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Operations Strategy

Case Study: Managing Inventory at ALKO Inc

Irawati Cipto – 1206186522

Dame Reiny Manalu - 1206185570 Ali Yudhi Hartanto - 1206185053

Azhar Harris – 1206185356

Magister Manajemen

Fakultas Ekonomi, Universitas Indonesia

Jakarta, 2013

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Case Synopsis

ALKO began in 1943 in a garage workshop set up by John Williams at his

Cleveland home. In February 1948, he obtained a patent for one of his lighting

design for lighting fixtures. He decided to produce it in his workshop and tried

marketing it in the Cleveland area. The product sold well and by 1957, ALKO had

grown to a $3 million company. It’s lighting fixtures were well known for their

outstanding quality. By then, it sold a total of 5 products.

ALKO go public in 1963. Since then, ALKO has been very successful, and the

company has started distributing its products nationwide. As competition intensified

in the 1980s, ALKO introduced many new lighting fixture designs. Altough ALKO had

taken great care to ensure that product quality did not suffer, the company’s

profitability began to worsen. The problem was that margins had begun to shrink as

competition in the market intensified.

The board decided to reorganized starting at the top. Gary Fisher was hired to

reorganize and restructure the company in 1999. Fisher found a company teetering

on the edge. Fisher then analyzed that the key was in the operating performance.

Altough the company had always been outstanding at developing and producing new

products, it had historically ignored its distribution system. Fisher set up a task force

to review the company’s current distribution system.

Problems Identification

The problem identification for managing inventories at ALKO :

1) What is the annual inventory and distribution cost of the current distribution

system?

2) What are the savings that would result from following the task force

recommendation and setting up an NDC? Evaluate the savings as the

correlation coefficient of demand in any pair of regions varies from 0 to 0.5 to

1.0. Do you recommend setting up a NDC?

3) Suggest other options that Fisher should consider. Evaluate each option and

recommend a distribution system for ALKO that would be most profitable

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Theory

Inventory is the stock of any item or resource used in an organization. An

inventory system is a set of policies and procedures that determines what inventory

levels should be maintained, when stock should be replenished and how large

orders should be.

Managing inventory types include :

a. Raw materials

b. Work in process inventory (include componet parts)

c. Finished products inventory

Inventory is created when supply exceeds the demand. The purpose of

holding inventory is to achieve economies of scale, protect suppliers from stockout

due to uneven and uncertain demand, and shelter demand variation during leadtime.

Inventory:

a. Cycle Inventory

Cycle inventory is the inventory that accrues in the supply chain as the result

of purchasing or producing larger lots than currently demanded by customers.

b. Safety Inventory

Safety inventory is created to protect against fluctuations and uncertainty in

demand, supply, and lead time. There are two major sources of uncertainty :

quantity and timing

c. Seasonal Inventory

When demand is seasonal, seasonal inventory is created to absorb uneven

rates of demand. d. In Transit Inventory

In transit inventory is a function of demand during lead time. In transit

inventory provides a safeguard during supply delivery time.

Inventory Costs:

Inventory is used to improve customer Service Level. Money invested in inventory is

an opportunity cost to company and its supply chain. The supply chain manager

needs to balance the advantage and disadvantage of both low and high inventory.

There are two major costs associated with inventory. One is holding cost and the

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other is ordering or set up cost. The primary reason for keeping inventory low is due

to the cost of holding inventory. Money invested in inventory cannot be used for

other investment. The primary reason for keeping inventory high is due to the cost of

replenishing inventory. Ordering cost or set up cost are the two major costs.

a. Managing Inventory Cost Economic Order Quantity (EOQ)

EOQ is to minimize total annual ordering cost and inventory holding cost through

ordering an optimal lot size and achieve economies of scale. The EOQ is found

by determined the minimum cost point. Making holding cost equals ordering cost

will give the optimal quantity.

