On apportioning costs to customers in centralized continuous review inventory systems

Many manufacturing firms use common production and warehousing resources to jointly supply customers’ demands that vary significantly in their variability. For example, it is a common practice in the defense manufacturing industry, while supplying both to the department of defense and the commercial market, to routinely combine safety stocks of the same part meant for different end users, thereby achieving lower overall operating costs. Whereas it might be possible to make a strong case for benefits of centralization (provided this does not result in substantial increases in administrative costs), it is not at all clear that an individual customer will necessarily benefit from centralization under some commonly used methods of allocating inventory costs to customers. For example, if inventory costs are spread evenly over all items stocked (produced), it is possible that a customer will end up paying more (in absolute terms) than what it would have paid on a stand-alone basis. The purpose of this paper is to first show that it is economical to consolidate. It then investigates some apparently ‘reasonable’ and popular methods of cost allocation to demonstrate their potential for unfairness. It also proposes a method that is fair in the sense that any customer’s post-centralization share of overheads does not exceed its costs without consolidation. The findings of this study are particularly relevant for customers with large steady demands, such as the department of defense, who might inadvertently be subsidizing inventory costs of customers with smaller and more variable demands under an unfair allocation scheme.