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Faculty of Technical Science

Title

“SUPPLY CHAIN MANAGEMENT”

Graduation Project

Course: PRODACTION SYSTEM CONTROL

Skopje - July, 2011

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Faculty of Technical Science

Title

“SUPPLY CHAIN MANAGEMENT”

Graduation Project

Course: PRODACTION SYSTEM CONTROL

Mentor:

Prof. (Tarik CAKAR)

Performed by:

Enis SELAM, Student ID No.08/09.20

Enis_sl m @ hotmai l .co m

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Skopje, July, 2011

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BRIEF CONTENTS

Preface xiii

Part I -- Building a Strategic Framework to Analyze Supply Chains

Chapter 1 Understanding the Supply ChainChapter 2 Supply Chain Performance: Achieving Strategic Fit and ScopeChapter 3 Supply Chain Drivers and Metrics

Part II -- Designing the Supply Chain Net w ork

Chapter 4 Designing Distribution Networks and Applications to e-BusinessChapter 5 Network Design in the Supply ChainChapter 6 Designing Global Supply Chain Networks

Part III -- Planning Demand and Supply in a Supply Chain

Chapter 7 Demand Forecasting in a Supply ChainChapter 8 Aggregate Planning in a Supply ChainChapter 9 Planning Supply and Demand in a Supply Chain

Part IV -- Planning and Manag i ng Inventories in a Supply Chain

Chapter 10 Managing Economies of Scale in a Supply Chain: Cycle Inventory Chapter 11 Managing Uncertainty in a Supply Chain: Safety Inventory Chapter 12 Determining the Optimal Level of Product Availability

Part V -- Designing and Planning Transportation Networks

Chapter 13 Transportation in a Supply Chain

Part VI -- Managing Cross-Fun c tional Drivers in a Supply Chain

Chapter 14 Sourcing Decisions in a Supply ChainChapter 15 Pricing and Revenue Management in a Supply ChainChapter 16 Information Technology in a Supply ChainChapter 17 Coordination in a Supply Chain

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CONTENTS

Preface xiiiPart I Building a Strategic Framework to Analyze Supply Chains

Ch 1 Understanding the Supply Chain1.1 What Is a Supply Chain?------------------------------------------------------------ 81.2 The Objective of a Supply Chain-------------------------------------------------- 91.3 The Importance of Supply Chain Decisions------------------------------------- 101.4 Decision Phases in a Supply Chain------------------------------------------------ 121.5 Process Views of a Supply Chain------------------------------------------------- 14

Ch 2 Supply Chain Performance: Achieving Strategic Fit and Scope2.1 Competitive and Supply Chain Strategies---------------------------------------- 182.2 Achieving Strategic Fit-------------------------------------------------------------- 202.3 Expanding Strategic Scope--------------------------------------------------------- 26

Ch 3 Supply Chain Drivers and Metrics3.1 Drivers of Supply Chain Performance-------------------------------------------- 273.2 Framework for Structuring Drivers----------------------------------------------- 273.3 Facilities------------------------------------------------------------------------------- 283.4 Inventory------------------------------------------------------------------------------ 283.5 Transportation------------------------------------------------------------------------ 293.6 Information--------------------------------------------------------------------------- 303.7 Sourcing------------------------------------------------------------------------------- 303.8 Pricing---------------------------------------------------------------------------------3.9 Obstacles to Achieving Strategic Fit----------------------------------------------

3132

Part II Designing the Supply Chain NetworkCh 4 Designing Distribution Networks and Applications to e-Business

4.1 The Role of Distribution in the Supply Chain----------------------------------- 324.2 Factors Influencing Distribution Network Design------------------------------ 324.3 Design Options for a Distribution Network-------------------------------------- 374.4 E-Business and the Distribution Network---------------------------------------- 404.5 Distribution Networks in Practice------------------------------------------------- 40

Ch 5 Network Design in the Supply Chain5.1 The Role of Network Design in the Supply Chain------------------------------ 415.2 Factors Influencing Network Design Decisions--------------------------------- 415.3 Framework for Network Design Decisions-------------------------------------- 435.4 Models for Facility Location and Capacity Allocation------------------------- 44

Ch 6 Designing Global Supply Chain Networks6.1 The Impact of Globalization on Supply Chain Networks---------------------- 476.2 The Off shoring Decision: Total Cost--------------------------------------------- 476.3 Risk Management in Global Supply Chains------------------------------------- 496.4 The Basic Aspects of Evaluating Global Supply Chain Design--------------- 496.5 Evaluating Network Design Decisions Using Decision Trees----------------- 53

6.6AM Tires: Evaluation of Global Supply Chain Design Decisions UnderUncertainty---------------------------------------------------------------------------

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9.1 Responding to Predictable Variability in the Supply Chain------------------- 709.2 Managing Supply-------------------------------------------------------------------- 709.3 Managing Demand------------------------------------------------------------------ 709.4 Implementing Sales and Operations Planning in Practice---------------------- 73Part IV Planning and Managing Inventories in a Supply Chain

Ch 10 Managing Economies of Scale in a Supply Chain: CycleI nventory

10.1 The Role of Cycle Inventory in a Supply Chain--------------------------------- 7410.2 Estimating Cycle Inventory-Related Costs in Practice------------------------- 7510.3 Economies of Scale to Exploit Fixed Costs-------------------------------------- 7910.4 Economies of Scale to Exploit Quantity Discounts----------------------------- 8310.5 Short-Term Discounting: Trade Promotions------------------------------------- 8410.6 Managing Multiechelon Cycle Inventory---------------------------------------- 85

Ch 11 Managing Uncertainty in a Supply Chain: Safety

nventory11.1 The Role of Safety Inventory in a Supply Chain-------------------------------- 8611.2 Impact of Supply Uncertainty on Safety Inventory----------------------------- 8611.3 Impact of Aggregation on Safety Inventory-------------------------------------- 9111.4 Impact of Replenishment Policies on Safety Inventory------------------------ 9211.5 Estimating and Managing Safety Inventory in Practice------------------------ 94

Ch 12 Determining the Optimal Level of Productvailability

12.1 The Importance of the Level of Product Availability--------------------------- 9512.2 Factors Affecting Optima Level of Product Availability----------------------- 9512.3 Managerial Levers to Improve Supply Chain Profitability--------------------- 95

12.4Setting Product Availability for Multiple Products Under CapacityConstraints----------------------------------------------------------------------------

95

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6.7Making Global Supply Chain Design Decisions Under Uncertainty inPractice--------------------------------------------------------------------------------

Part III Planning Demand and Supply in a Supply ChainCh 7 Demand Forecasting in a Supply Chain

7.1 The Role of Forecasting in a Supply Chain-------------------------------------- 567.2 Characteristics of Forecasts-------------------------------------------------------- 567.3 Components of a Forecast and Forecasting Methods--------------------------- 567.4 Basic Approach to Demand Forecasting------------------------------------------ 587.5 Time-Series Forecasting Methods------------------------------------------------- 587.6 Measures of Forecast Error--------------------------------------------------------- 647.7 Forecasting Demand at Tahoe Salt------------------------------------------------ 657.8 Forecasting in Practice-------------------------------------------------------------- 65

Ch 8 Aggregate Planning in a Supply Chain8.1 The Role of Aggregate Planning in a Supply Chain---------------------------- 658.2 The Aggregate Planning Problem------------------------------------------------- 658.3 Aggregate Planning Strategies----------------------------------------------------- 668.4 Implementing Aggregate Planning in Practice---------------------------------- 70

Ch 9 Sales and Operations Planning: Planning Supply and Demand in aSupply Chain

16.1 The Role of IT in a Supply Chain------------------------------------------------- 11316.2 The Supply Chain IT Framework-------------------------------------------------- 11416.3 Customer Relationship Management---------------------------------------------- 11516.4 Internal Supply Chain Management----------------------------------------------- 11516.5 Supplier Relationship Management----------------------------------------------- 11516.6 The Transaction Management Foundation--------------------------------------- 11516.7 The Future of IT in the Supply Chain--------------------------------------------- 11616.8 Supply Chain IT in Practice-------------------------------------------------------- 116

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12.5 Setting Optimal Levels of Product Availability in Practice--------------------Part V Designing and Planning Transportation Networks

95

Ch 13 Transportation in a SupplyChain

13.1 The Role of Transportation in a Supply Chain---------------------------------- 10013.2 Modes of Transportation and Their Performance Characteristics------------- 10013.3 Transportation Infrastructure and Policies--------------------------------------- 10213.4 Design Options for a Transportation Network----------------------------------- 10213.5 Trade-Offs in Transportation Design--------------------------------------------- 10313.6 Tailored Transportation------------------------------------------------------------- 10313.7 The Role of IT in Transportation-------------------------------------------------- 10413.8 Making Transportation Decisions in Practice------------------------------------ 104Part VI Managing Cross-Functional Drivers in a Supply Chain

Ch 14 Sourcing Decisions in a SupplyChain

14.1 The Role of Sourcing in a Supply Chain----------------------------------------- 10414.2 In-House or Outsource-------------------------------------------------------------- 10414.3 Third-and Fourth-Party Logistics Providers------------------------------------- 10514.4 Supplier Scoring and Assessment------------------------------------------------- 10514.5 Supplier Selection---Auctions and Negotiations-------------------------------- 10514.6 Contracts, Risk Sharing, and Supply Chain Performance---------------------- 10714.7 The Procurement Process----------------------------------------------------------- 10814.8 Sourcing Planning and Analysis--------------------------------------------------- 10914.9 Making Sourcing Decisions in Practice------------------------------------------- 109

Ch 15 Pricing and Revenue Management in a SupplyChain

15.1 The Role of Pricing and Revenue Management in a Supply Chain----------- 10915.2 Pricing and Revenue Management for Multiple Customer Segments-------- 11015.3 Pricing and Revenue Management for Perishable Assets---------------------- 11015.4 Pricing and Revenue Management for Seasonal Demand---------------------- 11115.5 Pricing and Revenue Management for Bulk and Spot Contracts-------------- 112

15.6 Using Pricing and Revenue Management in Practice--------------------------- 112

Ch 16 Information Technology in a Supply Chain

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Ch 17 Coordination in a SupplyChain

17.1 Lack of Supply Chain Coordination and the Bullwhip Effect----------------- 11617.2 The Effect on Performance of Lack of Coordination--------------------------- 11717.3 Obstacles to Coordination in a Supply Chain------------------------------------ 11717.4 Managerial Levers to Achieve Coordination------------------------------------- 11817.5 Building Strategic Partnerships and Trust Within a Supply Chain------------ 12017.6 Achieving Coordination in Practice----------------------------------------------- 122

Books and References--------------------------------------------------------------123

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1.1 What is a Supply Chain?

A supply chain consists of all parties involved, directly or indirectly, in fulfilling a Customer request. The supply chain not only includes the manufacturer and suppliers, but Also transporters, warehouses, retailers, and customers themselves. Within each Organization, such as manufacturer, the supply chain includes all functions involved in Receiving and filling a customer request. These functions include, but are not limited to, New product development, marketing, operations, distribution, finance, and customer service.

Consider a customer walking into a Wal-Mart store to purchase detergent. The supply chain begins with the customer and their need for detergent. The next stage ofthis supply chain is the Wal-Mart retail store that the customer visits. Wal-Mart stocks its shelves using inventory that may have been supplied from a finished-goods warehouse that Wal-Mart manages or from a distributor using trucks supplied by a third party. The distributor in turn is stocked by the manufacturer (say Procter & Gamble [P&G] in this case). The P&G manufacturing plant receives raw material from a variety of suppliers who may themselves have been supplied by lower tier suppliers. For example, packaging material may come from Tenneco packaging while Tenneco receives raw materials to manufacture the packaging from other suppliers.

A supply chain is dynamic and involves the constant flow of information, product, and funds between different stages. In our example, Wal-Mart provides the product, as well as pricing and availability information, to the customer. The customer transfers funds to Wal-Mart. Wal-Mart conveys point-of-sales data as well as replenishment order via trucks back to the store. Wal-Mart transfers funds to the distributor after the replenishment. The distributor also provides pricing information and sends delivery schedules to Wal-Mart. Similar information, material, and fund flows take place across the entire supply chain.

In another example, when a customer purchases online from Dell Computer, the supply chain includes, among others, the customer, Dell’s Web site that takes the customer’s order, the Dell assembly plant, and all of Dell’s suppliers and their suppliers. The Web site provides the customer with information regarding pricing, product variety, and product availability. Having made a product choice, the customer enters the site to check the status of the order. Stages further up the supply chain use customer order information to fill the order. That process involves an additional flow of information, product, and funds between various stages of the supply chain.

These examples illustrate that the customer is an integral part of the supply chain. The primary purpose from the existence of any supply chain is to satisfy customer needs, in the process generating profits for itself. Supply chain activities begin with a customer order and end when a satisfied customer has paid for his or her purchase. The termsupply chain conjures up images of product or supply moving from suppliers to manufacturers to distributors to retailers to customers along a chain. It is important to

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visualize information, funds, and product flows along both directions of this chain. The term supply chain may also imply that only one player is involved at each stage.

In reality, a manufacturer may receive material from several suppliers and then supply several distributors. Thus, most supply chains are actually networks. It may be more accurate to use the term supply network or supply web to describe the structure of most supply chains.

A typical supply chain may involve a variety of stages. These supply chain stages include:

• Customers• Retailers• Wholesalers/Distributors• Manufacturers• Component/Raw material suppliers

Each stage need not be presented in a supply chain. The appropriate design of the supply chain will depend on both the customer’s needs and the roles of the stages involved. In some cases, such as Dell, a manufacturer may fill customer orders directly. Dell builds-to-order; that is, a customer order initiates manufacturing at Dell. Dell does not have a retailer, wholesaler, or distributor in its supply chain. In other cases, such as the mail order company L.L. Bean, manufacturers do not respond to customer orders directly. In this case, L.L. Bean maintains an inventory or product from which they fill customer orders. Compared to the Dell supply chain, the L.L. Bean supply chain contains an extra stage (the retailer, L.L. Bean itself) between the customer and the manufacturer. In the case of other retail stores, the supply chain may also contain a wholesaler or distributor between the store and the manufacturer.

1.2 The Objective of a Supply Chain

The objective of every supply chain is to maximize the overall value generated.The value a supply chain generates is the difference between what the final product is worth to the customer and the effort the supply chain expends in filling the customer’s request. For most commercial supply chains, value will be strongly correlated with supply chain profitability, the difference between the revenue generated from the customer and the overall cost across the supply chain. For example, a customer purchasing a computer from Dell pays $2,000, which represents the revenue the supply chain receives. Dell and other stages of the supply chain incur costs to convey information, produce components, store them, transport them, transfer funds, and so on. The difference between the $2,000 that the customer paid and the sum of all costsincurred by the supply chain to produce and distribute the computer represents the supply chain profitability. Supply chain profitability is the total profit to be shared across all supply chain stages. The higher the supply chain profitability, the more successful the supply chain. Supply chain success should be measured in terms of supply chain profitability and not in terms of the profits at an individual stage.

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Having defined the success of a supply chain in terms of supply chain profitability, the next logical step is to look for sources of revenue and cost. For any supply chain, there is only one source of revenue: the customer. At Wal-Mart, acustomer purchasing detergent is the only one providing positive cash flow for the supply chain. All other cash flows are simply fund exchanges that occur within the supply chain given that different stages have different owners. When Wal-Mart pays its supplier, it is taking a portion of the funds the customer provides and passing that money on to the supplier. All flows of information, product, or funds generate costs within the supply chain. Thus, the appropriate management of these flows is a key to supply chain success. Supply chain management involves the management of flows between and among stage sin a supply chain to maximize total supply chain profitability.

1.3The importance of supply chain decisions

We classify the decisions for supply chain management into two broad categories -- strategic and operational. As the term implies, strategic decisions are made typically over a longer time horizon. These are closely linked to the corporate strategy (they sometimes{\it are} the corporate strategy), and guide supply chain policies from a design perspective. On the other hand, operational decisions are short term, and focus on activities over a day-to-day basis. The effort in these type of decisions is to effectively and efficiently manage the product flow in the "strategically" planned supply chain.

There are four major decision areas in supply chain management:1) location, 2) production, 3) inventory, and 4) transportation (distribution), and there are both strategic and operational elements in each of these decision areas.

Location Decisions :

The geographic placement of production facilities, stocking points, and sourcing points is the natural first step in creating a supply chain. The location of facilities involves a commitment of resources to a long-term plan. Once the size, number, and location of these are determined, so are the possible paths by which the product flows through to the final customer. These decisions are of great significance to a firm since they represent the basic strategy for accessing customer markets, and will have a considerable impact on revenue, cost, and level of service. These decisions should be determined by an optimization routine that considers production costs, taxes, duties and duty drawback,

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tariffs, local content, distribution costs, production limitations, etc. (See Arntzen, Brown, Harrison and Trafton [1995] for a thorough discussion of these aspects.) Although location decisions are primarily strategic, they also have implications on an operational level.

Production Decisions

The strategic decisions include what products to produce, and which plants to produce them in, allocation of suppliers to plants, plants to DC's, and DC's to customer markets. As before, these decisions have a big impact on the revenues, costs and customer service levels of the firm. These decisions assume the existence of the facilities, but determine the exact path(s) through which a product flows to and from these facilities. Another critical issue is the capacity of the manufacturing facilities--and this largely depends the degree of vertical integration within the firm. Operational decisions focus on detailedproduction scheduling. These decisions include the construction of the master production schedules, scheduling production on machines, and equipment maintenance. Other considerations include workload balancing, and quality control measures at a production facility.

Inventory Decisions

These refer to means by which inventories are managed. Inventories exist at every stage of the supply chain as either raw materials, semi-finished or finished goods. They can also be in-process between locations. Their primary purpose to buffer against any uncertainty that might exist in the supply chain. Since holding of inventories can cost anywhere between 20 to 40 percent of their value, their efficient management is critical in supply chain operations. It is strategic in the sense that top management sets goals. However, most researchers have approached the management of inventory from an operational perspective. These include deployment strategies (push versus pull), control policies --- the determination of the optimal levels of order quantities and reorder points, and setting safety stock levels, at each stocking location. These levels are critical, since they are primary determinants of customer service levels.

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Transportation Decisions

The mode choice aspect of these decisions are the more strategic ones. These are closely linked to the inventory decisions, since the best choice of mode is often found by trading- off the cost of using the particular mode of transport with the indirect cost of inventory associated with that mode. While air shipments may be fast, reliable, and warrant lesser safety stocks, they are expensive. Meanwhile shipping by sea or rail may be much cheaper, but they necessitate holding relatively large amounts of inventory to buffer against the inherent uncertainty associated with them. Therefore customer service levels, and geographic location play vital roles in such decisions. Since transportation is more than 30 percent of the logistics costs, operating efficiently makes good economic sense. Shipment sizes (consolidated bulk shipments versus Lot-for-Lot), routing and scheduling of equipment are key in effective management of the firm's transport strategy.

