Inventory Levels Accounting for the Impact of Part Substitution

15 Inventory Levels Accounting for the Impact of Part Substitution 

This section provides a numerical example to illustrate the inventory impact of part substitution on inventory levels and costs. Consider a retail location that sells two products. Product 1 costs 5, and product 2 costs 10. Product 2 can perform all the functions of product 1 and more. The retail selling price for product 1 is 10 and the retail selling price of product 2 is 13. Demand for each product is normally distributed each period with a mean of 50 units and a standard deviation of 25 units. Holding cost per unit per period is 0.20 per unit per period, and the backorder cost is 5 per unit per period. Each period the retailer places reorders from a supplier and faces a lead time of 4 periods for delivery. These data are captured in Table 6.1. 

Standard Deviation Expected Profit (No Substitution) Expected Profit (Substitution) 

Consider the impact of the following retailer scheme If the location were to run out of product 1, offer the customer product 2 for the price of product 1. Note that when the demand standard deviation is 25 units, the effect of substitution is to increase expected profit from 420.69 to 435.52. This increase in expected profit is realized because of the opportunity to get both revenue for product that could be potentially backordered as well as associated savings on the backorder costs in the presence of the alternate to substitute product demand. 

Thus permitting substitution may help both decrease inventories and increase service levels in a supply chain. 

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