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Inventory Management and Risk Pooling - Risk pooling

5 important questions on Inventory Management and Risk Pooling - Risk pooling

What is risk pooling?

Risk pooling suggests that demand variability is reduced if one aggregates demand across locations.

What is the coefficient of variation? And how do we calculate it?

The coefficient of variation is the ratio of standard deviation to average demand:

Explain the link between risk pooling and centralizing inventory.

Centralizing inventory reduces both safety stock and average inventory in the system. In a centralized distribution system, whenever demand from one market area is higher than average while demand in another market area is lower than average, items in the warehouse that were originally allocated for one market can be reallocated to the other.

Explain the link between risk pooling and a high coefficient of variation.

The higher the coefficient of variation, the greater the benefit obtained from centralized systems; that is, the greater the benefit from risk pooling. Average inventory includes two components: one proportional to average weekly demand (Q) and the other proportional to the standard deviation of weekly demand (safety stock). Since reduction in average inventory is achieved mainly through a reduction in safety stock, the higher the coefficient of variation, the larger the impact of safety stock in inventory reduction.

Explain the link between risk pooling and behavior of demand.

The benefits from risk pooling depend on the behavior of demand from one market relative to demand from another. We say that demand from two markets is positively correlated if it is very likely that whenever demand from one market is greater than average, demand from the other market is also greater than average. Similarly, when demand from one market is smaller than average, so is demand from the other. Intuitively, the benefit from risk pooling decreases as the correlation between demand from the two markets becomes more positive.