1.4 Decision Phases In a Supply Chain

Successful supply chain management requires many decisions relating to the flow of information, product, and funds. These decisions fall into three categories or phases, depending on the frequency of each decision and the time frame over which a decision phase has an impact.

1. Supply chain strategy or design: During this phase, a company decides how to structure the supply chain over the next several years. It decides what the chain’s configuration will be, how resources will be allocated, and what processes each stage will perform.

Strategic decisions made by companies include the location and capacities of production and warehouse facilities, the products to be manufactured or stored at various locations, the modes of transportation to be made available along different shipping legs, and the type of information system to be utilized. A firm must ensure that the supply chain configuration supports its strategic objectives during this phase. Dell’s decisions regarding the location and capacity of its manufacturing facilities, warehouses, and supply courses are all supply chain design or strategic decisions. Supply chain design decisions are typically made for the long term (a matter of years) and are very expensive to alter on short notice. Consequently, when companies make these decisions, they must take into account uncertainty in anticipated market conditions over the next few years.

2. Supply chain planning: For decisions made during this phase, the time frame considered is a quarter to a year. Therefore, the supply chain’s configuration determined in the strategic phase is fixed. The configuration establishes constraints within which

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planning must be done. Companies start the planning phase with a forecast for the coming year (or a comparable time frame) of demand in different markets.

Planning includes decisions regarding which markets will be supplied from which locations, the subcontracting of manufacturing, the inventory policies to be followed, and the timing and size of marketing promotions. Dell’s decisions regarding markets a given production facility will supply and target production quantities at different locations are classified as planning decisions. Planning establishes parameters within which a supply chain will function over a specified period of time. In the planning phase, companiesmust include uncertainty in demand, exchange rates, and competition over this time horizon in their decisions. Given a shorter time horizon and better forecasts than the design phase, companies in the planning phase try to incorporate any flexibility built into the supply chain in the design phase and exploit it to optimize performance. As a result of the planning phase, companies define a set of operating policies that govern short-term operations.

3. Supply chain operation: The time horizon here is weekly or daily, and during this phase companies make decisions regarding individual customer orders. At the operational level, supply chain configuration is considered fixed and planning policies are already defined. The goal of supply chain operations is to handle incoming customer orders in the best possible manner. During this phase, firms allocate inventory or production to individual orders, set a date that an order is to be filled, generate pick listsat a warehouse, allocate an order to a particular shipping mode and shipment, set delivery schedules of trucks, and place replenishment orders. Because operational decisions are being made in the short term (minutes, hours, or days), there is less uncertainty about demand information. Given the constraints established by the configuration and planning policies, the goal during the operation phase is to exploit the reduction of uncertainty and optimize performance.

The design, planning, and operation of a supply chain have a strong impact on overall profitability and success. Continuing with our example, consider Dell Computer. In the early 1990s, Dell management began to focus on improving the improved performance.

Both profitability and the stock price have soared and Dell stock has had outstanding returns over this period.

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1.5 Process View of a Supply Chain

* Cycle view: processes in a supply chain are divided into a series of cycles, each performed at theinterfaces between two successive supply chain stages

* Push/pull view: processes in a supply chain are divided into two categories depending on whether they are executed in response to a customer order (pull) or in anticipation of a customer order (push)

Cycle View of Supply Chains

Customer Order Cycle ↔

Replenishment Cycle ↔

Manufacturing Cycle ↔

Procurement Cycle ↔

Customer

Retailer

Distributor

Manufacturer

Supplier

Each cycle occurs at the interface between two successive stages

*Customer order cycle (customer-retailer)* Replenishment cycle (retailer-distributor)* Manufacturing cycle (distributor-manufacturer)* Procurement cycle (manufacturer-supplier)

Cycle view clearly defines processes involved and the owners of each process. Specifies the rolesand responsibilities of each member and the

desired outcome of each process.

Customer Order Cycle

Involves all processes directly involved in receiving and filling the customer’s order:

- Customer arrival- Customer order entry- Customer order fulfillment- Customer order receiving

Replenishment Cycle

All processes involved in replenishing retailer inventories (retailer is now the customer)

- Retail order trigger- Retail order entry- Retail order fulfillment- Retail order receiving

Manufacturing Cycle

All processes involved in replenishing distributor (or retailer) inventory

- Order arrival from the distributor, retailer, or customer- Production scheduling- Manufacturing and shipping- Receiving at the distributor, retailer, or customer

Procurement Cycle

All processes necessary to ensure that materials are available for manufacturing to occur according to schedule

- Manufacturer orders components from suppliers to

replenish component inventories

- However, component orders can be determined

precisely from production schedules (different fromretailer/distributor orders that are based on uncertaincustomer demand)

- Important that suppliers be linked to the manufacturer’s

production schedule

Push/Pull View of Supply Chains

Procurement, Push/Pull Boundary

Manufacturing andReplenishment cycles

↓ Customer Order Cycle

→→→ →→→→→→→

PUSH PROCESSES PULL PROCESSES

↑

CustomerOrder Arrives

Supply chain processes fall into one of two categories depending on the timing of their execution relative to customer demand:

-Pull: execution is initiated in response to a customer

order (reactive)

-Push: execution is initiated in anticipation of customer

orders (speculative)

-Push/pull boundary separates push processes from

pull processes

SUPPLY CHAIN MACRO PROCESSES IN A FIRM

´Three macro processes manage the flow of Information, Product, & funds required to generate, receive, & fulfill a customer request”

- Supplier Relationship Management (SRM) : All processes that focus on the interface the firm and its suppliers.-Source-Negotiate-Buy-Design Collaboration-Supply Collaboration

-Internal Supply Chain Management (ISCM) : All processes that are internal to the firm.- Strategic Planning- Demand Planning- Supply Planning- Fulfillment- Field Service

-Customer Relationship Management (CRM) : All processes that focus on the interface between the firm and its customers .- Market- Price- Sell- Call center- Order Management

2.1 Competitive and Supply Chain Strategies

Chances are you’ve heard the term supply chain strategy. Used informally, it is often confused with supply chain management, where supply chain operations are controlled to reduce costs. There’s some truth to this definition, but supply chain strategy really is broader; it defines how the supply chain should operate in orderto compete. Supply chain strategy is an iterative process that evaluates the costbenefit trade-offs of operational components.

Business strategy involves leveraging the core competencies of the organization to achieve a defined high-level goal or objective. It also includes the analytic and decision-making process surrounding what to offer (e.g., products and services),when to offer (timing, business cycles, etc), and where to offer (e.g., markets and segments) as a competitive plan.

While the business strategy constitutes the overall direction that an organization wishes to go, the supply chain strategy constitutes the actual operations of that organization and the extended supply chain to meet a specific supply chain objective.

That being said, most companies have a business strategy, but are unlikely to have overtly designed a supply chain strategy. So, why is a supply chain strategyso important? Well, one good reason is to operationalize and support your business strategy. At some point, a business strategy must be executed and typically this is done through the operational components of a company. Supply chain strategy also focuses on driving down operational costs and maximizing efficiencies.

For example, an organization may choose a strategy directed at supplier management as a way to remain competitive. By providinga clear purpose, the organization keeps sight of the strategy and is able to devise tactical steps to achieve these goals. Another reason for having a supply chain strategy is to establish how you work with your supply chain partners, including suppliers, distributors, customers, and even your customers’ customers. As the marketplace becomes more competitive, it is critical to reinforce existing relationships and work together. And for all these reasons, a well executed supply chain strategy results in value creation for the organization.-Competitive strategy:

defines the set of customer needs a firm seeks to satisfy through its products and services.

Low cost, Rapid Response, Product DifferentiationEx: Migros versus BIM

HP versus Dell

-Supply chain strategy:

-Determines the nature of material procurement, transportation of materials, and manufacture of product or creation of service, distribution of product.

-Consistency and support between supply chain strategy, competitive strategy, and other functional strategies is important!

The Value Chain: Linking Supply Chain and Business Strategy

Competitive Strategy

New ProductStrategy

MarketingStrategy Supply Chain Strategy

NewProduct

DevelopmentMarketing

andSales

OperationsDistribution

Service

Finance, Accounting, Information Technology, Human Resources

-Product development strategy: specifies the portfolio of new products that the company will try to develop

-Marketing and sales strategy: specifies how the market will be segmented and product positioned, priced, and promoted

-Supply Chain StrategyTraditionally, SC strategy includes:

-Suppliers Strategy-Operations Strategy

-Logistics Strategy

Regarding:inventory, transportation, operating facilities, information flows.

2.2 Achieving Strategic Fit

Strategic fit:

- Consistency between customer priorities of competitive strategy and supply chain capabilities specified by the supply chain strategy

- Competitive and supply chain strategies have the same goals- A company may fail because of a lack of strategic fit or because its processes and

resources do not provide the capabilities to execute the desired strategy- Example of strategic fit -- Dell

How is Strategic Fit Achieved?

Step 1: Understanding the customer and supply chain uncertaintyStep 2: Understanding the supply chainStep 3: Achieving strategic fit

Step 1: Understanding the Customer and Supply Chain Uncertainty

-- Identify the needs of the customer segment being served-- Quantity of product needed in each lot-- Response time customers will tolerate-- Variety of products needed-- Service level required-- Price of the product-- Desired rate of innovation in the product-- Overall attribute of customer demand-- Demand uncertainty: uncertainty of customer demand for a product-- Implied demand uncertainty: resulting uncertainty for the supply chain given the portion of the demand the supply chain must handle and attributes the customer desires-- Implied demand uncertainty also related to customer needs and product attributes-- Table 2.1-- Figure 2.2-- Table 2.2-- First step to strategic fit is to understand customers by mapping their demand on the implied uncertainty spectrum

“Understanding the Customer”– Lot size– Response time– Service level Implied– Product variety Demand

– Price Uncertainty– Innovation

Impact of Customer Needs on Implied Demand Uncertainty (Table 2.1)

Customer Need Causes implied demand uncertainty to increase because …

Range of quantity increases Wider range of quantity impliesgreater variance in demand

Lead time decreases Less time to react to orders

Variety of products required increases Demand per product becomes more disaggregated

Number of channels increases Total customer demand is now disaggregated over more channels

Rate of innovation increases New products tend to have more uncertain demand

Required service level increases Firm now has to handle unusual surges in demand

Levels of Implied Demand Uncertainty:

Predictable supply

and demand

Salt at a supermarke

t

Predictable supply and uncertain demand or uncertain supply and predictable demand or somewhat uncertain supply

and demand

An existing automobile

model

Highly uncertain supply and demand

A new communicatio

n device

Figure 2.2: The Implied Uncertainty (Demand and Supply)

Correlation Between Implied Demand Uncertainty and Other Attributes (Table 2.2)

Attribute Low Implied Uncertainty High ImpliedUncertainty

Product margin Low High

Avg. forecast error 10% 40%-100%

Avg. stockout rate 1%-2% 10%-40%

Avg. forced season-end markdown

0% 10%-25%

Step 2: Understanding the Supply Chain

-- There is a cost to achieving responsiveness-- Supply chain efficiency: cost of making and delivering the product to the customer-- Increasing responsiveness results in higher costs that lower efficiency-- Figure 2.3: cost-responsiveness efficient frontier-- Figure 2.4: supply chain responsiveness spectrum-- Second step to achieving strategic fit is to map the supply chain on the responsiveness spectrum-- Step is to ensure that what the supply chain does well is consistent with target customer’s needs-- Fig. 2.5: Uncertainty/Responsiveness map-- Fig. 2.6: Zone of strategic fit-- Examples: Dell, Barilla

Cost-Responsiveness Efficient Frontier Figure 2.3:

Responsiveness

High

Low

High LowCost

Responsiveness Spectrum Figure 2.4:

Highly efficient

Somewhat efficient

Somewhat responsive

Highly responsive

Integrated steel mill

Hanes apparel

Most automotive production

Dell

Achieving Strategic Fit Shown on the Uncertainty/Responsiveness Map Fig. 2.5:

Responsive supply chain

Responsivenes s spectrum

Zone ofStrategic Fit

Efficient supply chain

Certain demand

Implied uncertainty spectrum

Uncertain demand

Step 3: Achieving Strategic Fit

-- All functions in the value chain must support the competitive strategy to achieve strategic fit – Fig. 2.7-- Two extremes: Efficient supply chains (Barilla) and responsive supply chains(Dell) – Table 2.3-- Two key points

– there is no right supply chain strategy independent of competitive strategy– there is a right supply chain strategy for a given competitive strategy

Comparison of Efficient and Responsive Supply Chains Table 2.4:

Efficient Responsive

Primary goal Lowest cost Quick response

Product design strategy Min product cost Modularity to allow postponement

Pricing strategy Lower margins Higher margins

Mfg strategy High utilization Capacity flexibility

Inventory strategy Minimize inventory Buffer inventory

Lead time strategy Reduce but not at expense of greater cost

Aggressively reduce even if costs are significant

Supplier selection strategy

Cost and low quality Speed, flexibility, quality

Transportation strategy Greater reliance on low cost modes

Greater reliance on responsive (fast) modes

Other Issues Affecting Strategic Fit

- Multiple products and customer segments- Product life cycle- Competitive changes over time

1. Multiple Products and Customer Segments:

-- Firms sell different products to different customer segments (with different implied demand uncertainty)-- The supply chain has to be able to balance efficiency and responsiveness given its

portfolio of products and customer segments-- Two approaches:

– Different supply chains– Tailor supply chain to best meet the needs of each product’s demand

2. Product Life Cycle:-- The demand characteristics of a product and the needs of a customer segment change as a product goes through its life cycle-- Supply chain strategy must evolve throughout the life cycle-- Early: uncertain demand, high margins (time is important), product availability is most important, cost is secondary-- Late: predictable demand, lower margins, price is important-- Examples: pharmaceutical firms, Intel-- As the product goes through the life cycle, the supply chain changes from one emphasizing responsiveness to one emphasizing efficiency

3. Competitive Changes over Time

-- Competitive pressures can change over time-- More competitors may result in an increased emphasis on variety at a reasonable price-- The Internet makes it easier to offer a wide variety of products-- The supply chain must change to meet these changing competitive conditions

2.3 Expanding Strategic Scope

Scope of strategic fit:– The functions and stages within a supply chain that devise an integrated

strategy with a shared objective– One extreme: each function at each stage develops its own strategy– Other extreme: all functions in all stages devise a strategy jointly

Five categories:– Intracompany intraoperation scope– Intracompany intrafunctional scope– Intracompany interfunctional scope– Intercompany interfunctional scope– Flexible interfunctional scope

Different Scopes of Strategic Fit across a Supply Chain:

S u p p l i e r s M a n u f a c t u r e r D i s t r i b u t o r R e t a i l e r C u s t o m e r

C o m p e t i t i v eS t r a t e g y

P r o d u c tD e v e l o p m e n t

S t r a t e g y

S u p p l y C h a i nS t r a t e g y

M a r k e t i n gS t r a t e g y

I n t e r c o m p a n yI n t e r f u n c t i o n a l

I n t r a c o m p a n y I n t e r f u n c t i o n a l

a t D i s t r i b u t o r

I n t r a c o m p a n yI n t r a f u n c t i o n a l a t D i s t r i b u t o r

I n t r a c o m p a n y I n t r a o p e r a t i o n a t D i s t r i b u t o r

3.1 Drivers of Supply Chain Performance

-- Facilities:– places where inventory is stored, assembled, or fabricated– production sites and storage sites

-- Inventory:– raw materials, WIP, finished goods within a supply chain– inventory policies

-- Transportation:– moving inventory from point to point in a supply chain– combinations of transportation modes and routes

-- Information:– data and analysis regarding inventory, transportation, facilities throughout

the supply chain– potentially the biggest driver of supply chain performance

-- Sourcing:– functions a firm performs and functions that are outsourced

-- Pricing:– Price associated with goods and services provided by a firm to the supply

chain3.2 A Framework for Structuring Drivers

C o m p e titiv e S tr a te g y

Supply C h a in

Str a te gy

E fficien c y R e s p o n s iv e n e s s

Supply c ha in s tr uc tur e

L o g is tic a l D riv e rs

F a c ilitie s In v e n to ry T r a n s p o r ta tio n

In fo rm a tio n

3.3 Facilities

Sour c ing P r ic in g

C ro s s F u n c tio n a l D riv e rs

-- Role in the supply chain– the “where” of the supply chain.– manufacturing or storage (warehouses).

-- Role in the competitive strategy– economies of scale (efficiency priority).– larger number of smaller facilities (responsiveness priority).

-- Example 3.1: Toyota and Honda.-- Components of facilities decisions

- Location:– centralization (efficiency) vs. decentralization (responsiveness).– other factors to consider (e.g., proximity to customers).

- Capacity: (flexibility versus efficiency).- Manufacturing methodology: (product focused versus process focused).- Warehousing methodology: (SKU storage, job lot storage, cross-docking).- Overall trade-off: Responsiveness versus efficiency.

3.4 Inventory

1. Role in the supply chain.2. Role in the competitive strategy.3. Components of inventory decisions.

1. Role in the Supply Chain:-- Inventory exists because of a mismatch between supply and demand.-- Source of cost and influence on responsiveness.-- Impact on.

– material flow time: time elapsed between when material enters the supply chain to when it exits the supply chain.

– throughput» rate at which sales to end consumers occur.» I = RT (Little’s Law).» I = inventory; R = throughput; T = flow time.» Example.» Inventory and throughput are “synonymous” in a supply chain.

2. Role in Competitive Strategy:-- If responsiveness is a strategic competitive priority, a firm can locate larger amounts of inventory closer to customers.-- If cost is more important, inventory can be reduced to make the firm more efficient.-- Trade-off.-- Example 3.2 – Nordstrom.

3. Components of Inventory Decisions:-- Cycle inventory:

– Average amount of inventory used to satisfy demand between shipments.– Depends on lot size.

-- Safety inventory:– inventory held in case demand exceeds expectations.– costs of carrying too much inventory versus cost of losing sales.

-- Seasonal inventory:– inventory built up to counter predictable variability in demand.– cost of carrying additional inventory versus cost of flexible production.

-- Overall trade-off: Responsiveness versus efficiency.– more inventory: greater responsiveness but greater cost.– less inventory: lower cost but lower responsiveness.

3.5 Transportation

1. Role in the supply chain.2. Role in the competitive strategy.3. Components of transportation decisions.

1. Role in the supply chain:

-- Moves the product between stages in the supply chain.-- Impact on responsiveness and efficiency.-- Faster transportation allows greater responsiveness but lower efficiency.-- Also affects inventory and facilities.

2. Role in the competitive strategy:

-- If responsiveness is a strategic competitive priority, then faster transportation modes can provide greater responsiveness to customers who are willing to pay for it.-- Can also use slower transportation modes for customers whose priority is price(cost).-- Can also consider both inventory and transportation to find the right balance.-- Example 3.3: Laura Ashley.

