Creating an inventory hedge for Markov-modulated Poisson demand: An application and model

Many firms face environments with long manufacturing leadtimes, great product variety, and uncertain, nonstationary demand. A challenge is how to plan production and inventories to provide the best customer service at the least cost. In this paper, we first describe an application at Teradyne in which we implemented an inventory hedge to protect against cyclic demand variability. Based on this experience, we develop a model to better understand the efficacy of this hedging policy. We consider an inventory system for a single aggregate product with a Markov-modulated Poisson demand process. We provide approximate performance measures for this system and develop an optimization problem for determining the size and location of an intermediate-decoupling inventory. We use this optimization to show the value of an intermediate-decoupling inventory as a hedge for cyclic demand environments.