optimize system globally
Later, I will talk about decentralized systems

Costs

Holding cost
Fixed order cost
Stockout cost (vs. service level)
Multi-Echelon Inventory June 15,
2006

Deterministic Models

Suppose everything in the system is

deterministic (not random)

Demands, lead times,

Possible to achieve 100% service

If no fixed costs, explode BOM every period

If fixed costs are non-negligible, key tradeoff
is between fixed and holding costs

Multi-echelon version of EOQ

MRP systems (optimization component)
Multi-Echelon Inventory June 15,
2006

Outline

Introduction
Stochastic models

Base-stock model
Stochastic multi-echelon systems
Strategic safety stock placement
Supply uncertainty

Decentralized systems

Multi-Echelon Inventory June 15,

2006

Stochastic Models

Suppose now that demand is stochastic

(random)

Ill assume:

Still assume supply is deterministic

Including lead time, yield,
No fixed cost
Normally distributed demand: N(,2)

Key tradeoff is between holding and stockout

costs
Multi-Echelon Inventory June 15,
2006

The Base-Stock Model

Single stage (and echelon)

Excess inventory incurs holding cost of h per
unit per period
Unmet demand is backordered at a cost of p
per unit per period
Stage follows base-stock policy

Each period, order up to base-stock level, y

aka order-up-to policy
Similar to days-of-supply policy: y / DOS
Multi-Echelon Inventory June 15,
2006

The Base-Stock Model

Optimal base-stock level:

y* z
where z comes from normal distribution and

ph

is sometimes called the newsboy ratio

Multi-Echelon Inventory June 15,
2006

Interpretation

y* z

In other words, base-stock level = mean demand +

some # of SDs worth of demand
# of SDs depends on relationship between h and p
Ash z y*

Asp z y*

If lead time = L:

y* L z L
Multi-Echelon Inventory June 15,
2006

Stochastic Multi-Echelon
Systems

Need to set y at each stage

Could use base-stock formula

But how to quantify lead time?

Lead time is stochastic
Depends on upstream base-stock level and
stochastic demand

For serial systems, exact algorithms exist

Clark-Scarf (1960)
But they are cumbersome
Multi-Echelon Inventory June 15,
2006

An Approximate Method

Assume that each stage carries sufficient

inventory to deliver product within S periods
most of the time

Definition of most depends on service level

constant, z
S is called the committed service time (CST)

We simply ignore the times that the stage

does not meet its CST

For the purposes of the optimization

Allows us to pretend LT is deterministic
Multi-Echelon Inventory June 15,
2006

Net Lead Time

3

T3

S3

S2

T2

S1

T1

Each stage has a processing time T and a

CST S

Net lead time at stage i = Si+1 + Ti Si

bad LT good LT

Multi-Echelon Inventory June 15,

2006

Net Lead Time vs. Inventory

Suppose Si = Si+1 + Ti

e.g., inbound CST = 4, proc time = 2, outbound

CST = 6
Dont need to hold any inventory
Operate entirely as pull (make-to-order, JIT)
system

Suppose Si = 0

Promise immediate order fulfillment

Make-to-stock system
Multi-Echelon Inventory June 15,
2006

Net Lead Time vs. Inventory

Precise relationship between NLT and inventory:

y* NLT z NLT

NLT replaces LT in earlier formula

So, choosing inventory levels is equivalent to
choosing NLTs, i.e., choosing S at each stage
Efficient algorithms exist for finding optimal S values
to minimize expected holding cost while meeting
end-customer service requirement
Multi-Echelon Inventory June 15,
2006

Key Insight

It is usually optimal for only a few stages to

hold inventory

Other stages operate as pull systems

In a serial system, every stage either:

holds zero inventory (and quotes maximum CST)

or quotes CST of zero (and holds maximum
inventory)

Multi-Echelon Inventory June 15,

2006

Case Study

(Adapted from Simchi-Levi, Chen, and Bramel,

The Logic of Logistics, Springer, 2004)
PART 2
CHARLESTON ($7)

14
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32

PART 7
CHARLESTON ($30)

PART 3
AUSTIN ($2)

14

14
PART 4
BALTIMORE ($220)

PART 1
DALLAS ($260)

15

55

14

14

# below stage = processing time

# in white box = CST
In this solution, inventory is held of finished product
and its raw materials
Multi-Echelon Inventory June 15,
2006

A Pure Pull System

PART 2
CHARLESTON ($7)

14
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32

PART 7
CHARLESTON ($30)

PART 3
AUSTIN ($2)