3. Components of Transportation Decisions:

-- Mode of transportation:– air, truck, rail, ship, pipeline, electronic transportation.– vary in cost, speed, size of shipment, flexibility.

-- Route and network selection:– route: path along which a product is shipped.– network: collection of locations and routes.

-- In-house or outsource:-- Overall trade-off: Responsiveness versus efficiency.

3.6 Information

1. Role in the supply chain.2. Role in the competitive strategy.3. Components of information decisions.

1. Role in the supply chain:-- The connection between the various stages in the supply chain – allows coordination between stages.-- Crucial to daily operation of each stage in a supply chain – e.g., production scheduling, inventory levels.

2. Role in the Competitive Strategy:-- Allows supply chain to become more efficient and more responsive at the sa m e ti m e (reduces the need for a trade-off).-- Information technology.-- What information is most valuable?-- Example 3.4: Andersen Windows.-- Example 3.5: Dell.

3. Components of Information Decisions:-- Push (MRP) versus pull (demand information transmitted quickly throughout the supply chain)-- Coordination and information sharing:-- Forecasting and aggregate planning:-- Enabling technologies:

– EDI– Internet– ERP systems– Supply Chain Management software

-- Overall trade-off: Responsiveness versus efficiency

Sourcing

1. Role in the supply chain.2. Role in the competitive strategy.3. Components of sourcing decisions.

1. Role in the Supply Chain:-- Set of business processes required to purchase goods and services in a supply

chain.-- Supplier selection, single vs. multiple suppliers, contract negotiation.

2. Role in the Competitive Strategy:-- Sourcing decisions are crucial because they affect the level of efficiency and. responsiveness in a supply chain.-- In-house vs. outsource decisions- improving efficiency and responsiveness.-- Example 3.6: Cisco.

3. Components of Sourcing Decisions:-- In-house versus outsource decisions.-- Supplier evaluation and selection.-- Procurement process.-- Overall trade-off: Increase the supply chain profits.

3.8 Pricing

1. Role in the supply chain.2. Role in the competitive strategy.3. Components of pricing decisions.

1. Role in the Supply Chain:-- Pricing determines the amount to charge customers in a supply chain.-- Pricing strategies can be used to match demand and supply.

2. Role in the Competitive Strategy:-- Firms can utilize optimal pricing strategies to improve efficiency and responsiveness.-- Low price and low product availability; vary prices by response times.-- Example 3.7: Amazon.

3. Components of Pricing Decisions:-- Pricing and economies of scale-- Everyday low pricing versus high-low pricing-- Fixed price versus menu pricing-- Overall trade-off: Increase the firm profits

3.9 Obstacles to Achieving Strategic Fit

-- Increasing variety of products.-- Decreasing product life cycles.-- Increasingly demanding customers.-- Fragmentation of supply chain ownership.-- Globalization.-- Difficulty executing new strategies.

4.1 The Role of Distribution in the Supply Chain

-- Distribution: the steps taken to move and store a product from the supplier stage to the customer stage in a supply chain.-- Distribution directly affects cost and the customer experience and therefore drives profitability.-- Choice of distribution network can achieve supply chain objectives from low cost to high responsiveness.-- Examples: Wal-Mart, Dell, Proctor & Gamble, Grainger.

4.2 Factors Influencing Distribution Network Design

-- Distribution network performance evaluated along two dimensions at the highest level:

– Customer needs that are met– Cost of meeting customer needs

-- Distribution network design options must therefore be compared according to their impact on customer service and the cost to provide this level of service.

-- Elements of customer service influenced by network structure:– Response time– Product variety– Product availability– Customer experience– Order visibility– Return ability

-- Supply chain costs affected by network structure:– Inventories

– Transportation– Facilities and handling– Information

Number ofFacilities

Response Time

Service and Number of Facilities (Fig. 4.1)

Hi

Cost

Local FG

Mix

Regional FG

Local WIP

Central FG

Central WIP

Central Raw Material and Custom production

LowCustom production with raw material at suppliers

Low Response Time Hi

The Cost-Response Time Frontier

InventoryCosts

Number of facilities

Inventory Costs and Number of Facilities (Fig. 4.2)

TransportationCosts

Number of facilities

Transportation Costs and Number of Facilities (Fig. 4.3)

FacilityCosts

Number of facilities

Facility Costs and Number of Facilities (Fig. 4.4)

TTotalotal CostsCosts

FacilitiesFacilities

InventoryInventory

TransportationTransportation

NNuumbermber ofof FacilitFacilitiieses

Total Costs Related to Number of Facilities

ResponseResponse TTimeime

ToTottalalCosCosttss TTotalotal LLoogigissticstics CCoostssts

NNumberumber ofof FacFaciliilittiieses

Variation in Logistics Costs and Response Time with Number of Facilities (Fig. 4.5)

4.3 Design Options for a Distribution Network

-- Manufacturer Storage with Direct Shipping.-- Manufacturer Storage with Direct Shipping and In-Transit Merge.-- Distributor Storage with Carrier Delivery.-- Distributor Storage with Last Mile Delivery.-- Manufacturer or Distributor Storage with Consumer Pickup.-- Retail Storage with Consumer Pickup.-- Selecting a Distribution Network Design.

Manufacturer

Retailer

Customers

Product Flow

Information Flow

Manufacturer Storage with Direct Shipping (Fig. 4.6)

Factories

Retailer In-Transit Merge byCarrier

Customers

Product Flow

Information Flow

In-Transit Merge Network (Fig. 4.7)

Factories

Warehouse Storage byDistributor/Retailer

Customers

Product FlowInformation Flow

Distributor Storage with Carrier Delivery (Fig. 4.8)

Factories

Distributor/RetailerWarehouse

Customers

Product Flow

Information Flow

Distributor Storage with Last Mile Delivery (Fig. 4.9)

Factories

Retailer Cross Dock DC

Pickup Sites

Customers

Customer Flow Product Flow Information Flow

Manufacturer or Distributor Storage with Customer Pickup (Fig. 4.10)

Retail Storage with Customer

Pickup

Manufacturer Storage with Direct

Shipping

Manufacturer Storage with In- Transit Merge

Distributor Storage with

Package Carrier

Distributor storage with last

mile delivery

Manufacturer storage with pickup

Response Time 1 4 4Delivery

3 2 4

Product Variety4 1 1 2 3 1

Product Availability4 1 1 2 3 1

Customer Experience 5 4 3 2 1 5

Order Visibility 1 5 4 3 2 6

Returnability 1 5 5 4 3 2

Inventory 4 1 1 2 3 1

Transportation 1 4 3 2 5 1

Facility & Handling 6 1 2 3 4 5

Information 1 4 4 3 2 5

Comparative Performance of Delivery Network Designs (Table 4.7)Retail Storage with Customer

Pickup

Manufacturer Storage with

Direct Shipping

Manufacturer Storage with In- Transit Merge

Distributor Storage with Package Carrier

Delivery

Distributor storage with last mile

delivery

Manufacturer storage with

pickup

High demand product+2 -2 -1 0 +1 -1

Medium demand product+1 -1 0 +1 0 0

Low demand product-1 +1 0 +1 -1 +1

Very low demand product-2 +2 +1 0 -2 +1

Many product sources+1 -1 -1 +2 +1 0

High product value-1 +2 +1 +1 0 -2

Quick desired response+2 -2 -2 -1 +1 -2

High product variety-1 +2 0 +1 0 +2

Low customer effort-2 +1 +2 +2 +2 -1

Linking Product Characteristics and Customer Preferences to Network Design

4.4 E-Business and the Distribution Network

-- Impact of E-Business on Customer Service.-- Impact of E-Business on Cost.-- Using E-Business: Dell, Amazon, Peapod, and Grainger.

4.5 Distribution Networks in Practice

-- The ownership structure of the distribution network can have as big as an impact as the type of distribution network.-- The choice of a distribution network has very long-term consequences.-- Consider whether an exclusive distribution strategy is advantageous.-- Product, price, commoditization, and criticality have an impact on the type of

distribution system preferred by customers.

5.1 The role of network design in supply chain

Facility role: What role should each facility play? What processes should be performed at each facility?Facility location: Where should facilities be located?Capacity allocation: How much capacity should be allocated to each facility?Market and supply allocation: What markets should each facility serve? Which supply sources should feed each facility?(How many plants, DC’s, retail stores, etc. to build?)

• Facility role; production, storage, cross-docking, processes performed and products produced (flexibility):

– Toyota before ’97, factories serving local needs. In Asian crisis late ‘90s, Asian factory experienced idle capacity that could not be used to produce for other markets. Afterwards, Toyoda added flexibility to their plants so that they can serve other markets.

• Facility location:– Very costly to open or close a plant.– Toyota opened its first US plant in Lexington, Kentucky in ’88. This

decision provided Toyota a low cost production option, especially when yen is strengthened against dollar, and responsiveness.

– Amazon had to increase the number of warehouses to 6 to be cost effective in supplying books throughout US.

• Facility capacity:– Allocating too little or too much capacity is costly.– Capacity decisions would not change for years.

• Facility allocation to markets and supply sources:– has Significant impact on performance.– Must be reconsidered on a regular basis.– Amazon had to consider new allocations as it increased the number of

facilities in order to reduce the costs.

5.2 Factors influencing network design decisions• Strategic factors

– Convenience stores; many facilities for responsiveness.– Discount stores; few large facilities for effectiveness (low cost).– Different locations playing different role.

• Nike’s facilities in china and Indonesia produces lower priced shoes for mass markets, while its facilities in Korea and Taiwan focuses on responsiveness and produce higher-priced new design, with high variability.

• Technological factors:– Prodaction technologies with high economies of scale and high investment

(micro-chips); few high-capacity facility.– Technologies with low fixed investment cost and low economies of scale;

many close-to-market facilities, e.g. Cocacola bottling plants all over the world.

– Potential flexibility of the technology determines if we can have few plants that will serve the entire market.

• Macro economic factors:– Taxes, tariffs, incentives, exchange rates.– Tariffs are coming down because of regional arrangements (NAFT, EU).– Free-trade zones; production is exported, tariffs and taxes are reduced.– BMW located its US plant in North Carolina because of tax incentives

offered by this state.– China wavas tariffs entirely for “high-tech” products.– Some countries places limit on minimum local content.

• Political factors:– “rap” would not attract foreign investment– Political stability, clear legal system, signing international treatments.

• Infrastructure:– Availability of sites, closeness to transportation options (seaports, rail,

airports), availability of labor, local utilities– Example; Many companies located their factories in China near Shanghai,

Tianjin or Guangzhou, although the labor and land costs are not the lowestin these places

• Competitive factors:– Should the location be close to competitors or far fromthem.

• Positive externalities; locating together helps all the companies, e.g. Retail stores lacing together in a mall.

• Locating to capture the market; Locating close to the market to capture a large share, when prices by the firms in the market are comparable.

• Customer response time and local presence:– Conveniences stores must locate close to customer while the discount.– Stores do not need to be close; customers are ready to travel to buy larger

quantities with lower prices.– With faster transportation options, facilities can be consolidated and away

from customers.

• Logistics and facility costs:– Inventory, transportation and facility cost should be considered together.

5.3 Framework for network design decisions

Competitive STRATEGY

INTERNAL CONSTRAINTS Capital, growth strategy, existing network

PRODUCTION TECHNOLOGIES Cost, Scale/Scope impact, support required, flexibility

COMPETITIVE ENVIRONMENT

PRODUCTION METHODS Skill needs, response time

FACTOR COSTSLabor, materials, site specific

PHASE I Supply Chain

Strategy

PHASE II Regional Facility

Configuration

PHASE III Desirable Sites

PHASE IV Location Choices

GLOBAL COMPETITION

TARIFFS AND TAX INCENTIVES

REGIONAL DEMAND Size, growth, homogeneity, local specifications

POLITICAL, EXCHANGE RATE AND DEMAND RISK

AVAILABLE INFRASTRUCTURE

LOGISTICS COSTSTransport, inventory, coordination

Phase I - Strategy Considerations:• Understand where is the main emphasis:

– Cost leadership.– Responsiveness.– Product differentiation.

• Who are the key competitors at each target market?• Identify constraints on available capital:• Key mechanisms that will support growth:

– Reuse of existing facilities.– Build new facilities.– Partner with other companies (mergers and acquisitions are potential

options here).–

Phase II - Regional facility configuration:• Important Factors:• Regional demand:• Production technologies and economies of scale and scope:• Tariffs and Tax incentives:• Infrastructure factors:• Political, exchange rate and demand risk:• Competitive Environment:

Phases III & IV - Selecting specific locations:• Important factors:• Infrastructure:• Costs:

– Labor.– Materials.– Facilities.– Transport.– Inventory.– Taxes and Tariffs.

5.4 Models for facility location and capacity allocation-- Goal is to maximize the overall profitability while providing the appropriateresponsiveness.-- Managers use network design models in two different ways:

– Decide on locations and capacities of facilities– Decide on the market share of each facility and identify lanes of

transportation-- Models are two types:

– Network optimization models– Gravity models

The Required Inputs for the Models:

- Location of suppliers.- Location of potential facility sites.- Demand forecast by market.- Facility, labor, material costs.- Transportation costs between sites.- Inventory costs by site and unit.- Sale prices in different regions.- Taxes and tariffs between locations.- Desired response time and other service measures.

Plase II - Network Optimization Model:

The capacitated plant location modelInputs:

n: # potential plant locations/capacity m: # markets or demand pointsDj: Annual demand from market j, j=1,2,...,mKi: Potential capacity of plant i, i=1,2,...,nfi: Annualized fixed cost of keeping factory i opencij: Cost of producing and shipping one unit from factory i to market j.

n

n

n

∑

Decision variables:Yi: 1 if plant i is open, 0 otherwiseXij: quantity shipped from factory i to market j

n n m

Min ∑ f i y i + ∑ ∑ c ij x iji = 1

Subject ton

i = 1

j = 1

∑i = 1

m

x ij = D j , j = 1, 2 ,..., m

∑j = 1

x ij ≤ K i y i , i = 1, 2 ,..., n

y i ∈ { 0

,1}

i = 1, 2 ,..., n

Gravity Methods for Location:

Ton Mile-Center Solution

– x,y: Warehouse Coordinates

d n =

n

∑i =1

2 2

(x−xn) + ( y− yn)

xi F i

F i

– xn, yn : Coordinates of deliverylocation n

x = d i

∑ F i

i =1 d i

– dn : Distance to delivery location n

– Fn : Annual tonnage to deliverylocation n

yi F i

i =1 F i

y = d i

∑ F i

i =1 d i

∑ F (x −x)2+( y − y)2

i i i

Network Optimization Models:

-- Allocating demand to production facilities:-- Locating facilities and allocating capacity:

Key Costs:

• Fixed facility cost

• Transportation cost

• Production cost

• Inventory cost

• Coordination cost

Which plants to establish? How to configure the network?

Demand Allocation Model:

-- Which market is served by which plant?-- Which supply sources are used by a plant?xij = Quantity shipped from plant site i to

customer j

n m

Min ∑ ∑ c ij x ij

s .t .n

∑i = 1

m

∑j = 1

i = 1

x ij =

x ij ≤

j = 1

D j

K i

x ij ≥ 0

ii

K yi

Plant Location with Multiple Sourcing:-- yi = 1 if plant is located at site i, 0 otherwise-- xij = Quantity shipped from plant site i to customer j

n n m

Min∑ fi =1

y + ∑∑cij xiji =1 j =1

s.t.n

∑ xij = D j

i =1

n

∑ xij ≤

ij =1

m

∑ y ≤ k; y ∈{0,1}i i

i =1

6.1 The Impact of Uncertainty on Network Design

-- Supply chain design decisions include investments in number and size of plants, number of trucks, number of warehouses.-- These decisions cannot be easily changed in the short- term.-- There will be a good deal of uncertainty in demand, prices, exchange rates, and the competitive market over the lifetime of a supply chain network.-- Therefore, building flexibility into supply chain operations allows the supply chain to deal with uncertainty in a manner that will maximize profits.

6.2 Discounted Cash Flow Analysis

-- Supply chain decisions are in place for a long time, so they should be evaluated as a sequence of cash flows over that period.-- Discounted cash flow (DCF) analysis evaluates the present value of any stream of future cash flows and allows managers to compare different cash flow streams in terms of their financial value.-- Based on the time value of money – a dollar today is worth more than a dollar tomorrow.

Discount factor = 11 + k

tT ⎛ 1 ⎞NPV = C0 + ∑ ⎜t =1 ⎝ 1 +

⎟ Ctk ⎠where

C0 , C1 ,..., CT is a stream of cash flows over T periods

NPV = the net present value of this stream of cash flows

k = rate of return

• Compare NPV of different supply chain design options.• The option with the highest NPV will provide the greatest financial return.

NPV Example: Trips Logistics

-- How much space to lease in the next three years.-- Demand = 100,000 units.-- Requires 1,000 sq. ft. of space for every 1,000 units of demand.-- Revenue = $1.22 per unit of demand.-- Decision is whether to sign a three-year lease or obtain warehousing space on the spot market.-- Three-year lease: cost = $1 per sq. ft.-- Spot market: cost = $1.20 per sq. ft.-- k = 0.1.

For leasing warehouse space on the spot market:Expected annual profit = 100,000 x $1.22 – 100,000 x $1.20 = $2,000Cash flow = $2,000 in each of the next three years.

C 1 C 2NPV (no lease) = C 0 +1 + k

+(1 + k )2

= 2000+

2000

1 . 1

+ 2000

1 . 1 2

= $ 5 , 471

For leasing warehouse space with a three-year lease:Expected annual profit = 100,000 x $1.22 – 100,000 x $1.00 = $22,000Cash flow = $22,000 in each of the next three years.

C 1 C 2NPV (no lease) = C 0 +1 + k

+(1 + k )2

= 22000+

22000

1 .1+

22000

1 .1 2

= $ 60 ,182

The NPV of signing the lease is $54,711 higher; therefore, the manager decides to sign the lease.However, uncertainty in demand and costs may cause the manager to rethink his decision.

6.3 Representations of Uncertainty

1. Binomial Representation of Uncertainty:2. Other Representations of Uncertainty:

1. Binomial Representation of Uncertainty:-- When moving from one period to the next, the value of the underlying factor (e.g., demand or price) has only two possible outcomes – up or down.-- The underlying factor moves up by a factor or u > 1 with probability p, or down by a factor d < 1 with probability 1-p.-- Assuming a price P in period 0, for the multiplicative binomial, the possible outcomes for the next four periods:

– Period 1: Pu, Pd.– Period 2: Pu2, Pud, Pd2.– Period 3: Pu3, Pu2d, Pud2, Pd3.– Period 4: Pu4, Pu3d, Pu2d2, Pud3, Pd4.

