Question 17: Chapter 2

Inventory Management and Risk Pooling

KLF Electronics is an American manufacturer of electronic equipment. The company has a single manufacturing facility in San Jose,
California. KLF Electronics distributes its products through five regional warehouses located in Atlanta, Boston, Chicago, Dallas, and
Los Angeles. In the current distribution system, the United States is partitioned into five major markets, each of which is served by a
single regional warehouse. Customers, typically retail outlets, receive items directly from the regional warehouse in their market. That is,
in the current distribution system, each customer is assigned to a single market and receives deliveries from one regional warehouse.

The warehouses receive items from the manufacturing facility. Typically, it takes about two weeks to satisfy an order placed by any of the regional
warehouses. Currently, KLF provides their customers with a service level of about 90 percent. In recent years, KLF has seen a significant increase in
competition and huge pressure from their customers to improve the service level and reduce costs. To improve the service level and reduce costs, KLF
would like to consider an alternative distribution strategy in which the five regional warehouses are replaced with a single, central warehouse that will
be in charge of all customer orders. This warehouse should be one of the existing warehouses. The company CEO insists that whatever distribution
strategy is used, KLF will design the strategy so that service level is increased to about 97 percent.

Answer the following three questions:

Issue 1: a. A detailed analysis of customer demand in the five market areas reveals that the demand in the five regions is very similar; that is, it is
common that if weekly demand in one region is above average, so is the weekly demand in the other regions. How does this observation affect the
attractiveness of the new system?

Issue 2: b. To perform a rigorous analysis, you have identified a typical product, Product A. Table 2-11 provides historical data and includes weekly
demand for this product for the last 12 weeks in each of the market areas. An order (placed by a warehouse to the factory) costs $5,550 (per order), and
holding inventory costs $1.25 per unit per week. In the current distribution system, the cost of transporting a product from the manufacturing facility to
a warehouse is given in Table 2-12 (see the column “Inbound”). Table 2-12 also provides information about transportation cost per unit from each
warehouse to the stores in its market area (see the column “Outbound”). Finally, Table 2-13 provides information about transportation costs per unit
product from each existing regional warehouse to all other market areas, assuming this regional warehouse becomes the central warehouse.
Suppose you are to compare the two systems for Product A only; what is your recommendation? To answer this question, you should compare costs
and average inventory levels for the two strategies assuming demands occur according to the historical data. Also, you should determine which regional
warehouse will be used as the centralized warehouse.

Issue 3: c. It is proposed that in the centralized distribution strategy, that is, the one with a single warehouse, products will be distributed using UPS
Ground Service, which guarantees that products will arrive at the warehouse in three days (0.5 week). Of course, in this case, transportation cost for
shipping a unit product from a manufacturing facility to the warehouse increases. In fact, in this case, transportation costs increase by 50%. Thus, for
instance, shipping one unit from the manufacturing facility to Atlanta will cost $18.Would you recommend using this strategy? Explain your answer.
Answer (a)
In this case, the demands from all warehouses are positively correlated.
Therefore the benefits derived from proposed system would not be considerable and new centralized system wouldn’t be attractive.
Part 2
Table 1: Historical Data
Week 1 2 3 4 5 6 7 8 9 10 11 12
Atlanta 33 45 37 38 55 30 18 58 47 37 23 55
Boston 26 35 41 40 46 48 55 18 62 44 30 45
Chicago 44 34 22 55 48 72 62 28 27 95 35 45
Dallas 27 42 35 40 51 64 70 65 55 43 38 47
LA 32 43 54 40 46 74 40 35 45 38 48 56
Total 162 199 189 213 246 288 245 204 236 257 174 248

Table 2: Current transportation costs per unit

Warehouse Inbound Outbound
Atlanta 12 13
Boston 11.5 13
Chicago 11 13
Dallas 9 13
LA 7 13