SQDHQ

=2

Economic Order Quantity (EOQ) = HDS2

Q = order quantity

D = annual demand

S = cost to place an order or set up cost in manufacturing/per order

H = annual holding cost per unit

Inventory Replenishment – Reorder Point System

Reorder point system which is also known as Continuous Review System is an

inventory policy that tracks inventory position. Whenever inventory level reaches

the reorder point, an order is placed to replenish inventory. The reorder point has

two components :

(1) average demand during leadtime

(2) safety stock

Inventory Replenishment – Periodic Review System

Periodic review system is to review inventory position in a fixed time interval. The

inventory system simplifies delivery schedule because it follows a routine

replenishing cycle. A periodic review system also has two components :

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(1) average demand during lead time plus fixed time interval

(2) safety stock

b. Improving Customer Service Level – Managing Safety Stock

There are two reasons to keep safety stock. The first reason for keeping safety

stock is to protect against demand variation. Safety stock is related to forecasting

error in demand. The second reason for keeping safety stock is to protect against

time and quantity variation from the supply side.

Case Analysis

The current distribution system at Alco :

• All production occured at 3 facilities located in the Cleveland area.

• The plants scheduled production based on DC order.

• Orders were transported from plants to the DCs in TL quantities because

order sizes tended to be large. In 1999, TL costs from the plants to DCs

averaged $0.09 per unit.

• Customer placed orders with the DCs.

• Shipment from DC to customers were LTL. LTL shipping costs from DC to

customer averaged $0.10 per unit.

• DC ordered using a periodic review policy with a reorder interval of 6 days.

• Lead time 5 days between the time a DC placed an order with a plant and the

time the order was delivered from the plant.

• Holding cost $0.15 per unit per day.

• All DCs carried safety inventories to ensure a CSL of 95%.

Alternative Distibution System for Alco :

• ALKO closed its current 5 DC.

• ALKO build a National Distribution Center (NDC) outside Chicago.

• Costs from Plant to NDC $0.05 per unit.

• Shipment cost from NDC to customer $ 0.24 per unit.

• Total replenishment for NDC still five days.

• The CLS out of NDC still continued 95%.

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Solutions:

Summary of investment and annual cost for various options

Option Investment Annual Cost Savings from Base Case Rate of return NPV(10% )Decentralize all parts in five warehouses Base Case 960,326$ Centralize all parts at NDC 850,000$ 755,164$ 205,162$ 24.1% 1,406,777$ Centralize parts 3, 7, decentralize part 1 650,000$ 765,064$ 195,262$ 30.0% 1,497,884$

v From the demand data and given data for the current distribution system, we can

calculate annual inventory and distribution cost of the current distribution system.

The worksheet for annual inventory and distribution cost is in Appendix. After we

calculate, the annual inventory and distribution cost for current distribution system

is $960.326 (see exhibit 1)

v Then we calculate the cost for NDC. After we calculate, the cost for centralized all

parts at NDC is $755.164. So we can have saving $205.162 compare with base

cost DC (see exhibit 2).

v Another option is proposed, Centralize parts 3, 7, decentralize part 1. Total cost =

$765.064. Saving from base cost DC = $960.326 - $765.064 = $ 195.262 (see

exhibit 3).

Conclusion and Recommendation

Conclusion:

Ø Inventory is strategic importance to Supply Chain Management.

Ø Inventory is created when supply exceeds the demand. The purpose of holding

inventory is to achieve economies of scale, protect suppliers from stockout due to

uneven and uncertain demand, and shelter demand variation during leadtime.

Ø The supply chain manager needs to balance the advantage and disadvantage of

both low and high inventory. The primary reason for keeping inventory low is due

to the cost of holding inventory. Money invested in inventory cannot be used for

other investment. The primary reason for keeping inventory high is due to the

cost of replenishing inventory.

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Ø In order to managing inventory cost, there are several ways : EOQ, Inventory

Replenishment – Reorder point system, Inventory Replenishment – periodic

review system.

Ø There are two reasons to keep safety stock. The first reason for keeping safety

stock is to protect against demand variation. Safety stock is related to forecasting

error in demand. The second reason for keeping safety stock is to protect against

time and quantity variation from the supply side.