-- In general, for multiplicative binomial, period T has all possible outcomes Putd(T- t), for t = 0,1,…,T.-- From state Puad(T-a) in period t, the price may move in period t+1 to either

– Pua+1d(T-a) with probability p, or– Puad(T-a)+1 with probability (1-p).

-- For the additive binomial, the states in the following periods are:– Period 1: P+u, P-d.– Period 2: P+2u, P+u-d, P-2d.– Period 3: P+3u, P+2u-d, P+u-2d, P-3d.– Period 4: P+4u, P+3u-d, P+2u-2d, P+u-3d, P-4d.

-- In general, for the additive binomial, period T has all possible outcomes P+tu-(T- t)d, for t=0, 1, …, T.

6.4 Evaluating Network Design Decisions Using Decision Trees

-- A manager must make many different decisions when designing a supply chain network.-- Many of them involve a choice between a long-term (or less flexible) option and a short-term (or more flexible) option.-- If uncertainty is ignored, the long-term option will almost always be selected because it is typically cheaper.-- Such a decision can eventually hurt the firm, however, because actual future prices or demand may be different from what was forecasted at the time of the decision.-- A decision tree is a graphic device that can be used to evaluate decisions under uncertainty.

Decision Tree Methodology:

1. Identify the duration of each period (month, quarter, etc.) and the number of periods T over which the decision is to be evaluated.

2. Identify factors such as demand, price, and exchange rate, whose fluctuation will be considered over the next T periods.

3. Identify representations of uncertainty for each factor; that is, determine what distribution to use to model the uncertainty.

4. Identify the periodic discount rate k for each period.5. Represent the decision tree with defined states in each period, as well as the

transition probabilities between states in successive periods.6. Starting at period T, work back to period 0, identifying the optimal decision and

the expected cash flows at each step. Expected cash flows at each state in a given period should be discounted back when included in the previous period.

-Trips Logistics:

-- Decide whether to lease warehouse space for the coming three years and the quantity to lease.-- Long-term lease is currently cheaper than the spot market rate.-- The manager anticipates uncertainty in demand and spot prices over the next three years.-- Long-term lease is cheaper but could go unused if demand is lower than forecast;future spot market rates could also decrease.-- Spot market rates are currently high, and the spot market would cost a lot if future demand is higher than expected.

- Trips Logistics: Three Options

-- Get all warehousing space from the spot market as needed.-- Sign a three-year lease for a fixed amount of warehouse space and get additional requirements from the spot market.-- Sign a flexible lease with a minimum change that allows variable usage of warehouse space up to a limit with additional requirement from the spot market.

-- 1000 sq. ft. of warehouse space needed for 1000 units of demand.-- Current demand = 100,000 units per year.-- Binomial uncertainty: Demand can go up by 20% with. p = 0.5 or down by 20% with 1-p = 0.5.-- Lease price = $1.00 per sq. ft. per year.-- Spot market price = $1.20 per sq. ft. per year.-- Spot prices can go up by 10% with p = 0.5 or down by 10% with 1-p = 0.5.-- Revenue = $1.22 per unit of demand.-- k = 0.1.

Trips Logistics Decision Tree:

Period 2

Period 1 D=144

Period 0 p=$1.450.25

D=100

p=$1.20

0.25

0.25

0.25

D=120

p=$1.32

D=120

p=$1. 08

D=80

p=$1.32

0.25

0.25

0.25

D=144

p=$1.19

D=96

p=$1.45

D=144

p=$0.97

D=96

p=$1.19

D=96

p=$0.97

0.25D=80

p=$1.32

D=64

p=$1.45

D=64

p=$1.19

D=64

p=$0.97

Trips Logistics Example:-- Analyze the option of not signing a lease and obtaining all warehouse space from the spot market.-- Start with Period 2 and calculate the profit at each node.-- For D=144, p=$1.45, in Period 2:

C(D=144, p=1.45,2) = 144,000x1.45 = $208,800P(D=144, p =1.45,2) = 144,000x1.22 – C(D=144,p=1.45,2) = 175,680-208,800 =

-$33,120.-- Profit at other nodes is shown in Table 6.1.-- Expected profit at each node in Period 1 is the profit during Period 1 plus the present value of the expected profit in Period 2.-- Expected profit EP(D=, p=,1) at a node is the expected profit over all four nodes inPeriod 2 that may result from this node.

-- PVEP(D=,p=,1) is the present value of this expected profit and P(D=,p=,1), and the total expected profit, is the sum of the profit in Period 1 and the present value of the expected profit in Period 2.-- From node D=120, p=$1.32 in Period 1, there are four possible states in Period 2.-- Evaluate the expected profit in Period 2 over all four states possible from nodeD=120, p=$1.32 in Period 1 to be

EP(D=120,p=1.32,1) = 0.25xP(D=144, p=1.45,2) +0.25x P (D=144, p=1.19,2 ) +0.25x P (D=96, p=1.45,2 ) +0.25x P (D=96, p=1.19,2 )

= 0.25x(-33,120)+0.25x4,320+0.25x(-22,080)+0.25x2,880= -$12,000

-- The present value of this expected value in Period 1 isPVEP(D=12, p=1.32,1) = EP(D=120,p=1.32,1) / (1+k)

= -$12,000 / (1+0.1)= -$10,909

-- The total expected profit P(D=120,p=1.32,1) at node D=120,p=1.32 in Period 1 is the sum of the profit in Period 1 at this node, plus the present value of future expected profits possible from this node.

P(D=120,p=1.32,1) = [(120,000x1.22)-(120,000x1.32)] + PVEP(D=120,p=1.32,1)= -$12,000 + (-$10,909) = -$22,909

-- The total expected profit for the other nodes in Period 1 is shown in Table 6.2-- For Period 0, the total profit P(D=100,p=120,0) is the sum of the profit in Period 0 and the present value of the expected profit over the four nodes in Period 1

EP(D=100,p=1.20,0) = 0.25xP(D=120,p=1.32,1) += 0.25xP(D=120,p=1.08,1) += 0.25xP(D=96,p=1.32,1) += 0.25xP(D=96,p=1.08,1)

= 0.25x(-22,909)+0.25x32,073+0.25x(-15,273)+0.25x21,382= $3,818PVEP(D=100,p=1.20,0) = EP(D=100,p=1.20,0) / (1+k)= $3,818 / (1 + 0.1) = $3,471P(D=100,p=1.20,0) = 100,000x1.22-100,000x1.20 +

PVEP(D=100,p=1.20,0)= $2,000 + $3,471 = $5,471

-- Therefore, the expected NPV of not signing the lease and obtaining all warehouse space from the spot market is given by NPV(Spot Market) = $5,471-- Using the same approach for the lease option, NPV(Lease) = $38,364.-- Recall that when uncertainty was ignored, the NPV for the lease option was$60,182.-- However, the manager would probably still prefer to sign the three-year lease for100,000 sq. ft. because this option has the higher expected profit.

Evaluating Flexibility Using Decision Trees:-- Decision tree methodology can be used to evaluate flexibility within the supply chain.-- Suppose the manager at Trips Logistics has been offered a contract where, for an upfront payment of $10,000, the company will have the flexibility of using between60,000 sq. ft. and 100,000 sq. ft. of warehouse space at $1 per sq. ft. per year. Trips must pay $60,000 for the first 60,000 sq. ft. and can then use up to 40,000 sq. ft. on demand at $1 per sq. ft. as needed.-- Using the same approach as before, the expected profit of this option is $56,725.-- The value of flexibility is the difference between the expected present value of the flexible option and the expected present value of the inflexible options.-- The three options are listed in Table 6.7, where the flexible option has an expected present value $8,361 greater than the inflexible lease option (including the upfront$10,000 payment).

6.5 AM Tires: Evaluation of Supply Chain Design Decisions UnderUncertainty

-- Dedicated Capacity of 100,000 in the United States and 50,000 in Mexico– Period 2 Evaluation– Period 1 Evaluation– Period 0 Evaluation

-- Flexible Capacity of 100,000 in the United States and 50,000 in Mexico– Period 2 Evaluation– Period 1 Evaluation– Period 0 Evaluation

Evaluating Facility Investments: AM Tires:Plant Dedicated Plant Flexible Plant

Fixed Cost Variable Cost Fixed Cost Variable CostUS 100,000 $1 million/yr. $15 / tire $1.1 million

/ year$15 / tire

Mexico 50,000 4 million pesos / year

110 pesos /tire

4.4 million pesos / year

110 pesos /tire

U.S. Expected Demand = 100,000; Mexico Expected Demand = 50,000.1US$ = 9 pesos.Demand goes up or down by 20 percent with probability 0.5 andExchange rate goes up or down by 25 per cent with probability 0.5.

AM Tires:

Period 0 Period 1 Period 2

RU=100RM=50

E=9

RU=120RM = 60E=11.25

RU=120RM = 60E=6.75

RU=120RM = 40E=11.25

RU=120RM = 40E=6.75

RU=80RM = 60E=11.25

RU=80RM = 60E=6.75

RU=80RM = 40E=11.25

RU=80RM = 40E=6.75

RU=144RM = 72E=14.06

RU=144RM = 72E=8.44

RU=144RM = 48E=14.06

RU=144RM = 48E=8.44

RU=96RM = 72E=14.06

RU=96RM = 72E=8.44

RU=96RM = 48E=14.06

RU=96RM = 48E=8.44

Four possible capacity scenarios:• Both dedicated• Both flexible• U.S. flexible, Mexico dedicated• U.S. dedicated, Mexico flexible

For each node, solve the demand allocation model:

Plants Markets

U.S. U.S.

Mexico Mexico

AM Tires: Demand Allocation for RU = 144; RM = 72, E = 14.06

Source Destination Variable cost

Shipping cost

E Sale price Margin($)

U.S. U.S. $15 0 14.06 $30 $15U.S. Mexico $15 $1 14.06 240 pesos $1.1

Mexico U.S. 110 pesos $1 14.06 $30 $21.2Mexico Mexico 110 pesos 0 14.06 240 pesos $9.2

Plants100,000

100,000

Markets

Profit (flexible) =U.S. U.S.

44,000$1,075,055Profit (dedicated) =$649,360

Mexico 50,0006,000

Mexico

Facility Decision at AM Tires:

Plant Configuration NPVUnited States Mexico

Dedicated Dedicated $1,629,319Flexible Dedicated $1,514,322

Dedicated Flexible $1,722,447Flexible Flexible $1,529,758

6.6 Making Supply Chain Design Decisions under Uncertainty inPractice

1. Combine strategic planning and financial planning during network design.2. Use multiple metrics to evaluate supply chain networks.3. Use financial analysis as an input to decision making, not as the decision-making

process.4. Use estimates along with sensitivity analysis.

7.1 Role of Forecasting in a Supply Chain

-- The basis for all strategic and planning decisions in a supply chain.-- Used for both push and pull processes.-- Examples:

– Production: scheduling, inventory, aggregate planning.– Marketing: sales force allocation, promotions, new production

introduction.– Finance: plant/equipment investment, budgetary planning.– Personnel: workforce planning, hiring, layoffs.

-- All of these decisions are interrelated.

7.2 Characteristics of Forecasts

-- Forecasts are always wrong .Should include expected value and measure of error.-- Long-term forecasts are less accurate than short-term forecasts (forecast horizon is important).-- Aggregate forecasts are more accurate than disaggregate forecasts.

7.3 Components of forecasts and forecasting methods

-- Qualitative: primarily subjective; rely on judgment and opinion.-- Time Series: use historical demand only.

– Static– Adaptive

-- Causal: use the relationship between demand and some other factor to develop forecast.-- Simulation:

– Imitate consumer choices that give rise to demand– Can combine time series and causal methods

Components of an Observation:

Observed demand (O) = Systematic component (S) + Random component (R)

Level (current deseasonalized demand)

Trend (growth or decline in demand)

Seasonality (predictable seasonal fluctuation)

• Systematic component: Expected value of demand.

• Random component: The part of the forecast that deviatesfrom the systematic component.

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• Forecast error: difference between forecast and actual demand.

57

Quarter Demand Dt

II, 1998III, 1998IV, 1998I, 1999

8000130002300034000

II, 1999III, 1999IV, 1999I, 2000

10000180002300038000

II, 2000III, 2000IV, 2000I, 2001

12000130003200041000

Time Series Forecasting:

Forecast demand for theNext four quarters.

50,000

40,000

30,000

20,000

10,000

0

Forecasting Methods:

-- Static-- Adaptive

– Moving average.– Simple exponential smoothing.– Holt’s model (with trend).– Winter’s model (with trend and seasonality).

58

7.4 Basic Approach to Demand Forecasting

1. Understand the objectives of forecasting.2. Integrate demand planning and forecasting.3. Identify major factors that influence the demand forecast.4. Understand and identify customer segments.5. Determine the appropriate forecasting technique.6. Establish performance and error measures for the forecast.

7.5 Time Series Forecasting Methods

-- Goal is to predict systematic component of demand.– Multiplicative: (level)(trend)(seasonal factor)– Additive: level + trend + seasonal factor– Mixed: (level + trend)(seasonal factor)

-- Static methods.-- Adaptive forecasting.

Static Methods:

-- Assume a mixed model:Systematic component = (level + trend)(seasonal factor) Ft+l = [L + (t + l)T]St+.l= forecast in period t for demand in period t + l.L = estimate of level for period 0. T = estimate of trend.St = estimate of seasonal factor for period t.Dt = actual demand in period t.Ft = forecast of demand in period t.

1. Estimating level and trend:2. Estimating seasonal factors:

1. Estimating level and trend:

-- Before estimating level and trend, demand data must be deseasonalized-- Deseasonalized demand = demand that would have been observed in the absence of seasonal fluctuations-- Periodicity (p)

– the number of periods after which the seasonal cycle repeats itself– for demand at Tahoe Salt (Table 7.1, Figure 7.1) p = 4

Dem

and

Deseasonalizing Demand:

[Dt-(p/2) + Dt+(p/2) + Σ 2Di] / 2p for p even Dt = (sum is from i = t+1-(p/2) to t+1+(p/2))

Σ Di / p for p odd(sum is from i = t-(p/2) to t+(p/2)), p/2 truncated to lower integer

For the example, p = 4 is evenFor t = 3:D3 = {D1 + D5 + Sum (I =2 to 4) [2Di]}/8= {8000+10000 + [(2)(13000)+(2)(23000)+(2)(34000)]}/8= 19750D4 = {D2 + D6 + Sum (I =3 to 5) [2Di]}/8= {13000+18000 + [(2)(23000)+(2)(34000)+(2)(10000)]/8= 20625Then include trendDt = L + tTWhere Dt = deseasonalized demand in period tL = level (deseasonalized demand at period 0)T = trend (rate of growth of deseasonalized demand)Trend is determined by linear regression using deseasonalized demand as the dependent variable and period as the independent variable (can be done in Excel)In the example, L = 18,439 and T = 524

Time Series of Demand (Figure 7.3)

50000

40000

30000

20000

10000

0

1 2 3 4 5 6 7 8 9 10 11 12

Period

Dt

Dt-bar

59

60

2. Estimating Seasonal Factors:

Use the previous equation to calculate deseasonalized demand for each periodSt = Dt / Dt = seasonal factor for period tIn the example,D2 = 18439 + (524)(2) = 19487 D2 = 13000S2 = 13000/19487 = 0.67The seasonal factors for the other periods are calculated in the same manner

Estimating Seasonal Factors (Fig. 7.4)

t Dt Dt-bar S-bar

1 8000 18963 0.42 = 8000/189632 13000 19487 0.67 = 13000/194873 23000 20011 1.15 = 23000/200114 34000 20535 1.66 = 34000/205355 10000 21059 0.47 = 10000/210596 18000 21583 0.83 = 18000/215837 23000 22107 1.04 = 23000/221078 38000 22631 1.68 = 38000/226319 12000 23155 0.52 = 12000/23155

10 13000 23679 0.55 = 13000/2367911 32000 24203 1.32 = 32000/2420312 41000 24727 1.66 = 41000/24727

The overall seasonal factor for a “season” is then obtained by averaging all of the factors for a “season”If there are r seasonal cycles, for all periods of the form pt + I, 1< I < p, the seasonal factor for season I isSi = [Sum (j=0 to r-1) Sjp + I]/rIn the example, there are 3 seasonal cycles in the data and p=4, soS1 = (0.42+0.47+0.52)/3 = 0.47S2 = (0.67+0.83+0.55)/3 = 0.68S3 = (1.15+1.04+1.32)/3 = 1.17S4 = (1.66+1.68+1.66)/3 = 1.67Estimating the Forecast:Using the original equation, we can forecast the next four periods of demand:

F13 = (L+13T)S1 = [18439+(13)(524)](0.47) = 11868F14 = (L+14T)S2 = [18439+(14)(524)](0.68) = 17527F15 = (L+15T)S3 = [18439+(15)(524)](1.17) = 30770F16 = (L+16T)S4 = [18439+(16)(524)](1.67) = 44794

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Adaptive Forecasting:-- The estimates of level, trend, and seasonality are adjusted after each demand

observation.-- General steps in adaptive forecasting.-- Moving average.-- Simple exponential smoothing.-- Trend-corrected exponential smoothing (Holt’s model).-- Trend- and seasonality-corrected exponential smoothing (winter’s model).

Basic Formula for Adaptive Forecasting:Ft+1 = (Lt + lT)St+1 = forecast for period t+l in period tLt = Estimate of level at the end of period t Tt = Estimate of trend at the end of period t St = Estimate of seasonal factor for period tFt = Forecast of demand for period t (made period t-1 or earlier) Dt = Actual demand observed in period tEt = Forecast error in period tAt = Absolute deviation for period t = |Et|MAD = Mean Absolute Deviation = average value of At

General Steps in Adaptive Forecasting:-- Initialize: Compute initial estimates of level (L0), trend (T0), and seasonal factors

(S1,…,Sp). This is done as in static forecasting.-- Forecast: Forecast demand for period t+1 using the general equation-- Estimate error: Compute error Et+1 = Ft+1- Dt+1-- Modify estimates: Modify the estimates of level (Lt+1), trend (Tt+1), and seasonal factor (St+p+1), given the error Et+1 in the forecast-- Repeat steps 2, 3, and 4 for each subsequent period

Moving Average:-- Used when demand has no observable trend or seasonality.-- Systematic component of demand = level.-- The level in period t is the average demand over the last N periods (the N-period moving average).-- Current forecast for all future periods is the same and is based on the current estimate of the level.