Table 3: Transportation costs per unit in centralized system

Warehouse Atlanta Boston Chicago Dallas LA
Atlanta 13 14 14 15 17
Boston 14 13 22 15 17
Chicago 14 22 13 15 16
Dallas 15 15 15 13 22
LA 17 17 16 22 13

Service Level 90% and lead time 2 weeks

Avg. Inv. Level

Regions Avg. Demand STD CV Q Inbound per Unit Outbound per unit Avg. Inbound Cost Avg. Outbound Cost Carrying Cost Ordering cost TC
(SR = 90% and L=2)

Atlanta 39.7 12.8 0.32 590.8 12 13 476.0 515.7 397.8 497.3 369.3 1858.2
Boston 40.8 12.2 0.30 599.4 11.5 13 469.6 530.8 403.5 504.4 374.7 1879.5
Chicago 47.3 21.2 0.45 644.8 11 13 519.8 614.3 455.2 569.0 403.0 2106.1
Dallas 48.1 13.2 0.27 650.5 9 13 432.8 625.1 445.3 556.7 406.6 2021.1
LA 45.9 11.3 0.25 635.7 7 13 321.4 596.9 430.2 537.7 397.3 1853.4
Centralized 221.8 37.5 0.17 1396.9 766.4 958.0 873.1

Service Level 90% and lead time 2 weeks

Carrying + Ordering
Centralized Atlanta Boston Chicago Dallas LA Inbound Atlanta Boston Chicago Dallas LA Inbound TC
Cost
Atlanta 13 14 14 15 17 12 515.7 571.7 661.5 721.3 780.6 2661.0 1831.1 7742.7
Boston 14 13 22 15 17 11.5 555.3 530.8 1039.5 721.3 780.6 2550.1 1831.1 8008.7
Chicago 14 22 13 15 16 11 555.3 898.3 614.3 721.3 734.7 2439.3 1831.1 7794.1
Dallas 15 15 15 13 22 9 595.0 612.5 708.8 625.1 1010.2 1995.8 1831.1 7378.3
LA 17 17 16 22 13 7 674.3 694.2 756.0 1057.8 596.9 1552.3 1831.1 7162.6

Decentralized System:
Avg. Inventory = 2132.2

Centralized System:
Avg. Inventory = 766.4

Percentage reduction in inventory level (approx.) = 64%

So, by changing the system from decentralized to centralized, the company is expected to save 64% approximately in average inventory level.

Comparing the costs for each regional warehouse, LA is selected to be the centralized warehouse due to its lowest TC.
Part 3 (L = 2)
Table 1: Historical Data
Week 1 2 3 4 5 6 7 8 9 10 11 12
Atlanta 33 45 37 38 55 30 18 58 47 37 23 55
Boston 26 35 41 40 46 48 55 18 62 44 30 45
Chicago 44 34 22 55 48 72 62 28 27 95 35 45
Dallas 27 42 35 40 51 64 70 65 55 43 38 47
LA 32 43 54 40 46 74 40 35 45 38 48 56
Total 162 199 189 213 246 288 245 204 236 257 174 248

Table 2: Current transportation costs per unit

Warehouse Inbound Outbound
Atlanta 12 13
Boston 11.5 13
Chicago 11 13
Dallas 9 13
LA 7 13

Table 3: Transportation costs per unit in centralized system

Warehouse Atlanta Boston Chicago Dallas LA

Atlanta 13 14 14 15 17

Boston 14 13 22 15 17
Chicago 14 22 13 15 16
Dallas 15 15 15 13 22
LA 17 17 16 22 13

Avg. Inv. Level

Regions Avg. Demand STD CV Q Inbound per Unit Outbound per unit Avg. Inbound Cost Avg. Outbound Cost
(SR = 90% and L=2)
Carrying Cost Ordering cost TC