Ø ALKO should review its current distribution system in order to reduce cost but still

maintain the CSL of 95%.

Recommendation:

Ø After analyzed the calculation for current distribution system, we recommend

ALKO to build a National Distribution Center (NDC). If we compare the cost from

current distribution system and proposal for build NDC, we can conclude that

NDC will reduce the cost of distribution system for ALKO. Ø ALKO can also make several options to reduce cost of distribution system such

as combine : centralize parts 3, 7, decentralize part 1. But however this cost for

centralize and decentralize decision still higher than centralize all parts at NDC.

Refferences:

1. Chopra, S. & Meindl, P. (2007). Supply Chain Management: Strategy, Planning & Operations, 3rd Edition, New Jersey: Pearson Prentice Hall

2. Li, L. (2007). Supply Chain Management: Concepts, Techniques & Practices,

Singapore: World Scientific Publishing Co

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Appendix

Exhibit 1. The annual inventory and distribution cost of the current distribution system

InputsHolding cost, H = 0.15$ per unit and dayTL costs from plants to DCs = 0.09$ per unitLTL costs from DC to customers = 0.10$ per unitTL costs from plants to central whse. = 0.05$ per unitLTL cost from central whse. to cust. = 0.24$ per unitReorder Interval, T = 6 daysLead Time, L = 5 daysTarget cycle service level, CSL = 0.95Correlation Coefficient = 0

Demand data by part and region # of parts Region 1 Region 2 Region 3 Region 4 Region 5 All Regions

Part 1 Mean, R 10 35.48 22.61 17.66 11.81 3.36 90.92Part 1 SD 6.98 6.48 5.26 3.48 4.49 NAPart 3 Mean 20 2.48 4.15 6.15 6.16 7.49 26.43Part 3 SD 3.16 6.20 6.39 6.76 3.56 NAPart 7 Mean 70 0.48 0.73 0.80 1.94 2.54 6.49Part 7 SD 1.98 1.42 2.39 3.76 3.98 NA

Coefficient of variation by part and regionRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions

Part 1 0.20 0.29 0.30 0.29 1.34 NAPart 3 1.27 1.49 1.04 1.10 0.48 NAPart 7 4.13 1.95 2.99 1.94 1.57 NA

Demand during reorder interval and replenishment lead timeRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions

Part 1 Mean 390.28 248.71 194.26 129.91 36.96 1000.12Part 1 SD 23.15 21.49 17.45 11.54 14.89 NAPart 3 Mean 27.28 45.65 67.65 67.76 82.39 290.73Part 3 SD 10.48 20.56 21.19 22.42 11.81 NAPart 7 Mean 5.28 8.03 8.80 21.34 27.94 71.39Part 7 SD 6.57 4.71 7.93 12.47 13.20 NA

OutputsCycle stock and required safety stock by part and region

Region 1 Region 2 Region 3 Region 4 Region 5 All RegionsPart 1Cycle Inventory 106.44 67.83 52.98 35.43 10.08 272.76Part 1 SS 38.08 35.35 28.70 18.98 24.49 145.60Part 3 Cycle Inventory 7.44 12.45 18.45 18.48 22.47 79.29Part 3 SS 17.24 33.82 34.86 36.88 19.42 142.22Part 7 Cycle Inventory 1.44 2.19 2.40 5.82 7.62 19.47Part 7 SS 10.80 7.75 13.04 20.51 21.71 73.81

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Costs per unit by region and partRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions

Inventory cost 0.61$ 0.68$ 0.69$ 0.69$ 1.54$ 0.69$ Transportation cost 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ Total cost part 1 0.80$ 0.87$ 0.88$ 0.88$ 1.73$ 0.88$ Inventory cost 1.49$ 1.67$ 1.30$ 1.35$ 0.84$ 1.26$ Transportation cost 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ Total cost part 3 1.68$ 1.86$ 1.49$ 1.54$ 1.03$ 1.45$ Inventory cost 3.83$ 2.04$ 2.89$ 2.04$ 1.73$ 2.16$ Transportation cost 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ Total cost part 7 4.02$ 2.23$ 3.08$ 2.23$ 1.92$ 2.35$