Lt = (Dt + Dt-1 + … + Dt-N+1) / N Ft+1 = Lt and Ft+n = LtAfter observing the demand for period t+1, revise the estimates as follows: Lt+1 = (Dt + 1 + Dt + … + Dt-N+2) / NFt+2 = Lt+1

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Moving Average Example:

From Tahoe Salt example (Table 7.1)At the end of period 4, what is the forecast demand for periods 5 through 8 using a 4- period moving average?L4 = (D4+D3+D2+D1)/4 = (34000+23000+13000+8000)/4 = 19500F5 = 19500 = F6 = F7 = F8Observe demand in period 5 to be D5 = 10000Forecast error in period 5, E5 = F5 - D5 = 19500 - 10000 = 9500Revise estimate of level in period 5:L5 = (D5+D4+D3+D2)/4 = (10000+34000+23000+13000)/4 = 20000F6 = L5 = 20000

Simple Exponential Smoothing:-- Used when demand has no observable trend or seasonality.-- Systematic component of demand = level.-- Initial estimate of level, L0, assumed to be the average of all historical data

L0 = [Sum(i=1 to n)Di]/nCurrent forecast for all future periods is equal to the current estimate of the level.

and is given as follows:Ft+1 = Lt and Ft+n = LtAfter observing demand Dt+1, revise the estimate of the level: Lt+1 = aDt+1 + (1-a)LtLt+1 = Sum(n=0 to t+1)[a(1-a)nDt+1-n ]

Simple Exponential Smoothing Example:

From Tahoe Salt data, forecast demand for period 1 using exponential smoothingL0 = average of all 12 periods of data= Sum (i=1 to 12)[Di]/12 = 22083F1 = L0 = 22083Observed demand for period 1 = D1 = 8000Forecast error for period 1, E1, is as follows: E1 = F1 - D1 = 22083 - 8000 = 14083Assuming a = 0.1, revised estimate of level for period 1:L1 = aD1 + (1-a) L0 = (0.1) (8000) + (0.9) (22083) = 20675F2 = L1 = 20675Note that the estimate of level for period 1 is lower than in period 0

63

Trend-Corrected Exponential Smoothing (Holt’s Model):

-- Appropriate when the demand is assumed to have a level and trend in the systematic component of demand but no seasonality-- Obtain initial estimate of level and trend by running a linear regression of the following form:

Dt = at + bT0 = aL0 = bIn period t, the forecast for future periods is expressed as follows: Ft+1 = Lt + TtFt+n = Lt + nTt

After observing demand for period t, revise the estimates for level and trend as follows: Lt+1 = aDt+1 + (1-a)(Lt + Tt)Tt+1 = b(Lt+1 - Lt) + (1-b)Tta = smoothing constant for level b = smoothing constant for trendExample: Tahoe Salt demand data. Forecast demand for period 1 using Holt’s model(trend corrected exponential smoothing) Using linear regression,L0 = 12015 (linear intercept) T0 = 1549 (linear slope)

Holt’s Model Example:

Forecast for period 1:F1 = L0 + T0 = 12015 + 1549 = 13564Observed demand for period 1 = D1 = 8000E1 = F1 - D1 = 13564 - 8000 = 5564Assume a = 0.1, b = 0.2L1 = aD1 + (1-a)(L0+T0) = (0.1)(8000) + (0.9)(13564) = 13008T1 = b(L1 - L0) + (1-b)T0 = (0.2)(13008 - 12015) + (0.8)(1549)

= 1438F2 = L1 + T1 = 13008 + 1438 = 14446F5 = L1 + 4T1 = 13008 + (4)(1438) = 18760

Trend- and Seasonality-Corrected Exponential Smoothing:

-- Appropriate when the systematic component of demand is assumed to have a level, trend, and seasonal factor.-- Systematic component = (level + trend)(seasonal factor).-- Assume periodicity p.-- Obtain initial estimates of level (L0), trend (T0), seasonal factors (S1,…,Sp) using procedure for static forecasting.-- In period t, the forecast for future periods is given by:

Ft+1 = (Lt + Tt) (St+1) and Ft + n = (Lt + nTt) St + n.

64

After observing demand for period t+1, revise estimates for level, trend, and seasonal factors as follows:Lt+1 = a (Dt + 1/St+1) + (1-a) (Lt + Tt) Tt+1 = b (Lt+1 - Lt) + (1-b)TtSt+p+1 = g (Dt + 1/Lt+1) + (1-g) St+1 a = smoothing constant for level.b = smoothing constant for trend.g = smoothing constant for seasonal factor.Example: Tahoe Salt data. Forecast demand for period 1 using Winter’s model. Initial estimates of level, trend, and seasonal factors are obtained as in the static forecasting case.

Trend- and Seasonality-Corrected Exponential Smoothing Example

L0 = 18439 T0 = 524 S1=0.47, S2=0.68, S3=1.17, S4=1.67F1 = (L0 + T0) S1 = (18439+524) (0.47) = 8913The observed demand for period 1 = D1 = 8000Forecast error for period 1 = E1 = F1-D1 = 8913 - 8000 = 913Assume a = 0.1, b=0.2, g=0.1; revise estimates for level and trend for period 1 and for seasonal factor for period 5L1 = a (D1/S1) + (1-a) (L0+T0) = (0.1) (8000/0.47) + (0.9) (18439+524) = 18769T1 = b (L1-L0) + (1-b) T0 = (0.2) (18769-18439) + (0.8) (524) = 485S5 = g (D1/L1) + (1-g) S1 = (0.1) (8000/18769) + (0.9) (0.47) = 0.47

F2 = (L1+T1) S2 = (18769 + 485) (0.68) = 13093

7.6 Measures of Forecast Error

-- Forecast error = E t = Ft - Dt-- Mean squared error (MSE)

MSEn = (Sum (t=1 to n)[Et2])/n-- Absolute deviation = A t = |Et|-- Mean absolute deviation (MAD)

MADn = (Sum (t=1 to n) [At])/n s = 1.25MAD

-- Mean absolute percentage error (MAPE) MAPEn = (Sum (t=1 to n) [|Et/ Dt|100])/n

-- Bias-- Shows whether the forecast consistently under- or overestimates demand; should fluctuate around 0

biasn = Sum(t=1 to n)[Et]-- Tracking signal-- Should be within the range of +6-- Otherwise, possibly use a new forecasting method

TSt = bias / MADt

65

7.7 Forecasting Demand at Tahoe Salt

-- Moving average.-- Simple exponential smoothing.-- Trend-corrected exponential smoothing.-- Trend- and seasonality-corrected exponential smoothing.

7.8 Forecasting in Practice

-- Collaborate in building forecasts.-- The value of data depends on where you are in the supply chain.-- Be sure to distinguish between demand and sales.

8.1 Role of Aggregate Planning in a Supply Chain-- Capacity has a cost; lead times are greater than zero.-- Aggregate planning:

– Process by which a company determines levels of capacity, production, subcontracting, inventory, stock outs, and pricing over a specified time horizon.

– Goal is to maximize profit.– Decisions made at a product family (not SKU) level.– Time frame of 3 to 18 months.– How can a firm best use the facilities it has?

-- Specify operational parameters over the time horizon:– Production rate.– Workforce.– Overtime.– Machine capacity level.– Subcontracting.– Backlog.– Inventory on hand.

-- All supply chain stages should work together on an aggregate plan that will optimize supply chain performance.

8.2 The Aggregate Planning Problem

-- Given the demand forecast for each period in the planning horizon, determine the production level, inventory level, and the capacity level for each period that maximizes the firm’s (supply chain’s) profit over the planning horizon.-- Specify the planning horizon (typically 3-18 months).-- Specify the duration of each period.-- Specify key information required to develop an aggregate plan.

66

Information Needed for an Aggregate Plan:-- Demand forecast in each period.-- Production costs.

– labor costs, regular time ($/hr) and overtime ($/hr)– subcontracting costs ($/hr or $/unit)– cost of changing capacity: hiring or layoff ($/worker) and cost of adding

or reducing machine capacity ($/machine)-- Labor/machine hours required per unit.-- Inventory holding cost ($/unit/period).-- Stockout or backlog cost ($/unit/period).-- Constraints: limits on overtime, layoffs, capital available, stockouts and backlogs.

Outputs of Aggregate Plan:-- Production quantity from regular time, overtime, and subcontracted time: used to determine number of workers and supplier purchase levels.-- Inventory held: used to determine how much warehouse space and working capital is needed.-- Backlog/stockout quantity: used to determine what customer service levels will be.-- Machine capacity increase/decrease: used to determine if new production equipment needs to be purchased.-- A poor aggregate plan can result in lost sales, lost profits, excess inventory, or excess capacity.

8.3 Aggregate Planning Strategies

-- Trade-off between capacity, inventory, backlog/lost sales-- Chase strategy – using capacity as the lever-- Time flexibility from workforce or capacity strategy – using utilization as the lever-- Level strategy – using inventory as the lever-- Mixed strategy – a combination of one or more of the first three strategies

Chase Strategy:

-- Production rate is synchronized with demand by varying machine capacity or hiring and lying off workers as the demand rate varies.-- However, in practice, it is often difficult to vary capacity and workforce on short notice.-- Expensive if cost of varying capacity is high.-- Negative effect on workforce morale.-- Results in low levels of inventory.-- Should be used when inventory holding costs are high and costs of changing capacity are low.

67

Time Flexibility Strategy:

-- Can be used if there is excess machine capacity.-- Workforce is kept stable, but the number of hours worked is varied over time to synchronize production and demand.-- Can use overtime or a flexible work schedule.-- Requires flexible workforce, but avoids morale problems of the chase strategy.-- Low levels of inventory, lower utilization.-- Should be used when inventory holding costs are high and capacity is relatively inexpensive.

Level Strategy:

-- Maintain stable machine capacity and workforce levels with a constant output rate.-- Shortages and surpluses result in fluctuations in inventory levels over time.-- Inventories that are built up in anticipation of future demand or backlogs are carried over from high to low demand periods.-- Better for worker morale.-- Large inventories and backlogs may accumulate.-- Should be used when inventory holding and backlog costs are relatively low.

Aggregate Planning at Red Tomato Tools:

Month Demand ForecastJanuary 1,600February 3,000March 3,200April 3,800May 2,200June 2,200

Fundamental Tradeoffs in Aggregate Planning:

-- Capacity (regular time, overtime, subcontract).-- Inventory.-- Backlog / lost sales.

Basic Strategy:

-- Chase strategy.-- Time flexibility from workforce or capacity.-- Level strategy.

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Aggregate Planning:

Item CostMaterials $10/unitInventory holding cost $2/unit/monthMarginal cost of a stockout $5/unit/monthHiring and training costs $300/workerLayoff cost $500/workerLabor hours required 4/unitRegular time cost $4/hourOver time cost $6/hourCost of subcontracting $30/unit

Aggregate Planning (Define Decision Variables):

Wt = Workforce size for month t, t = 1, ..., 6Ht = Number of employees hired at the beginning of month t,t = 1, ..., 6Lt = Number of employees laid off at the beginning of month t,t = 1, ..., 6Pt = Production in month t, t = 1, ..., 6It = Inventory at the end of month t, t = 1, ..., 6St = Number of units stocked out at the end of month t,t = 1, ..., 6Ct = Number of units subcontracted for month t, t = 1, ..., 6Ot = Number of overtime hours worked in month t, t = 1, ..., 6

Aggregate Planning (Define Objective Function):

Min

6

6

∑t = 1

640 W t +

6

6

∑t = 1

300 H t

6+ ∑

t = 1

6

500 L t +

6

∑ 6 O tt = 1

+ ∑ 2 I tt = 1

6+ ∑ 5 S t +

t = 1∑ 10t = 1

P t + ∑ 30 C tt = 1

Aggregate Planning (Define Constraints Linking Variables):1. Workforce size for each month is based on hiring and layoffs

W t = W t −1 + H t − Lt, or

W t −W t −1 − H t + Lt = 0

for t = 1,...,6, whereW 0 = 80.

Aggregate Planning (Constraints):2. Production for each month cannot exceed capacity

Pt ≤ 40W t + Ot 4,

40W t +

Ot

4 −

Pt

≥ 0,

for t =1,...,6.

Aggregate Planning (Constraints):3. Inventory balance for each month

I t −1 + Pt + Ct = Dt + St −1 + I t − St ,

I t −1 + Pt + Ct − Dt − St −1 − I t + St = 0,

for t =1,...,6,whereI 0 =1,000,

S0 = 0,and I 6 ≥ 500.

Aggregate Planning (Constraints):4. Over time for each month

Ot ≤ 10W t,

10W t−

Ot

≥ 0,

for t = 1,...,6.

Scenarios:

-- Increase in holding cost (from $2 to $6).-- Overtime cost drops to $4.1 per hour.-- Increased demand fluctuation.

Increased Demand Fluctuation:

Month Demand ForecastJanuary 1,000February 3,000

March 3,800April 4,800May 2,000June 1,400

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8.4 Aggregate Planning in Practice

-- Think beyond the enterprise to the entire supply chain.-- Make plans flexible because forecasts are always wrong.-- Rerun the aggregate plan as new information emerges.-- Use aggregate planning as capacity utilization increases.

9.1 Responding to Predictable Variability in a Supply Chain

-- Predictable variability is change in demand that can be forecasted.-- Can cause increased costs and decreased responsiveness in the supply chain.-- A firm can handle predictable variability using two broad approaches:

– Manage supply using capacity, inventory, subcontracting, and backlogs.– Manage demand using short-term price discounts and trade promotions.

9.2 Managing Supply

-- Managing capacity:– Time flexibility from workforce.– Use of seasonal workforce.– Use of subcontracting.– Use of dual facilities – dedicated and flexible.– Designing product flexibility into production processes.

-- Managing inventory:– Using common components across multiple products.– Building inventory of high demand or predictable demand products.

Inventory/Capacity Trade-off:-- Leveling capacity forces inventory to build up in anticipation of seasonal variation in demand.-- Carrying low levels of inventory requires capacity to vary with seasonal variation in demand or enough capacity to cover peak demand during season.

9.3 Managing Demand

-- Promotion.-- Pricing.-- Timing of promotion and pricing changes is important.-- Demand increases can result from a combination of three factors:

– Market growth (increased sales, increased market size).– Stealing share (increased sales, same market size).– Forward buying (same sales, same market size).

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Demand Management:

-- Pricing and aggregate planning must be done jointly.-- Factors affecting discount timing.

– Product margin: Impact of higher margin ($40 instead of $31).– Consumption: Changing fraction of increase coming from forward buy

(100% increase in consumption instead of 10% increase).– Forward buy.

-- Off-Peak (January) Discount from $40 to $39

Month Demand ForecastJanuary 3,000

February 2,400March 2,560April 3,800May 2,200June 2,200

Cost = $421,915, Revenue = $643,400, Profit =$221,485

-- Peak (April) Discount from $40 to $39

Month Demand ForecastJanuary 1,600February 3,000

March 3,200April 5,060May 1,760June 1,760

Cost = $438,857, Revenue = $650,140, Profit = $211,283

-- January Discount: 100% Increase in Consumption, Sale Price = $40 ($39)

Month Demand ForecastJanuary 4,440February 2,400

March 2,560April 3,800May 2,200June 2,200

Off-peak discount: Cost = $456,750, Revenue = $699,560

72

-- Peak (April) Discount: 100% Increase in Consumption, Sale Price = $40 ($39)

Month Demand ForecastJanuary 1,600February 3,000

March 3,200April 8,480May 1,760June 1,760

Peak discount: Cost = $536,200, Revenue = $783,520

-- Performance under Different Scenarios:

Regular

Price

Promotion

Price

Promotion

Period

Percent

increase in

demand

Percent

forward

buy

Profit Average

Inventory

$40 $40 NA NA NA $217,725 895

$40 $39 January 10% 20% $221,485 523

$40 $39 April 10% 20% $211,283 938

$40 $39 January 100% 20% $242,810 208

$40 $39 April 100% 20% $247,320 1,492

$31 $31 NA NA NA $73,725 895

$31 $30 January 100% 20% $84,410 208

$31 $30 April 100% 20% $69,120 1,492

73

-- Factors Affecting Promotion Timing:

Factor Favored timingHigh forward buying Low demand periodHigh stealing share High demand periodHigh growth of market High demand periodHigh margin High demand periodLow margin Low demand periodHigh holding cost Low demand periodLow flexibility Low demand period

-- Factors Influencing Discount Timing:

-- Impact of discount on consumption.-- Impact of discount on forward buy.-- Product margin.

9.4 Implementing Solutions to Predictable Variability in Practice

-- Coordinate planning across enterprises in the supply chain.-- Take predictable variability into account when making strategic decisions.-- Preempt, do not just react to, predictable variability.

74

10.1 Role of Inventory in the Supply Chain

Improve Matching of Supply and Demand

Improved Forecasting

Reduce Material Flow Time

Reduce Waiting Time

Reduce Buffer Inventory

Economies of ScaleSupply / Demand

VariabilitySeasonal

Variability

Cycle Inventory Safety Inventory Seasonal Inventory-- Lot, or batch size: quantity that a supply chain stage either produces or orders at a

given time.-- Cycle inventory: average inventory that builds up in the supply chain because a supply chain stage either produces or purchases in lots that are larger than those demanded by the customer.

– Q = lot or batch size of an order– D = demand per unit time

-- Inventory profile: plot of the inventory level over time(Fig. 10.1).-- Cycle inventory = Q/2 (depends directly on lot size)-- Average flow time = Avg inventory / Avg flow rate-- Average flow time from cycle inventory = Q / (2D)

Q = 1000 units.D = 100 units/day.Cycle inventory = Q/2 = 1000/2 = 500 = Avg inventory level from cycle inventoryAvg flow time = Q/2D = 1000/(2)(100) = 5 days.

-- Cycle inventory adds 5 days to the time a unit spends in the supply chain.-- Lower cycle inventory is better because:

– Average flow time is lower.– Working capital requirements are lower.– Lower inventory holding costs.

-- Cycle inventory is held primarily to take advantage of economies of scale in the supply chain.-- Supply chain costs influenced by lot size:

– Material cost = C– Fixed ordering cost = S– Holding cost = H = hC (h = cost of holding $1 in inventory for one year)

-- Primary role of cycle inventory is to allow different stages to purchase product in lot sizes that minimize the sum of material, ordering, and holding costs.-- Ideally, cycle inventory decisions should consider costs across the entire supply chain, but in practice, each stage generally makes its own supply chain decisions – increases total cycle inventory and total costs in the supply chain.

10.2 Economies of Scale to Exploit Fixed Costs

-- How do you decide whether to go shopping at a convenience store or at Sam’sClub?-- Lot sizing for a single product (EOQ).-- Aggregating multiple products in a single order.-- Lot sizing with multiple products or customers:

– Lots are ordered and delivered independently for each product– Lots are ordered and delivered jointly for all products– Lots are ordered and delivered jointly for a subset of products

Annual demand = DNumber of orders per year = D/Q Annual material cost = CR Annual order cost = (D/Q) SAnnual holding cost = (Q/2) H = (Q/2) h CTotal annual cost = TC = CD + (D/Q) S + (Q/2) h CFigure 10.2 shows variation in different costs for different lot sizes.