Atlanta 39.7 12.8 0.32 590.8 12 13 476.0 515.7 397.8 497.3 369.3 1858.2
Boston 40.8 12.2 0.30 599.4 11.5 13 469.6 530.8 403.5 504.4 374.7 1879.5
Chicago 47.3 21.2 0.45 644.8 11 13 519.8 614.3 455.2 569.0 403.0 2106.1
Dallas 48.1 13.2 0.27 650.5 9 13 432.8 625.1 445.3 556.7 406.6 2021.1
LA 45.9 11.3 0.25 635.7 7 13 321.4 596.9 430.2 537.7 397.3 1853.4
Centralized 221.8 37.5 0.17 1396.9 798.2 997.8 873.1

Service Level 97% and lead time 2 weeks

Carrying + Ordering
Centralized Atlanta Boston Chicago Dallas LA Inbound Atlanta Boston Chicago Dallas LA Inbound TC
Cost
Atlanta 13 14 14 15 17 12 515.7 571.7 661.5 721.3 780.6 2661.0 1870.8 7782.5
Boston 14 13 22 15 17 11.5 555.3 530.8 1039.5 721.3 780.6 2550.1 1870.8 8048.5
Chicago 14 22 13 15 16 11 555.3 898.3 614.3 721.3 734.7 2439.3 1870.8 7833.9
Dallas 15 15 15 13 22 9 595.0 612.5 708.8 625.1 1010.2 1995.8 1870.8 7418.1
LA 17 17 16 22 13 7 674.3 694.2 756.0 1057.8 596.9 1552.3 1870.8 7202.3
Part 3 (L = 0.5)
Table 1: Historical Data
Week 1 2 3 4 5 6 7 8 9 10 11 12
Atlanta 33 45 37 38 55 30 18 58 47 37 23 55
Boston 26 35 41 40 46 48 55 18 62 44 30 45
Chicago 44 34 22 55 48 72 62 28 27 95 35 45
Dallas 27 42 35 40 51 64 70 65 55 43 38 47
LA 32 43 54 40 46 74 40 35 45 38 48 56
Total 162 199 189 213 246 288 245 204 236 257 174 248

Table 2: Current transportation costs per unit

Warehouse Inbound Outbound
Atlanta 12 13
Boston 11.5 13
Chicago 11 13
Dallas 9 13
LA 7 13

Table 3: Transportation costs per unit in centralized system

Warehouse Atlanta Boston Chicago Dallas LA

Atlanta 13 14 14 15 17

Boston 14 13 22 15 17
Chicago 14 22 13 15 16
Dallas 15 15 15 13 22
LA 17 17 16 22 13

Avg. Inv. Level

Regions Avg. Demand STD CV Q Inbound per Unit Outbound per unit Avg. Inbound Cost Avg. Outbound Cost
(SR = 90% and L=2)
Carrying Cost Ordering cost TC

Atlanta 39.7 12.8 0.32 590.8 12 13 476.0 515.7 397.8 497.3 369.3 1858.2
Boston 40.8 12.2 0.30 599.4 11.5 13 469.6 530.8 403.5 504.4 374.7 1879.5
Chicago 47.3 21.2 0.45 644.8 11 13 519.8 614.3 455.2 569.0 403.0 2106.1
Dallas 48.1 13.2 0.27 650.5 9 13 432.8 625.1 445.3 556.7 406.6 2021.1
LA 45.9 11.3 0.25 635.7 7 13 321.4 596.9 430.2 537.7 397.3 1853.4
Centralized 221.8 37.5 0.17 1396.9 748.3 935.4 873.1

Service Level 97% and lead time 0.5 week

Carrying + Ordering
Centralized Atlanta Boston Chicago Dallas LA Inbound Atlanta Boston Chicago Dallas LA Inbound TC
Cost
Atlanta 13 14 14 15 17 18 515.7 571.7 661.5 721.3 780.6 3991.5 1808.5 9050.7
Boston 14 13 22 15 17 17.25 555.3 530.8 1039.5 721.3 780.6 3825.2 1808.5 9261.2
Chicago 14 22 13 15 16 16.5 555.3 898.3 614.3 721.3 734.7 3658.9 1808.5 8991.2
Dallas 15 15 15 13 22 13.5 595.0 612.5 708.8 625.1 1010.2 2993.6 1808.5 8353.6
LA 17 17 16 22 13 10.5 674.3 694.2 756.0 1057.8 596.9 2328.4 1808.5 7916.1