Total Annual Inventory and Distribution Cost # of parts Region 1 Region 2 Region 3 Region 4 Region 5 All Regions

Part 1 10 $103,729 $72,171 $56,964 $37,982 $21,260 $292,107Part 3 20 $30,463 $56,425 $66,904 $69,161 $56,259 $279,213Part 7 70 $49,246 $41,626 $63,051 $110,336 $124,747 $389,005All Parts $183,439 $170,223 $186,920 $217,479 $202,266 $960,326

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Exhibit 2. The savings that would result from following the task force recommendation and setting up an NDC

InputsHolding cost, H = 0.15$ per unit and dayTL costs from plants to DCs = 0.09$ per unitLTL costs from DC to customers = 0.10$ per unitTL costs from plants to central whse. = 0.05$ per unitLTL cost from central whse. to cust. = 0.24$ per unitReorder Interval, T = 6.00$ daysLead Time, L = 5.00$ daysTarget cycle service level, CSL = 0.95$ Correlation Coefficient = -$

Demand data by part and region # of partsRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions Central

Part 1 Mean # 35.48 22.61 17.66 11.81 3.36 90.92 90.91Part 1 SD 6.98 6.48 5.26 3.48 4.49 NA 12.27Part 3 Mean # 2.48 4.15 6.15 6.16 7.49 26.43 26.43Part 3 SD 3.16 6.20 6.39 6.76 3.56 NA 12.15Part 7 Mean # 0.48 0.73 0.80 1.94 2.54 6.49 6.49Part 7 SD 1.98 1.42 2.39 3.76 3.98 NA 6.45

Demand during reorder interval and replenishment lead timeRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions Central

Part 1 Mean 390.28 248.71 194.26 129.91 36.96 1000.12 1000.01Part 1 SD 23.15 21.49 17.45 11.54 14.89 NA 40.71Part 3 Mean 27.28 45.65 67.65 67.76 82.39 290.73 290.73Part 3 SD 10.48 20.56 21.19 22.42 11.81 NA 40.30Part 7 Mean 5.28 8.03 8.80 21.34 27.94 71.39 71.39Part 7 SD 6.57 4.71 7.93 12.47 13.20 NA 21.40

OutputsCycle stock and required safety stock by part and region

Region 1 Region 2 Region 3 Region 4 Region 5 All Regions CentralPart 1Cycle Inventory 106.44 67.83 52.98 35.43 10.08 272.76 272.73Part 1 SS 38.08 35.35 28.70 18.98 24.49 145.60 66.96Part 3 Cycle Inventory 7.44 12.45 18.45 18.48 22.47 79.29 79.29Part 3 SS 17.24 33.82 34.86 36.88 19.42 142.22 66.28Part 7 Cycle Inventory 1.44 2.19 2.40 5.82 7.62 19.47 19.47Part 7 SS 10.80 7.75 13.04 20.51 21.71 73.81 35.20

Costs per unit by region and partRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions Central

Inventory cost 0.61$ 0.68$ 0.69$ 0.69$ 1.54$ 0.69$ 0.56$ Transportation cost 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.29$ Total cost part 1 0.80$ 0.87$ 0.88$ 0.88$ 1.73$ 0.88$ 0.85$ Inventory cost 1.49$ 1.67$ 1.30$ 1.35$ 0.84$ 1.26$ 0.83$ Transportation cost 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.29$ Total cost part 3 1.68$ 1.86$ 1.49$ 1.54$ 1.03$ 1.45$ 1.12$ Inventory cost 3.83$ 2.04$ 2.89$ 2.04$ 1.73$ 2.16$ 1.26$ Transportation cost 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ 0.29$ Total cost part 7 4.02$ 2.23$ 3.08$ 2.23$ 1.92$ 2.35$ 1.55$