Fixed Costs: Optimal Lot Size and Reorder Interval (EOQ)

D: Annual demandS: Setup or Order CostC: Cost per unith: Holding cost per year as a fraction of product costH: Holding cost per unit per yearQ: Lot SizeT: Reorder interval

H =

Q * =

n * =

hC

2 DS

H

2 S

Material cost is constant and therefore is not considered DH

in this model

Example 10.1:

Demand, D = 12,000 computers per year d = 1000 computers/monthUnit cost, C = $500Holding cost fraction, h = 0.2Fixed cost, S = $4,000/orderQ* = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980 computersCycle inventory = Q/2 = 490Flow time = Q/2d = 980 / (2) (1000) = 0.49 monthReorder interval, T = 0.98 monthAnnual ordering and holding cost = (12000/980) (4000) + (980/2) (0.2) (500) =$97,980Suppose lot size is reduced to Q=200, which would reduce flow time:Annual ordering and holding cost = (12000/200) (4000) + (200/2) (0.2) (500) =$250,000To make it economically feasible to reduce lot size, the fixed cost associated with each lot would have to be reduced.

Key Points from EOQ Model:1. In deciding the optimal lot size, the tradeoff is between setup (order) cost and

holding cost.

2. If demand increases by a factor of 4, it is optimal to increase batch size by a factor of 2 and produce (order) twice as often. Cycle inventory (in days of demand) should decrease as demand increases.

3. If lot size is to be reduced, one has to reduce fixed order cost. To reduce lot size by a factor of 2, order cost has to be reduced by a factor of 4.

Aggregating Multiple Products in a Single Order:

-- Transportation is a significant contributor to the fixed cost per order.-- Can possibly combine shipments of different products from the same supplier.

– same overall fixed cost– shared over more than one product– effective fixed cost is reduced for each product– lot size for each product can be reduced

-- Can also have a single delivery coming from multiple suppliers or a single truck delivering to multiple retailers.-- Aggregating across products, retailers, or suppliers in a single order allows for a reduction in lot size for individual products because fixed ordering and transportation costs are now spread across multiple products, retailers, or suppliers.

Example: Aggregating Multiple Products in a Single Order.

-- Suppose there are 4 computer products in the previous example: Deskpro, Litepro, Medpro, and Heavpro.-- Assume demand for each is 1000 units per month.-- If each product is ordered separately:

– Q* = 980 units for each product– Total cycle inventory = 4(Q/2) = (4)(980)/2 = 1960 units

-- Aggregate orders of all four products:– Combined Q* = 1960 units– For each product: Q* = 1960/4 = 490– Cycle inventory for each product is reduced to 490/2 = 245– Total cycle inventory = 1960/2 = 980 units– Average flow time, inventory holding costs will be reduced

Lot Sizing with Multiple Products or Customers:

-- In practice, the fixed ordering cost is dependent at least in part on the variety associated with an order of multiple models.

– A portion of the cost is related to transportation (independent of variety)– A portion of the cost is related to loading and receiving (not independent

of variety)-- Three scenarios:

– Lots are ordered and delivered independently for each product– Lots are ordered and delivered jointly for all three models– Lots are ordered and delivered jointly for a selected subset of models

Lot Sizing with Multiple Products:-- Demand per year.

– DL = 12,000; DM = 1,200; DH = 120-- Common transportation cost, S = $4,000.-- Product specific order cost.

– sL = $1,000; sM = $1,000; sH = $1,000-- Holding cost, h = 0.2.-- Unit cost.

– CL = $500; CM = $500; CH = $500

Delivery Options:-- No Aggregation: Each product ordered separately.-- Complete Aggregation: All products delivered on each truck.-- Tailored Aggregation: Selected subsets of products on each truck.

Litepro Medpro Heavypro

Demand per year 12,000 1,200 120

Fixed cost / order $5,000 $5,000 $5,000

Optimal order size 1,095 346 110

Order frequency 11.0 / year 3.5 / year 1.1 / year

Annual cost $109,544 $34,642 $10,954

No Aggregation: Order Each Product Independently.

Total cost = $155,140

Aggregation: Order All Products Jointly.

S* = S + sL + sM + sH = 4000+1000+1000+1000 = $7000 n* = Sqrt[(DLhCL+ DMhCM+ DHhCH)/2S*]= 9.75QL = DL/n* = 12000/9.75 = 1230QM = DM/n* = 1200/9.75 = 123QH = DH/n* = 120/9.75 = 12.3Cycle inventory = Q/2Average flow time = (Q/2)/(weekly demand)

Complete Aggregation: Order All Products Jointly.

Litepro Medpro Heavypro

Demand per year 12,000 1,200 120

Order frequency 9.75/year 9.75/year 9.75/year

Optimal order size

1,230 123 12.3

Annual holding cost

$61,512 $6,151 $615

Annual order cost = 9.75 × $7,000 = $68,250Annual total cost = $136,528

Lessons from Aggregation:

-- Aggregation allows firm to lower lot size without increasing cost.-- Complete aggregation is effective if product specific fixed cost is a small fraction of joint fixed cost.-- Tailored aggregation is effective if product specific fixed cost is a large fraction of joint fixed cost.

10.3 Economies of Scale to Exploit Quantity Discounts

-- All-unit quantity discounts.-- Marginal unit quantity discounts.-- Why quantity discounts?

– Coordination in the supply chain– Price discrimination to maximize supplier profits

Quantity Discounts:

-- Lot size based.– All units– Marginal unit

-- Volume based.

-- How should buyer react?-- What are appropriate discounting schemes?

All-Unit Quantity Discounts:-- Pricing schedule has specified quantity break points q0, q1, …, qr, where q0 = 0.-- If an order is placed that is at least as large as qi but smaller than qi+1, then each unit has an average unit cost of Ci.-- The unit cost generally decreases as the quantity increases, i.e., C0>C1>…>Cr.-- The objective for the company (a retailer in our example) is to decide on a lot size that will minimize the sum of material, order, and holding costs.

All-Unit Quantity Discount Procedure:

Step 1: Calculate the EOQ for the lowest price. If it is feasible (i.e., this order quantity is in the range for that price), then stop. This is the optimal lot size. Calculate TC for this lot size.Step 2: If the EOQ is not feasible, calculate the TC for this price and the smallest quantity for that price.Step 3: Calculate the EOQ for the next lowest price. If it is feasible, stop and calculate the TC for that quantity and price.Step 4: Compare the TC for Steps 2 and 3. Choose the quantity corresponding to the lowest TC.Step 5: If the EOQ in Step 3 is not feasible, repeat Steps 2, 3, and 4 until a feasible EOQis found.

All-Unit Quantity Discounts: Example.

Cost/Unit Total Material Cost

$3$2.96

$2.92

5,000 10,000 5,000 10,000

Order Quantity Order Quantity

All-Unit Quantity Discount: Example.

Order quantity Unit Price0-5000 $3.005001-10000 $2.96Over 10000 $2.92

q0 = 0, q1 = 5000, q2 = 10000C0 = $3.00, C1 = $2.96, C2 = $2.92D = 120000 units/year, S = $100/lot, h = 0.2

Step 1: Calculate Q2* = Sqrt[(2DS)/hC2]= Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410Not feasible (6410 < 10001)Calculate TC2 using C2 = $2.92 and q2 = 10001TC2 = (120000/10001) (100) + (10001/2) (0.2) (2.92) + (120000) (2.92)= $354,520Step 2: Calculate Q1* = Sqrt[(2DS)/hC1]=Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367Feasible (5000<6367<10000) Î StopTC1 = (120000/6367) (100) + (6367/2) (0.2) (2.96) + (120000) (2.96)= $358,969TC2 < TC1 Î The opti m al order quantity Q* is q2 = 10001

All-Unit Quantity Discounts:

-- Suppose fixed order cost were reduced to $4.– Without discount, Q* would be reduced to 1265 units– With discount, optimal lot size would still be 10001 units

-- What is the effect of such a discount schedule?– Retailers are encouraged to increase the size of their orders– Average inventory (cycle inventory) in the supply chain is increased– Average flow time is increased– Is an all-unit quantity discount an advantage in the supply chain?

Why Quantity Discounts?-- Coordination in the supply chain.

– Commodity products– Products with demand curve

» 2-part tariffs» Volume discounts

Coordination for Commodity Products:

-- D = 120,000 bottles/year-- SR = $100, hR = 0.2, CR = $3-- SS = $250, hS = 0.2, CS = $2

Retailer’s optimal lot size = 6,324 bottlesRetailer cost = $3,795; Supplier cost = $6,009Supply chain cost = $9,804.

-- What can the supplier do to decrease supply chain costs?– Coordinated lot size: 9,165; Retailer cost = $4,059; Supplier cost =

$5,106; Supply chain cost = $9,165-- Effective pricing schemes.

– All-unit quantity discount» $3 for lots below 9,165» $2.9978 for lots of 9,165 or more

– Pass some fixed cost to retailer (enough that he raises order size from6,324 to 9,165)

Quantity Discounts When Firm Has Market Power:

-- No inventory related costs.-- Demand curve.

360,000 - 60,000pWhat are the optimal prices and profits in the following situations?

– The two stages coordinate the pricing decision» Price = $4, Profit = $240,000, Demand = 120,000

– The two stages make the pricing decision independently» Price = $5, Profit = $180,000, Demand = 60,000

Two-Part Tariffs and Volume Discounts:

-- Design a two-part tariff that achieves the coordinated solution.-- Design a volume discount scheme that achieves the coordinated solution.-- Impact of inventory costs.

– Pass on some fixed costs with above pricing.

Lessons from Discounting Schemes:

-- Lot size based discounts increase lot size and cycle inventory in the supply chain.-- Lot size based discounts are justified to achieve coordination for commodity products.-- Volume based discounts with some fixed cost passed on to retailer are more effective in general.

d

*

– Volume based discounts are better over rolling horizon10.4 Short-Term Discounting: Trade Promotions

-- Trade promotions are price discounts for a limited period of time (also may require specific actions from retailers, such as displays, advertising, etc.).

-- Key goals for promotions from a manufacturer’s perspective:– Induce retailers to use price discounts, displays, advertising to increase

sales– Shift inventory from the manufacturer to the retailer and customer– Defend a brand against competition– Goals are not always achieved by a trade promotion

-- What is the impact on the behavior of the retailer and on the performance of the supply chain?-- Retailer has two primary options in response to a promotion:

– Pass through some or all of the promotion to customers to spur sales– Purchase in greater quantity during promotion period to take advantage of

temporary price reduction, but pass through very little of savings to customers

Short Term Discounting:

Q*: Normal order quantity C: Normal unit costd: Short term discountD: Annual demandh: Cost of holding $1 per yearQ

d: Short term order quantity

Forward buy = Qd - Q*

Q = dD

(C - d )h

C Q+

C - d

Short Term Discounts: Forward Buying.

Normal order size, Q* = 6,324 bottles Normal cost, C = $3 per bottle Discount per tube, d = $0.15Annual demand, D = 120,000Holding cost, h = 0.2

Qd =Forward buy =

Promotion Pass Through to Consumers:

Demand curve at retailer: 300,000 - 60,000pNormal supplier price, CR = $3.00

– Optimal retail price = $4.00– Customer demand = 60,000

Promotion discount = $0.15– Optimal retail price = $3.925– Customer demand = 64,500

Retailer only passes through half the promotion discount and demand increases by only 7.5%.

Trade Promotions:

-- When a manufacturer offers a promotion, the goal for the manufacturer is to take actions (countermeasures) to discourage forward buying in the supply chain.-- Counter measures:

– EDLP– Scan based promotions– Customer coupons

10.5 Managing Multi-Echelon Cycle Inventory

-- Multi-echelon supply chains have multiple stages, with possibly many players at each stage and one stage supplying another stage.-- The goal is to synchronize lot sizes at different stages in a way that no unnecessary cycle inventory is carried at any stage.-- Figure 10.6: Inventory profile at retailer and manufacturer with no synchronization.-- Figure 10.7: Illustration of integer replenishment policy.-- Figure 10.8: An example of a multi-echelon distribution supply chain.-- In general, each stage should attempt to coordinate orders from customers who order less frequently and cross-dock all such orders. Some of the orders from customers that order more frequently should also be cross-docked.

10.6 Estimating Cycle Inventory-Related Costs in Practice-- Inventory holding cost:

– Cost of capital– Obsolescence cost– Handling cost– Occupancy cost– Miscellaneous costs

-- Order cost:– Buyer time– Transportation costs– Receiving costs– Other costs

Levers to Reduce Lot Sizes without Hurting Costs:

-- Cycle Inventory Reduction:– Reduce transfer and production lot sizes:

» Aggregate fixed costs across multiple products, supply points, or delivery points.

– Are quantity discounts consistent with manufacturing and logistics operations?

» Volume discounts on rolling horizon.» Two-part tariff.

– Are trade promotions essential?» EDLP.» Based on sell-thru rather than sell-in.

11.1 The Role of Safety Inventory in a Supply Chain

-- Forecasts are rarely completely accurate.-- If average demand is 1000 units per week, then half the time actual demand will be greater than 1000, and half the time actual demand will be less than 1000; what happens when actual demand is greater than 1000?-- If you kept only enough inventory in stock to satisfy average demand, half the time you would run out.-- Saf e ty i n ventory: Inventory carried for the purpose of satisfying demand that exceeds the amount forecasted in a given period.-- Average inventory is therefore cycle inventory plus safety inventory.-- There is a fundamental tradeoff:

– Raising the level of safety inventory provides higher levels of product availability and customer service.

– Raising the level of safety inventory also raises the level of average inventory and therefore increases holding costs:

» Very important in high-tech or other industries where obsolescence is a significant risk (where the value of inventory, such as PCs, can drop in value).

» Compaq and Dell in PCs.

11.2 Determining the Appropriate Level of Safety Inventory

-- Measuring demand uncertainty.-- Measuring product availability.-- Replenishment policies.-- Evaluating cycle service level and fill rate.-- Evaluating safety level given desired cycle service level or fill rate.-- Impact of required product availability and uncertainty on safety inventory.

Determining the Appropriate Level of Demand Uncertainty:

-- Appropriate level of safety inventory determined by:– supply or demand uncertainty– desired level of product availability

-- Higher levels of uncertainty require higher levels of safety inventory given a particular desired level of product availability.-- Higher levels of desired product availability require higher levels of safety inventory given a particular level of uncertainty.

Measuring Demand Uncertainty:

-- Demand has a systematic component and a random component.-- The estimate of the random component is the measure of demand uncertainty.-- Random component is usually estimated by the standard deviation of demand.-- Notation:

D = Average demand per period.sD = standard deviation of demand per period.L = lead time = time between when an order is placed and when it is received

-- Uncertainty of demand during lead time is what is important.-- P = demand during k periods = kD.-- W = s t d dev of demand during k periods = sRSqrt (k).-- Coefficient of variation = cv = m/s = mean/(std dev) = size of uncertainty relative to demand.

Measuring Product Availability:

-- Product a vailabilit y : a firm’s ability to fill a customer’s order out of available inventory.-- Stockout: a customer order arrives when product is not available.-- Product f ill rate (f r ): fraction of demand that is satisfied from product in inventory.-- Ord e r f ill rate: fraction of orders that are filled from available inventory.-- Cycle s ervice level: fraction of replenishment cycles that end with all customer demand met.

Replenishment Policies:

-- Replenishment policy: decisions regarding when to reorder and how much to reorder.-- Continuous revie w : inventory is continuously monitored and an order of size Q is placed when the inventory level reaches the reorder point ROP.-- Pe r i odic revie w : inventory is checked at regular (periodic) intervals and an order is placed to raise the inventory to a specified threshold (the “order-up-to” level).

Continuous Review Policy: Safety Inventory and Cycle Service Level:

L: Lead time for replenishmentD: Average demand per unit

time D L = DL

σD:Standard deviation of demand σ L = L σ D

−1

per periodDL: Mean demand during lead timeσL: Standard deviation of demand

during lead time

ss = F S (CSL ) ×σ L

ROP = D L + ss

CSL = F ( ROP , D L ,σ L

)

CSL: Cycle service levelss: Safety inventory

Average Inventory = Q/2 + ss

Example 11.1: Estimating Safety Inventory (Continuous Review Policy):

D = 2,500/week; σD = 500L = 2 weeks; Q = 10,000; ROP = 6,000

DL = DL = (2500)(2) = 5000ss = ROP - RL = 6000 - 5000 = 1000Cycle inventory = Q/2 = 10000/2 = 5000Average Inventory = cycle inventory + ss = 5000 + 1000 = 6000Average Flow Time = Avg inventory / throughput = 6000/2500 = 2.4 weeks

Example 11.2: Estimating Cycle Service Level (Continuous Review Policy):

D = 2,500/week; σD = 500L = 2 weeks; Q = 10,000; ROP = 6,000

σ L σ R= L = (500 ) 2 = 707

Cycle service level, CSL = F (DL + ss, DL, σL) == NORMDIST (DL + ss, DL, σL) = NORMDIST (6000, 5000, 707.1)= 0.92 (This value can also be determined from a Normal probability distribution table).

⎜s

L ⎠

Fill Rate:

-- Proportion of customer demand satisfied from stock-- Stockout occurs when the demand during

fr = 1 − ESC

Q

⎛ ss ⎞lead time exceeds the reorder point ESC = − ss {1 − ⎜ ⎟}F S ⎜ ⎟-- ESC is the expected shortage per cycle (average demand in excess of reorder point in each replenishment cycle)-- ss is the safety inventory-- Q is the order quantity

⎝ σ L ⎠

⎛ ⎞+ σ L f ⎜ ⎟

S ⎟⎝ σ

ESC = -ss{1-NORMDIST(ss/σL, 0, 1, 1)} + σL NORMDIST(ss/ σL, 0, 1, 0)

Example 11.3: Evaluating Fill Rate:

ss = 1,000, Q = 10,000, sL = 707, Fill Rate (fr) = ?ESC = -ss {1-NORMDIST (ss/σL, 0, 1, 1)} +

σL NORMDIST (ss/σL, 0, 1, 0)= -1,000{1-NORMDIST (1,000/707, 0, 1, 1)} +

707 NORMDIST (1,000/707, 0, 1, 0)= 25.13

fr = (Q - ESC)/Q = (10,000 - 25.13)/10,000 = 0.9975

Factors Affecting Fill Rate:

-- Saf e ty i n ventory : Fill rate increases if safety inventory is increased. This also increases the cycle service level.-- Lot si z e : Fill rate increases on increasing the lot size even though cycle service level does not change.

Example 11.4: Evaluating Safety Inventory Given CSL.

