Explain the impact of aggregation on safety inventory
What will be an ideal response?
Answer: Aggregation reduces the standard deviation of demand only if demand across the regions being aggregated is not perfectly positively correlated. Demand for most products does not show perfect positive correlation across different geographical regions. In case demand in different geographical regions is about the same size and independent, aggregation reduces safety inventory by the square root of the number of areas aggregated. In other words, if the number of independent stocking locations decreases by a factor of n, the average safety inventory is expected to decrease by a factor of n.
There are two major disadvantages of aggregating all inventory in one location:
1. Increase in response time to customer order
2. Increase in transportation cost to customer
Both disadvantages result because the average distance between the inventory and the customer increases with aggregation. With this situation, either the customer has to travel more to reach the product or the product has to be shipped over longer distances to reach the customer. However, there are clear benefits to aggregating safety inventory.
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