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Total Annual Inventory and Distribution Cost # of partsRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions Central Savings

Part 1 $103,729 $72,171 $56,964 $37,982 $21,260 $292,107 $282,208 $9,899Part 3 $30,463 $56,425 $66,904 $69,161 $56,259 $279,213 $215,356 $63,857Part 7 $49,246 $41,626 $63,051 $110,336 $124,747 $389,005 $257,600 $131,405All Parts $183,439 $170,223 $186,920 $217,479 $202,266 $960,326 $755,164

Savings: $205,162

Cost Savings from Centralization as a function of the correlation coefficient and target cycle service level

All parts$205,162 0.00 0.25 0.50 0.75 1.00

0.9 $144,599 $74,213 $19,155 -$27,633 -$69,0350.91 $154,468 $80,830 $23,229 -$25,720 -$69,0350.92 $165,190 $88,019 $27,655 -$23,642 -$69,0350.93 $176,979 $95,924 $32,521 -$21,357 -$69,0350.94 $190,145 $104,752 $37,956 -$18,806 -$69,0350.95 $205,162 $114,821 $44,155 -$15,896 -$69,0350.96 $222,804 $126,651 $51,438 -$12,477 -$69,0350.97 $244,493 $141,194 $60,391 -$8,273 -$69,0350.98 $273,324 $160,526 $72,293 -$2,686 -$69,0350.99 $318,766 $190,996 $91,052 $6,121 -$69,035

Type 1 only$9,899 0.00 0.25 0.50 0.75 1.000.9 $389 -$10,751 -$19,388 -$26,701 -$33,1590.91 $1,939 -$9,716 -$18,752 -$26,403 -$33,1590.92 $3,622 -$8,591 -$18,061 -$26,079 -$33,1590.93 $5,474 -$7,355 -$17,301 -$25,722 -$33,1590.94 $7,541 -$5,974 -$16,453 -$25,324 -$33,1590.95 $9,899 -$4,399 -$15,485 -$24,871 -$33,1590.96 $12,670 -$2,548 -$14,348 -$24,337 -$33,1590.97 $16,076 -$273 -$12,950 -$23,682 -$33,1590.98 $20,603 $2,751 -$11,091 -$22,810 -$33,1590.99 $27,739 $7,517 -$8,162 -$21,437 -$33,159

Type 3 only$63,857 0.00 0.25 0.50 0.75 1.000.9 $45,492 $24,074 $7,384 -$6,776 -$19,2940.91 $48,484 $26,077 $8,616 -$6,197 -$19,2940.92 $51,736 $28,254 $9,955 -$5,569 -$19,2940.93 $55,311 $30,647 $11,427 -$4,878 -$19,2940.94 $59,304 $33,319 $13,071 -$4,107 -$19,2940.95 $63,857 $36,368 $14,947 -$3,227 -$19,2940.96 $69,207 $39,949 $17,150 -$2,193 -$19,2940.97 $75,785 $44,352 $19,858 -$922 -$19,2940.98 $84,528 $50,205 $23,458 $767 -$19,2940.99 $98,308 $59,429 $29,133 $3,430 -$19,294

Type 7 only$131,405 0.00 0.25 0.50 0.75 1.00

0.9 $98,719 $60,890 $31,159 $5,844 -$16,5820.91 $104,045 $64,469 $33,365 $6,880 -$16,5820.92 $109,832 $68,357 $35,761 $8,006 -$16,5820.93 $116,194 $72,632 $38,395 $9,243 -$16,5820.94 $123,300 $77,407 $41,338 $10,626 -$16,5820.95 $131,405 $82,852 $44,693 $12,202 -$16,5820.96 $140,927 $89,250 $48,636 $14,054 -$16,5820.97 $152,632 $97,115 $53,483 $16,331 -$16,5820.98 $168,193 $107,571 $59,926 $19,357 -$16,5820.99 $192,719 $124,050 $70,081 $24,128 -$16,582