D = 2,500/week; σD = 500L = 2 weeks; Q = 10,000; CSL = 0.90DL = 5000, σL = 707 (from earlier example)

ss = FS-1(CSL)σL = [NORMSINV(0.90)](707) = 906(This value can also be determined from a Normal probability distribution table)

ROP = DL + ss = 5000 + 906 = 5906

s

Evaluating Safety Inventory Given Desired Fill Rate:

D = 2500, σD = 500, Q = 10000If desired fill rate is fr = 0.975, how much safety inventory should be

held?ESC = (1 - fr)Q = 250Solve

⎡ESC = 250 = −ss ⎢1 −

⎛ ss ⎞⎤⎜ ⎟⎥ +

⎛ ⎞

f ⎜ ⎟

F S ⎜ ⎟ σ L S ⎜ ⎟⎝σ L ⎠ ⎝ σL ⎠

⎡ ⎛ ss ⎞⎤ ⎛ ss ⎞250 = −ss ⎢1 − NORMSDIST ⎜ ⎟⎥ + NORMDIST ⎜ ,1,1,0 ⎟

⎝ σ ⎠σL

⎝ σ ⎠⎜ ⎟ ⎜ ⎟

L L

Evaluating Safety Inventory Given Fill Rate (try different values of ss)

Fill Rate Safety Inventory

97.5% 67

98.0% 183

98.5% 321

99.0% 499

99.5% 767

s

σ

11.3 Impact of Required Product Availability and Uncertainty on SafetyInventory

-- Desired product availability (cycle service level or fill rate) increases, required safety inventory increases.-- Demand uncertainty (sL) increases, required safety inventory increases.-- Managerial levers to reduce safety inventory without reducing product availability.

– reduce supplier lead time, L (better relationships with suppliers)– reduce uncertainty in demand, sL (better forecasts, better information

collection and use)

Impact of Supply Uncertainty:

-- D: Average demand per period-- σD: Standard deviation of demand per period-- L: Average lead time-- sL: Standard deviation of lead time

D L = DL

2 2 2

L = L σ D

+ D s L

D = 2,500/day; σD = 500L = 7 days; Q = 10,000; CSL = 0.90; sL = 7 daysDL = DL = (2500) (7) = 17500

σ L σ D L

= L 2 + D2 s

2

= (7) 5002 + (2500)

2 (7)

2 = 17500

ss = F-1 (CSL)σL

= 22,491= NORMSINV(0.90) x 17550

Safety inventory when sL = 0 is 1,695Safety inventory when sL = 1 is 3,625Safety inventory when sL = 2 is 6,628Safety inventory when sL = 3 is 9,760Safety inventory when sL = 4 is 12,927Safety inventory when sL = 5 is 16,109Safety inventory when sL = 6 is 19,298

11.4 Impact of Aggregation on Safety Inventory

C

− C

-- Models of aggregation.-- Information centralization.-- Specialization.-- Product substitution.-- Component commonality.-- Postponement.

n

D = ∑ D ii = 1

nC 2σ D

=

C

∑ σ ii = 1

Cσ L=

ss = F

L σ D

( CSLs

) × σ L

Impact of Aggregation (Example 11.7):

Car Dealer: 4 dealership locations (disaggregated)D = 25 cars; sD = 5 cars; L = 2 weeks; desired CSL=0.90What would the effect be on safety stock if the 4 outlets are consolidated into 1 large outlet (aggregated)?At each disaggregated outlet:For L = 2 weeks, sL = 7.07 carsss = Fs-1(CSL) x sL = Fs-1(0.9) x 7.07 = 9.06Each outlet must carry 9 cars as safety stock inventory, so safety inventory for the 4 outlets in total is (4)(9) = 36 cars.One outlet (aggregated option):RC = D1 + D2 + D3 + D4 = 25+25+25+25 = 100 cars/wk sRC = Sqrt(52 + 52 + 52 + 52) = 10sLC = sDC Sqrt(L) = (10)Sqrt(2) = (10)(1.414) = 14.14 ss = Fs-1(CSL) x sLC = Fs-1(0.9) x 14.14 =18.12or about 18 carsIf r does not equal 0 (demand is not completely independent), the impact of aggregation is not as great (Table 11.3).

Impact of Aggregation:

-- If number of independent stocking locations decreases by n, the expected level of safety inventory will be reduced by square root of n (square root law).-- Many e-commerce retailers attempt to take advantage of aggregation (Amazon)compared to bricks and mortar retailers (Borders).-- Aggregation has two major disadvantages:

– Increase in response time to customer order– Increase in transportation cost to customer– Some e-commerce firms (such as Amazon) have reduced aggregation to

mitigate these disadvantages

Information Centralization:

-- Virtual aggregation.-- Information system that allows access to current inventory records in all warehouses from each warehouse.-- Most orders are filled from closest warehouse.-- In case of a stockout, another warehouse can fill the order.-- Better responsiveness, lower transportation cost, higher product availability, but reduced safety inventory.-- Examples: McMaster-Carr, Gap, Wal-Mart.

Specialization:

-- Stock all items in each location or stock different items at different locations?– Different products may have different demands in different locations (e.g.,

snow shovels).– There can be benefits from aggregation.

-- Benefits of aggregation can be affected by:– coefficient of variation of demand (higher cv yields greater reduction in

safety inventory from centralization).– value of item (high value items provide more benefits from centralization)– Table 11.4.

Value of Aggregation at Grainger (Table 11.4):

Motors CleanerMean demand 20 1,000SD of demand 40 100Disaggregate cv 2 0.1Value/Unit $500 $30Disaggregate ss $105,600,000 $15,792,000Aggregate cv 0.05 0.0025Aggregate ss $2,632,000 $394,770Holding Cost Saving $25,742,000 $3,849,308

PrSodauvcint

gSu/bUstnitiut tion:$7.74 $0.046

-- Substitution: use of one product to satisfy the demand for another product.-- Manufacturer-driven one-way substitution.-- Customer-driven two-way substitution.

Component Commonality:

-- Using common components in a variety of different products.-- Can be an effective approach to exploit aggregation and reduce component inventories.

Example 11.9: Value of Component Commonality.

450000

400000

350000300000

250000

200000

150000100000

50000

0

SS

1 2 3 4 5 6 7 8 9

Postponement:-- The ability of a supply chain to delay product differentiation or customization until closer to the time the product is sold.-- Goal is to have common components in the supply chain for most of the push phase and move product differentiation as close to the pull phase as possible.-- Examples: Dell, Benetton.

11.5 Impact of Replenishment Policies on Safety Inventory

-- Continuous review policies.-- Periodic review policies.

11.6 Estimating and Managing Safety Inventory in Practice-- Account for the fact that supply chain demand is lumpy.-- Adjust inventory policies if demand is seasonal.-- Use simulation to test inventory policies.-- Start with a pilot.-- Monitor service levels.-- Focus on reducing safety inventories.

12.1 Importance of the Level of Product Availability

-- Product availability measured by cycle service level or fill rate.-- Also referred to as the customer service level.-- Product availability affects supply chain responsiveness.-- Trade-off:

– High levels of product availability Î increased responsiveness and higher revenues

– High levels of product availability Î increased inventory levels and higher costs

-- Product availability is related to profit objectives, and strategic and competitive issues (e.g., Nordstrom, power plants, supermarkets, e-commerce retailers).-- What is the level of fill rate or cycle service level that will result in maximum supply chain profits?

12.2 Factors Affecting the Optimal Level of Product Availability

-- Cost of overstocking.-- Cost of under stocking.-- Possible scenarios.

– Seasonal items with a single order in a season.– Continuously stocked items.– Demand during stock out is backlogged.– Demand during stock out is lost.

12.3 Managerial Levers to Improve Supply Chain Profitability

-- “Obvious” actions:– Increase salvage value of each unit– Decrease the margin lost from a stockout

1. Improved forecasting.2. Quick response.3. Postponement.4. Tailored sourcing.

1. Improved Forecasts:

-- Improved forecasts result in reduced uncertainty.-- Less uncertainty (lower sR) results in either:

– Lower levels of safety inventory (and costs) for the same level of product availability, or

– Higher product availability for the same level of safety inventory, or– Both lower levels of safety inventory and higher levels of product

availability

Impact of Improving Forecasts (Example):

Demand: Normally distributed with a mean of R = 350 and standard deviation of σR =100Purchase price = $100Retail price = $250Disposal value = $85Holding cost for season = $5

How many units should be ordered as σR changes? Impact of Improving Forecasts:

σR O* ExpectedOverstock

ExpectedUnderstock

Expected Profit

150 526 186.7 8.6 $47,469

120 491 149.3 6.9 $48,476

90 456 112.0 5.2 $49,482

60 420 74.7 3.5 $50,488

30 385 37.3 1.7 $51,494

0 350 0 0 $52,500

2. Quick Response:

-- Set of actions taken by managers to reduce lead time.-- Reduced lead time results in improved forecasts:

– Typical example of quick response is multiple orders in one season for retail items (such as fashion clothing).

– For example, a buyer can usually make very accurate forecasts after the first week or two in a season.

– Multiple orders are only possible if the lead time is reduced – otherwise there wouldn’t be enough time to get the later orders before the season ends.

-- Benefits:– Lower order quantities Æ less inventory, same product availability.– Less overstock.– Higher profits.

Quick Response: Multiple Orders per Season:

-- Ordering shawls at a department store:– Selling season = 14 weeks.– Cost per handbag = $40.– Sale price = $150.– Disposal price = $30.– Holding cost = $2 per week.

-- Expected weekly demand = 20.-- SD of weekly demand = 15.

Impact of Quick Response:

Single Order Two Orders in Season

ServiceLevel

OrderSize

EndingInvent.

Expect.Profit

InitialOrder

OUL for2nd

Order

AverageTotal Order

EndingInvent.

Expect.Profit

0.96 378 97 $23,624 209 209 349 69 $26,590

0.94 367 86 $24,034 201 201 342 60 $27,085

0.91 355 73 $24,617 193 193 332 52 $27,154

0.87 343 66 $24,386 184 184 319 43 $26,944

0.81 329 55 $24,609 174 174 313 36 $27,413

0.75 317 41 $25,205 166 166 302 32 $26,916

Forecast Improves for Second Order (SD=3 Instead of 15):

Single Order Two Orders in Season

ServiceLevel

OrderSize

EndingInvent.

Expect.Profit

InitialOrder

OUL for2

nd

Order

AverageTotal Order

EndingInvent.

Expect.Profit

0.96 378 96 $23,707 209 153 292 19 $27,007

0.94 367 84 $24,303 201 152 293 18 $27,371

0.91 355 76 $24,154 193 150 288 17 $26,946

0.87 343 63 $24,807 184 148 288 14 $27,583

0.81 329 52 $24,998 174 146 283 14 $27,162

0.75 317 44 $24,887 166 145 282 14 $27,268

3. Postponement:

-- Delay of product differentiation until closer to the time of the sale of the product.-- All activities prior to product differentiation require aggregate forecasts more accurate than individual product forecasts.-- Individual product forecasts are needed close to the time of sale – demand is known with better accuracy (lower uncertainty).-- Results in a better match of supply and demand.-- There is a cost associated with postponement. Production cost per unit is usually higher.-- Valuable in e-commerce – time lag between when an order is placed and when customer receives the order (this delay is expected by the customer and can be used for postponement).-- Higher profits, better match of supply and demand.

Value of Postponement: Benetton.

-- Garment sales. Four collars. Two option for producing:– Dying thread and knitting – Order for each collar 20 weeks ahead.– Knitting and then dying.- Order for aggregate uncolored need 20 weeks

ahead. Quantity for individual colors is determined after the demand is known.

-- Knitting takes 20 weeks.-- For each color:

– Mean demand = 1,000; SD = 500.-- For each garment:

– Sale price = $50.– Salvage value = $10.– Production cost using Option 1 = $20.– Production cost using Option 2 (uncolored thread) = $22.

-- What is the value of postponement?-- Option 1:

– CSL = 30/40 = 0,75.– O*=Norminv(0,75,1000,500)=1337 for each collor.– Exp. Profit, Exp.Overstock, Exp. Understock,

» $23644, 412, 75– Total exp. Profit Exp., Overstock, Exp. Understock,

» 94576, 1648 300-- Option 2:

– CSL = 28/40=0,7.– Mean=4x1000, std = sqrt(4)*5000.– O*= Norminv(0,7,4000,1000)=4524.– Total exp. Profit Exp., Overstock, Exp. Understock,

» 98092, 715 190

Value of Postponement with Dominant Product:

-- Color with dominant demand: Mean = 3,100, SD = 800.-- Other three colors: Mean = 300, SD = 200.-- 80% of demand is for the dominant color.-- Expected profit without postponement = $102,205.-- Expected profit with postponement = $99,872.-- If majority of demand is for a specific product, postponement may increase costs since the increase in unit production costs applies to all the items.

Tailored Postponement: Benetton:

-- Produce the portion of demand that is likely using no postponement and with lower costs, produce for the uncertain part using postponement. No close form formula for optimal decision.-- Produce Q1 units for each color using Option 1 and QA units (aggregate) usingOption 2.-- Results: (Table 12-6).

– Q1 = 800– QA = 1,550– Profit = $104,603

-- Tailored postponement allows a firm to increase profits by postponing differentiation only for products with the most uncertain demand; products with more predictable demand are produced at lower cost without postponement.

4. Tailored Sourcing:

-- A firm uses a combination of two supply sources.-- One is lower cost but is unable to deal with uncertainty well.-- The other is more flexible, and can therefore deal with uncertainty, but is higher cost.-- The two sources must focus on different capabilities.-- The value of the tailored sourcing depends on the reduction of the cost that can be achieved.-- Increase profits, better match supply and demand.-- Volume based or product-based tailored sourcing.

– Benetton (65% to low cost long lead time suppliers 35% to local flexible suppliers close to sales season).

– Levi Strauss (standard size jeans produced in efficient low cost plants while customized jeans are produced at flexible facility.

13.1 Factors affecting transportation decisions

-- Carrier (party that moves or transports the product).– Vehicle-related cost.– Fixed operating cost.– Trip-related cost.

-- Shipper (party that requires the movement of the product between two points in the supply chain).

– Transportation cost.– Inventory cost.– Facility cost.

13.2 Modes of transportation and their performance characteristics

1. Trucks:a) TL.b) LTL.

2. Rail:3. Air:4. Package Carriers:5. Water:6. Pipeline:7. Intermodal:

1-a) Truckload (TL):

-- Average revenue per ton mile (1996) = 9.13 cents.-- Average haul = 274 miles.-- Average Capacity = 42,000 - 50,000 lb.-- Low fixed and variable costs.-- Major Issues:

– Utilization.– Consistent service.– Backhauls.

1-b) Less than Truckload (LTL):

-- Average revenue per ton-mile (1996) = 25.08 cents.-- Average haul = 646 miles.-- Higher fixed costs (terminals) and low variable costs.-- Major issues:

– Location of consolidation facilities.– Utilization.– Vehicle routing.– Customer service.

2. Rail:

-- Average revenue / ton-mile (1996) = 2.5 cents.-- Average haul = 720 miles.-- Average load = 80 tons.-- Key issues:

– Scheduling to minimize delays / improve service.– Off-track delays (at pickup and delivery end).– Yard operations.– Variability of delivery times.

3. Air:

-- Key issues:– Location/number of hubs.– Location of fleet bases/crew bases.– Schedule optimization.– Fleet assignment.– Crew scheduling.– Yield management.

4. Package Carriers:

-- Companies like FedEx, UPS, and USPS that carry small packages ranging from letters to shipments of about 150 pounds.-- Expensive.-- Rapid and reliable delivery.-- Small and time-sensitive shipments.-- Preferred mode for e-businesses (e.g., Amazon, Dell, McMaster-Carr).-- Consolidation of shipments (especially important for package carriers that use air as a primary method of transport).

5. Water:

-- Limited to certain geographic areas.-- Ocean, inland waterway system, coastal waters.-- Very large loads at very low cost.-- Slowest.-- Dominant in global trade (autos, grain, apparel, etc.).

6. Pipeline:

-- High fixed cost.-- Primarily for crude petroleum, refined petroleum products, natural gas.-- Best for large and predictable demand.-- Would be used for getting crude oil to a port or refinery, but not for getting refined gasoline to a gasoline station (why?).

7. Intermodal:

-- Use of more than one mode of transportation to move a shipment to its destination.-- Most common example: rail/truck.-- Also water/rail/truck or water/truck.-- Grown considerably with increased use of containers.-- Increased global trade has also increased use of intermodal transportation.-- More convenient for shippers (one entity provides the complete service).-- Key issue involves the exchange of information to facilitate transfer between different transport modes.

13.3 Design Options for a Transportation Network

-- What are the transportation options? Which one to select? On what basis?-- Direct shipping network.-- Direct shipping with milk runs.-- All shipments via central DC.-- Shipping via DC using milk runs.-- Tailored network.

13.4 Trade-offs in Transportation Design

-- Transportation and inventory cost trade-off:– Choice of transportation mode.– Inventory aggregation.

-- Transportation cost and responsiveness trade-off.

Choice of Transportation Mode:

-- A manager must account for inventory costs when selecting a mode of transportation.-- A mode with higher transportation costs can be justified if it results in significantly lower inventories.

Inventory Aggregation: Inventory vs. Transportation Cost:

-- As a result of physical aggregation:– Inventory costs decrease.– Inbound transportation cost decreases.– Outbound transportation cost increases.

-- Inventory aggregation decreases supply chain costs if the product has a high value to weight ratio, high demand uncertainty, or customer orders are large.-- Inventory aggregation may increase supply chain costs if the product has a low value to weight ratio, low demand uncertainty, or customer orders are small.

Trade-offs Between Transportation Cost and Customer Responsiveness:

-- Temporal aggregation is the process of combining orders across time.-- Temporal aggregation reduces transportation cost because it results in larger shipments and reduces variation in shipment sizes.-- However, temporal aggregation reduces customer responsiveness.

13.5 Tailored Transportation

-- The use of different transportation networks and modes based on customer and product characteristics.-- Factors affecting tailoring:

– Customer distance and density.– Customer size.– Product demand and value.

13.6 Role of IT in Transportation

-- The complexity of transportation decisions demands to use of IT systems.-- IT software can assist in:

– Identification of optimal routes by minimizing costs subject to delivery constraints.

– Optimal fleet utilization.– GPS applications.

13.7 Risk Management in Transportation

-- Three main risks to be considered in transportation are:– Risk that the shipment is delayed.– Risk of disruptions.– Risk of hazardous material.

-- Risk mitigation strategies:– Decrease the probability of disruptions.– Alternative routings.– In case of hazardous materials the use of modified containers, low-risk

transportation models, modification of physical and chemical properties can prove to be effective.

13.8 Making Transportation Decisions in Practice

-- Align transportation strategy with competitive strategy.-- Consider both in-house and outsourced transportation.-- Design a transportation network that can handle e-commerce.-- Use technology to improve transportation performance.-- Design flexibility into the transportation network.

14.1The Role of Sourcing in a Supply Chain

-- Sourcing is the set of business processes required to purchase goods and services.-- Sourcing processes include:

– Supplier scoring and assessment.– Supplier selection and contract negotiation.– Design collaboration.– Procurement.– Sourcing planning and analysis.