With service level of 97% and lead time of 2 weeks:

Avg. Inventory Level = 798

With service level of 97% and lead time of 0.5 week:

Avg. Inventory Level = 748

Percentage reduction in inventory level (approx.) = 6.27%

So, by decreasing lead time from 2 weeks to 1/2 week, the company is expected to save 6.3% approximately in average inventory level.
LA Warehouse
Table 1: Historical Data
Week 1 2 3 4 5 6 7 8 9 10 11 12
Atlanta 33 45 37 38 55 30 18 58 47 37 23 55
Boston 26 35 41 40 46 48 55 18 62 44 30 45
Chicago 44 34 22 55 48 72 62 28 27 95 35 45
Dallas 27 42 35 40 51 64 70 65 55 43 38 47
LA 32 43 54 40 46 74 40 35 45 38 48 56
Total 162 199 189 213 246 288 245 204 236 257 174 248

Table 2: Current transportation costs per unit

Warehouse Inbound Outbound
Atlanta 12 13
Boston 11.5 13
Chicago 11 13
Dallas 9 13
LA 7 13

Table 3: Transportation costs per unit in centralized system

Warehouse Atlanta Boston Chicago Dallas LA

Atlanta 13 14 14 15 17

Boston 14 13 22 15 17
Chicago 14 22 13 15 16
Dallas 15 15 15 13 22
LA 17 17 16 22 13

Avg. Inv. Level

Regions Avg. Demand STD CV Q Inbound per Unit Outbound per unit Avg. Inbound Cost Avg. Outbound Cost
(SR = 90% and L=2)
Carrying Cost Ordering cost TC

Atlanta 39.7 12.8 0.32 590.8 12 13 476.0 515.7 397.8 497.3 369.3 1858.2
Boston 40.8 12.2 0.30 599.4 11.5 13 469.6 530.8 403.5 504.4 374.7 1879.5
Chicago 47.3 21.2 0.45 644.8 11 13 519.8 614.3 455.2 569.0 403.0 2106.1
Dallas 48.1 13.2 0.27 650.5 9 13 432.8 625.1 445.3 556.7 406.6 2021.1
LA 45.9 11.3 0.25 635.7 7 13 321.4 596.9 430.2 537.7 397.3 1853.4
Centralized 221.8 37.5 0.17 1396.9 748.3 935.4 873.1

Service Level 97% and lead time 0.5 week

Carrying + Ordering
Centralized Atlanta Boston Chicago Dallas LA Inbound Atlanta Boston Chicago Dallas LA Inbound TC
Cost
Atlanta 13 14 14 15 17 18 515.7 571.7 661.5 721.3 780.6 3991.5 1808.5 9050.7
Boston 14 13 22 15 17 17.25 555.3 530.8 1039.5 721.3 780.6 3825.2 1808.5 9261.2
Chicago 14 22 13 15 16 16.5 555.3 898.3 614.3 721.3 734.7 3658.9 1808.5 8991.2
Dallas 15 15 15 13 22 13.5 595.0 612.5 708.8 625.1 1010.2 2993.6 1808.5 8353.6
LA 17 17 16 22 13 10.5 674.3 694.2 756.0 1057.8 596.9 2328.4 1808.5 7916.1

LA Warehouse:
Increase in cost when lead time is changed from 2 to 0.5 week = 9.02%

If we use this strategy, we will be able to save only 6.3% of average inventory level by increasing 9% of total cost ($707) at LA warehouse. Hence, this strategy does not seem too attractive to be applied.