Correlation Cofficient

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Exhibit 3. Other option to be considered: building NDC while keeping the Regional DCs open

InputsHolding cost = 0.15$ per unit and dayTL costs from plants to DCs = 0.09$ per unitLTL costs from DC to customers = 0.10$ per unitTL costs from plants to central whse. = 0.05$ per unitLTL cost from central whse. to cust. = 0.24$ per unitReorder Interval = 6 daysLead Time = 5 daysTarget cycle service level = 0.95Correlation Coefficient = 0

Demand data by part and region # of partsRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions

Part 1 Mean 10 35.48 22.61 17.66 11.81 3.36 90.92Part 1 SD 6.98 6.48 5.26 3.48 4.49 NAPart 3 Mean 20 2.48 4.15 6.15 6.16 7.49 26.43Part 3 SD 3.16 6.20 6.39 6.76 3.56 NAPart 7 Mean 70 0.48 0.73 0.80 1.94 2.54 6.49Part 7 SD 1.98 1.42 2.39 3.76 3.98 NA

Coefficient of variation by part and regionRegion 1 Region 2 Region 3 Region 4 Region 5 All Regions

Part 1 0.20 0.29 0.30 0.29 1.34 NAPart 3 1.27 1.49 1.04 1.10 0.48 NAPart 7 4.13 1.95 2.99 1.94 1.57 NA

Demand during reorder interval and replenishment lead timeRegion 1 Region 2 Region 3 Region 4 Region 5 Central

Part 1 Mean 390.28 248.71 194.26 129.91 36.96Part 1 SD 23.15 21.49 17.45 11.54 14.89Part 3 Mean 290.73Part 3 SD 40.30Part 7 Mean 71.39Part 7 SD 21.40

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OutputsCycle stock and required safety stock by part and region

Region 1 Region 2 Region 3 Region 4 Region 5 CentralPart 1Cycle Stock 106.44 67.83 52.98 35.43 10.08Part 1 SS 38.08 35.35 28.70 18.98 24.49Part 3 Cycle Stock 79.29Part 3 SS 66.28Part 7 Cycle Stock 19.47Part 7 SS 35.20

Costs per unit by region and partRegion 1 Region 2 Region 3 Region 4 Region 5 Central

Inventory cost 0.61$ 0.68$ 0.69$ 0.69$ 1.54$ Transportation cost 0.19$ 0.19$ 0.19$ 0.19$ 0.19$ Total cost part 1 0.80$ 0.87$ 0.88$ 0.88$ 1.73$ Inventory cost 0.83$ Transportation cost 0.29$ Total cost part 3 1.12$ Inventory cost 1.26$ Transportation cost 0.29$ Total cost part 7 1.55$

Total Annual Inventory and Distribution Cost # of parts Region 1 Region 2 Region 3 Region 4 Region 5 Central

Part 1 10 $103,729 $72,171 $56,964 $37,982 $21,260 $0Part 3 20 $215,356Part 7 70 $257,600All Parts $103,729 $72,171 $56,964 $37,982 $21,260 $472,956

Total logistic system: $765,064Costs Savings

Benchmark: All parts in the field: $960,326 $195,262All partscentralized: $755,164 -$9,899

$765,064 0.00 0.25 0.50 0.75 1.000.9 $701,631 $760,877 $807,298 $846,772 $881,717

0.91 $711,968 $773,951 $822,516 $863,814 $900,3730.92 $723,197 $788,154 $839,049 $882,328 $920,6410.93 $735,545 $803,771 $857,228 $902,685 $942,9260.94 $749,335 $821,213 $877,530 $925,421 $967,8150.95 $765,064 $841,106 $900,686 $951,351 $996,2020.96 $783,542 $864,477 $927,890 $981,815 $1,029,5520.97 $806,259 $893,209 $961,335 $1,019,267 $1,070,5520.98 $836,457 $931,403 $1,005,794 $1,069,054 $1,125,0540.99 $884,053 $991,601 $1,075,866 $1,147,523 $1,210,956

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