14

14
PART 4
BALTIMORE ($220)

7
55

14

14

Produce to order
Long CST to customer
No inventory held in system
Multi-Echelon Inventory June 15,
2006

PART 1
DALLAS ($260)

15

77

A Pure Push System

PART 2
CHARLESTON ($7)

14
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32

PART 7
CHARLESTON ($30)

PART 3
AUSTIN ($2)

14

14
PART 4
BALTIMORE ($220)

PART 1
DALLAS ($260)

15

55

14

14

Produce to forecast
Zero CST to customer
Hold lots of finished goods inventory
Multi-Echelon Inventory June 15,
2006

A Hybrid Push-Pull System

PART 2
CHARLESTON ($7)

7
8

14
PART 5
CHICAGO ($155)

45
5

45
PART 6
CHARLESTON ($2)

32

32

PART 7
CHARLESTON ($30)

14

PART 3
AUSTIN ($2)

14
PART 4
BALTIMORE ($220)

PART 1
DALLAS ($260)

30

15

push/pull boundary

14

Part of system operated produce-to-stock,

part produce-to-order
Moderate lead time to customer
Multi-Echelon Inventory June 15,
2006

CST vs. Inventory Cost

Push System

$14,000

Inventory Cost ($/year)

$12,000

Push-Pull System

$10,000
$8,000
$6,000
$4,000

Pull System

$2,000
$0
0

10

20

30

40

50

60

Committed Lead Time to Customer (days)

Multi-Echelon Inventory June 15,

2006

70

80

Optimization Shifts the Tradeoff

Curve
$14,000

Inventory Cost ($/year)

$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$0
0

10

20

30

40

50

60

Committed Lead Time to Customer (days)

Multi-Echelon Inventory June 15,

2006

70

80

Supply Uncertainty

Types of supply uncertainty:

Strategies for dealing with demand and supply

uncertainty are similar

Lead-time uncertainty
Yield uncertainty
Disruptions

Safety stock inventory

Dual sourcing
Improved forecasts

But the two are not the same

Multi-Echelon Inventory June 15,
2006

Risk Pooling

One warehouse, several retailers

If demand is uncertain:

Who should hold inventory?

Smaller inventory reqt if warehouse holds inv.
Consolidation is better

If supply is uncertain (but demand is not):

Disruption risk is minimized if retailers hold inv.

Diversificaiton is better
Multi-Echelon Inventory June 15,
2006

Inventory Placement

Hold inventory upstream or downstream?

Conventional wisdom:

Hold inventory upstream

Holding cost is smaller

Under supply uncertainty:

Hold inventory downstream

Protects against stockouts anywhere in system
Multi-Echelon Inventory June 15,
2006

Outline

Introduction
Stochastic models
Decentralized systems

Suboptimality
Contracting
The bullwhip effect

Multi-Echelon Inventory June 15,

2006

Decentralized Systems

So far, we have assumed the system is

centralized

Can optimize at all stages globally

One stage may incur higher costs to benefit the
system as a whole

What if each stage acts independently to

minimize its own cost / maximize its own
profit?
Multi-Echelon Inventory June 15,
2006

Suboptimality

Optimizing locally is likely to result in some

degree of suboptimality
Example: upstream stages want to operate
make-to-order

Results in too much inventory downstream

Another example:

Wholesaler chooses wholesale price

Retailer chooses order quantity
Optimizing independently, the two parties will
always leave money on the table
Multi-Echelon Inventory June 15,
2006

Contracting

One solution is for the parties to impose a

contracting mechanism

Splits the costs / profits / risks / rewards

Still allows each party to act in its own best interest
If structured correctly, system achieves optimal cost / profit,
even with parties acting selfishly

There is a large body of literature on contracting

In practice, idea is commonly used

Actual OR models rarely implemented

Multi-Echelon Inventory June 15,

2006

Bullwhip Effect (BWE)

Demand for diapers:

Multi-Echelon Inventory June 15,

2006

Irrational Behavior Causes

BWE

Firms over-react to demand signals

Order too much when they perceive an upward

demand trend
Then back off when they accumulate too much
inventory

Firms under-weight the supply line

Both are irrational behaviors
Demonstrated by beer game
Multi-Echelon Inventory June 15,
2006

Rational Behavior Causes

BWE

Famous paper by Hau Lee, et al. (1997)

BWE can be cause by rational behavior

i.e., by acting in optimal ways according to OR

inventory models

Four causes:

Demand forecast updating

Batch ordering
Rationing game
Price variations
Multi-Echelon Inventory June 15,
2006

Questions?