14.2 Benefits of Effective Sourcing Decisions

-- Better economies of scale can be achieved if orders are aggregated.-- More efficient procurement transactions can significantly reduce the overall cost of purchasing.-- Design collaboration can result in products that are easier to manufacture and distribute, resulting in lower overall costs.-- Good procurement processes can facilitate coordination with suppliers.-- Appropriate supplier contracts can allow for the sharing of risk.-- Firms can achieve a lower purchase price by increasing competition through the use of auctions.

14.3 Supplier Scoring and Assessment

-- Supplier performance should be compared on the basis of the supplier’s impact on total cost.-- There are several other factors besides purchase price that influence total cost.

Supplier Assessment Factors:

-- Replenishment Lead Time.-- On-Time Performance.-- Supply Flexibility.-- Delivery Frequency / Minimum Lot Size.-- Supply Quality.-- Inbound Transportation Cost.

-- Pricing Terms.-- Information Coordination Capability.-- Design Collaboration Capability.-- Exchange Rates, Taxes, Duties.-- Supplier Viability.

14.4 Supplier Selection- Auctions and Negotiations

-- Supplier selection can be performed through competitive bids, reverse auctions, and direct negotiations.-- Supplier evaluation is based on total cost of using a supplier.-- Auctions:

– Sealed-bid first-price auctions.– English auctions.– Dutch auctions.– Second-price (Vickery) auctions.

14.5 Contracts and Supply Chain Performance

1. Contracts for Product Availability and Supply Chain Profits:a) Buyback Contracts.b) venue-Sharing Contracts.c) Quantity Flexibility Contracts.

2. Contracts to Coordinate Supply Chain Costs.3. Contracts to Increase Agent Effort.4. Contracts to Induce Performance Improvement.

1. Contracts for Product Availability and Supply Chain Profits:

-- Many shortcomings in supply chain performance occur because the buyer and supplier are separate organizations and each tries to optimize its own profit.-- Total supply chain profits might therefore be lower than if the supply chain coordinated actions to have a common objective of maximizing total supply chain profits.-- Recall Chapter 10: double marginalization results in suboptimal order quantity.-- An approach to dealing with this problem is to design a contract that encourages a buyer to purchase more and increase the level of product availability.-- The supplier must share in some of the buyer’s demand uncertainty, however.

a) Contracts for Product Availability and Supply Chain Profits: BuybackContracts:

-- Allows a retailer to return unsold inventory up to a specified amount at an agreed upon price.-- Increases the optimal order quantity for the retailer, resulting in higher product availability and higher profits for both the retailer and the supplier.-- Most effective for products with low variable cost, such as music, software, books, magazines, and newspapers.-- Downside is that buyback contract results in surplus inventory that must be disposed of, which increases supply chain costs.-- Can also increase information distortion through the supply chain because the supply chain reacts to retail orders, not actual customer demand.

b) Contracts for Product Availability and Supply Chain Profits: RevenueSharing Contracts:

-- The buyer pays a minimal amount for each unit purchased from the supplier but shares a fraction of the revenue for each unit sold.-- Decreases the cost per unit charged to the retailer, which effectively decreases the cost of overstocking.-- Can result in supply chain information distortion, however, just as in the case of buyback contracts.

c) Contracts for Product Availability and Supply Chain Profits: QuantityFlexibility Contracts:

-- Allows the buyer to modify the order (within limits) as demand visibility increases closer to the point of sale.-- Better matching of supply and demand.-- Increased overall supply chain profits if the supplier has flexible capacity.-- Lower levels of information distortion than either buyback contracts or revenue sharing contracts.

2. Contracts to Coordinate Supply Chain Costs:

-- Differences in costs at the buyer and supplier can lead to decisions that increase total supply chain costs.-- Example: Replenishment order size placed by the buyer. The buyer’s EOQ does not take into account the supplier’s costs.-- A quantity discount contract may encourage the buyer to purchase a larger quantity (which would be lower costs for the supplier), which would result in lower total supply chain costs.-- Quantity discounts lead to information distortion because of order batching.

3. Contracts to Increase Agent Effort:

-- There are many instances in a supply chain where an agent acts on the behalf of a principal and the agent’s actions affect the reward for the principal.-- Example: A car dealer who sells the cars of a manufacturer, as well as those of other manufacturers.-- Examples of contracts to increase agent effort include two-part tariffs and threshold contracts.-- Threshold contracts increase information distortion, however.

4. Contracts to Induce Performance Improvement:

-- A buyer may want performance improvement from a supplier who otherwise would have little incentive to do so.-- A shared savings contract provides the supplier witha fraction of the savings that result from the performance improvement.-- Particularly effective where the benefit from improvement accrues primarily to the buyer, but where the effort for the improvement comes primarily from the supplier.

14.6 Design Collaboration

-- 50-70 percent of spending at a manufacturer is through procurement.-- 80 percent of the cost of a purchased part is fixed in the design phase.-- Design collaboration with suppliers can result in reduced cost, improved quality, and decreased time to market.-- Important to employ design for logistics, design for manufacturability.-- Manufacturers must become effective design coordinators throughout the supply

chain.

Critical Items Strategic Items

General Items Bulk Purchase Items

14.7 The Procurement Process

-- The process in which the supplier sends product in response to orders placed by the buyer.-- Goal is to enable orders to be placed and delivered on schedule at the lowest possible overall cost.-- Two main categories of purchased goods:

– Direct materials: components used to make finished goods.– Indirect materials: goods used to support the operations of a firm.– Differences between direct and indirect materials listed in Table 13.2.

-- Focus for direct materials should be on improving coordination and visibility with supplier.-- Focus for indirect materials should be on decreasing the transaction cost for each order.-- Procurement for both should consolidate orders where possible to take advantage of economies of scale and quantity discounts.

Product Categorization by Value and Criticality (Figure 14.2):

High

Criticality

Low

Low Value/Cost High

14.8 Sourcing Planning and Analysis

-- A firm should periodically analyze its procurement spending and supplier performance and use this analysis as an input for future sourcing decisions.-- Procurement spending should be analyzed by part and supplier to ensure appropriate economies of scale.-- Supplier performance analysis should be used to build a portfolio of suppliers with complementary strengths.

– Cheaper but lower performing suppliers should be used to supply base demand.

– Higher performing but more expensive suppliers should be used to buffer against variation in demand and supply from the other source.

14.9 Making Sourcing Decisions in Practice

-- Use multifunction teams.-- Ensure appropriate coordination across regions and business units.-- Always evaluate the total cost of ownership.-- Build long-term relationships with key suppliers.

15.1 The Role of Revenue Management in the Supply Chain

-- Revenue management is the use of pricing to increase the profit generated from a limited supply of supply chain assets.-- Supply assets exist in two forms: capacity and inventory.-- Revenue management may also be defined as the use of differential pricing based on customer segment, time of use, and product or capacity availability to increase supply chain profits.-- Most common example is probably in airline pricing.

Conditions under Which Revenue Management Has the Greatest Effect:

-- The value of the product varies in different market segments (Example: airline seats).-- The product is highly perishable or product waste occurs (Example: fashion and seasonal apparel).-- Demand has seasonal and other peaks (Example: products ordered atAmazon.com).-- The product is sold both in bulk and on the spot market (Example: owner of warehouse who can decide whether to lease the entire warehouse through long-term contracts or save a portion of the warehouse for use in the spot market).

15.2 Revenue Management for Multiple Customer Segments

-- If a supplier serves multiple customer segments with a fixed asset, the supplier can improve revenues by setting different prices for each segment.-- Prices must be set with barriers such that the segment willing to pay more is not able to pay the lower price.-- The amount of the asset reserved for the higher price segment is such that the expected marginal revenue from the higher priced segment equals the price of the lower price segment.

pL = the price charged to the lower price segment. pH = the price charged to the higher price segment. DH = mean demand for the higher price segment.sH = standard deviation of demand for the higher price segment. CH = capacity reserved for the higher price segment.RH (CH) = expected marginal revenue from reserving more capacity = Probability(demand from higher price segment > CH) x pH RH(CH) = pLProbability (demand from higher price segment > CH) = pL / pH CH = F-1(1- pL/pH, DH,sH) = NORMINV(1- pL/pH, DH,sH).

Example 15.2: ToFrom Trucking:

Revenue from segment A = pA = $3.50 per cubic ft. Revenue from segment B = pB = $3.50 per cubic ft. Mean demand for segment A = DA = 3,000 cubic ft.S t d dev of segment A demand = sA = 1,000 cubic ft.CA = NORMINV (1- pB/pA, DA,sA) = NORMINV(1- (2.00/3.50), 3000, 1000) = 2,820 cubic ft If pA increases to $5.00 per cubic foot, then,CA = NORMINV (1- pB/pA, DA,sA) = NORMINV(1- (2.00/5.00), 3000, 1000) = 3,253 cubic ft.

15.3 Revenue Management for Perishable Assets

-- Any asset that loses value over time is perishable.-- Examples: high-tech products such as computers and cell phones, high fashion apparel, underutilized capacity, fruits and vegetables.-- Two basic approaches:

– Vary price over time to maximize expected revenue.– Overbook sales of the asset to account for cancellations.

-- Overbooking or overselling of a supply chain asset is valuable if order cancellations occur and the asset is perishable.-- The level of overbooking is based on the trade-off between the cost of wasting the asset if too many cancellations lead to unused assets and the cost of arranging a backup if too few cancellations lead to committed orders being larger than the available capacity.

p = price at which each unit of the asset is soldc = cost of using or producing each unit of the assetb = cost per unit at which a backup can be used in the case of asset shortageCw = p – c = marginal cost of wasted capacityCs = b – c = marginal cost of a capacity shortageO* = optimal overbooking levelS * = Probability (cancellations < O*) = Cw / (Cw + Cs)

If the distribution of cancellations is known to be normal with mean mc and standard deviation sc then:O* = F-1(s*, mc, sc) = NORMINV(s*, mc, sc).If the distribution of cancellations is known only as a function of the booking level (capacity L + overbooking O) to have a mean of m(L+O) and std deviation of s(L+O), the optimal overbooking level is the solution to the following equation:O= F-1(s*, m (L+O), s (L+O)) = NORMINV(s*, m (L+O), s (L+O)).

Example 15.5:

Cost of wasted capacity = Cw = $10 per dress Cost of capacity shortage = Cs = $5 per dress s* = Cw / (Cw + Cs) = 10/(10+5) = 0.667mc = 800; sc = 400O* = NORMINV(s*, mc,sc) = NORMINV(0.667,800,400) = 973If the mean is 15% of the booking level and the coefficient of variation is 0.5, then the optimal overbooking level is the solution of the following equation:O = NORMINV (0.667, 0.15 (5000+O), 0.075 (5000+O)) Using Excel Solver, O* = 1,115.

15.4 Revenue Management for Seasonal Demand

-- Seasonal peaks of demand are common in many supply chains.-- Examples: Most retailers achieve a large portion of total annual demand inDecember (Amazon.com).-- Off-peak discounting can shift demand from peak to non-peak periods.-- Charge higher price during peak periods and a lower price during off-peak periods.

15.5 Revenue Management for Bulk and Spot Customers

-- Most consumers of production, warehousing, and transportation assets in a supply chain face the problem of constructing a portfolio of long-term bulk contracts and short-term spot market contracts.-- The basic decision is the size of the bulk contract.-- The fundamental trade-off is between wasting a portion of the low-cost bulk contract and paying more for the asset on the spot market.-- Given that both the spot market price and the purchaser’s need for the asset are uncertain, a decision tree approach as discussed in Chapter 6 should be used to evaluate the amount of long-term bulk contract to sign.

For the simple case where the spot market price is known but demand is uncertain, a formula can be used cB = bulk rate cS = spot market price.Q* = optimal amount of the asset to be purchased in bulk.p* = probability that the demand for the asset does not exceed Q*Marginal cost of purchasing another unit in bulk is cB. The expected marginal cost ofnot purchasing another unit in bulk and then purchasing it in the spot market is (1-p*) cS.

If the optimal amount of the asset is purchased in bulk, the marginal cost of the bulk purchase should equal the expected marginal cost of the spot market purchase, orcB = (1-p*)cS Solving for p* yields p* = (cS – cB) / cS.If demand is normal with mean m and std deviation s, the optimal amount Q* to be purchased in bulk is Q* = F-1(p*,m,s) = NORMINV(p*,m,s).

Example 15.6:

Bulk contract cost = cB = $10,000 per million units. Spot market cost = cS = $12,500 per million units.m = 10 million units s = 4 million units.p* = (cS – cB) / cS = (12,500 – 10,000) / 12,500 = 0.2.Q* = NORMINV (p*,m,s) = NORMINV(0.2,10,4) = 6.63.The manufacturer should sign a long-term bulk contract for 6.63 million units per month and purchase any transportation capacity beyond that on the spot market.

15.6 Using Revenue Management in Practice

-- Evaluate your market carefully.-- Quantify the benefits of revenue management.-- Implement a forecasting process.-- Apply optimization to obtain the revenue management decision.-- Involve both sales and operations.-- Understand and inform the customer.-- Integrate supply planning with revenue management.

16.1 Role of Information Technology in a Supply Chain

-- Information is the driver that serves as the “glue” to create a coordinated supply chain.-- Information must have the following characteristics to be useful:

– Accurate.– Accessible in a timely manner.– Information must be of the right kind.

-- Information provides the basis for supply chain management decisions:– Inventory.– Transportation.– Facility.

Characteristics of Useful Supply Chain Information:

-- Accurate.-- Accessible in a timely manner.-- The right kind.-- Provides supply chain visibility.

Use of Information in a Supply Chain:

-- Information used at all phases of decision making: strategic, planning, and operational.-- Examples:

– Strategic: location decisions.– Operational: what products will be produced during today’s production

run?-- Inventory: demand patterns, carrying costs, stock out costs, ordering costs.-- Transportation: costs, customer locations, shipment sizes.-- Facility: location, capacity, schedules of a facility; need information about trade- offs between flexibility and efficiency, demand, exchange rates, taxes, etc.

Role of Information Technology in a Supply Chain:

-- Information technology (IT):– Hardware and software used throughout the supply chain to gather and

analyze information.– Captures and delivers information needed to make good decisions.

-- Effective use of IT in the supply chain can have a significant impact on supply chain performance.

The Importance of Information in a Supply Chain:

-- Relevant information available throughout the supply chain allows managers to make decisions that take into account all stages of the supply chain.-- Allows performance to be optimized for the entire supply chain, not just for one stage – leads to higher performance for each individual firm in the supply chain.

16.2 The Supply Chain IT Framework

-- The Supply Chain Macro Processes:– Customer Relationship Management (CRM).– Internal Supply Chain Management (ISCM).– Supplier Relationship Management (SRM).– Plus: Transaction Management Foundation.– Figure 16.1.

-- Why Focus on the Macro Processes?-- Macro Processes Applied to the Evolution of Software.

Macro Processes in a Supply Chain (Figure 16.1):

Supplier Relationship Management

(SRM)

Internal Supply Chain Management

(ISCM)

Customer Relationship Management

(CRM)

Transaction Management Foundation (TFM)

16.3 Customer Relationship Management

-- The processes that take place between an enterprise and its customers downstream in the supply chain.-- Key processes:

– Marketing.– Selling.– Order management.– Call/Service center.

16.4 Internal Supply Chain Management

-- Includes all processes involved in planning for and fulfilling a customer order.-- ISCM processes:

– Strategic Planning.– Demand Planning.– Supply Planning.– Fulfillment.– Field Service.

-- There must be strong integration between the ISCM and CRM macro processes.

16.5 Supplier Relationship Management

-- Those processes focused on the interaction between the enterprise and suppliers that are upstream in the supply chain.-- Key processes:

– Design Collaboration.– Source.– Negotiate.– Buy.– Supply Collaboration.

-- There is a natural fit between ISCM and SRM processes.

16.6 The Transaction Management Foundation

-- Enterprise software systems (ERP).-- Earlier systems focused on automation of simple transactions and the creation of an integrated method of storing and viewing data across the enterprise.-- Real value of the TMF exists only if decision making is improved.-- The extent to which the TMF enables integration across the three macro processes determines its value.

16.7 The Future of IT in the Supply Chain

-- At the highest level, the three SCM macro processes will continue to drive the evolution of enterprise software.-- Software focused on the macro processes will become a larger share of the total enterprise software market and the firms producing this software will become more successful.-- Functionality, the ability to integrate across macro processes, and the strength of their ecosystems, will be keys to success.

16.8 Supply Chain Information Technology in Practice

-- Select an IT system that addresses the company’s key success factors.-- Take incremental steps and measure value.-- Align the level of sophistication with the need for sophistication.-- Use IT systems to support decision making, not to make decisions.-- Think about the future.

17.1 Lack of SC Coordination and the Bullwhip Effect

-- Supply chain coordination – all stages in the supply chain take actions together(usually results in greater total supply chain profits).-- SC coordination requires that each stage take into account the effects of its actions on the other stages.-- Lack of coordination results when:

– Objectives of different stages conflict or.– Information moving between stages is distorted.

Bullwhip Effect:

-- Fluctuations in orders increase as they move up the supply chain from retailers to wholesalers to manufacturers to suppliers (shown in Figure 16.1).-- Distorts demand information within the supply chain, where different stages have very different estimates of what demand looks like.-- Results in a loss of supply chain coordination.-- Examples: Proctor & Gamble (Pampers); HP (printers); Barilla (pasta).

17.2 The Effect of Lack of Coordination on Performance

-- Manufacturing cost (increases).-- Inventory cost (increases).-- Replenishment lead time (increases).-- Transportation cost (increases).-- Labor cost for shipping and receiving (increases).-- Level of product availability (decreases).-- Relationships across the supply chain (worsens).-- Profitability (decreases).-- The bullwhip effect reduces supply chain profitability by making it more expensive to provide a given level of product availability.

17.3 Obstacles to Coordination in a Supply Chain

-- Incentive Obstacles.-- Information Processing Obstacles.-- Operational Obstacles.-- Pricing Obstacles.-- Behavioral Obstacles.

Incentive Obstacles:

-- When incentives offered to different stages or participants in a supply chain lead to actions that increase variability and reduce total supply chain profits – misalignment of total supply chain objectives and individual objectives.-- Local optimization within functions or stages of a supply chain.-- Sales force incentives.

Information Processing Obstacles:

-- When demand information is distorted as it moves between different stages of the supply chain, leading to increased variability in orders within the supply chain.-- Forecasting based on orders, not customer demand:

– Forecasting demand based on orders magnifies demand fluctuations moving up the supply chain from retailer to manufacturer.

-- Lack of information sharing.

Operational Obstacles:

-- Actions taken in the course of placing and filling orders that lead to an increase in variability.-- Ordering in large lots (much larger than dictated by demand) – Figure 17.2.-- Large replenishment leads times.-- Rationing and shortage gaming (common in the computer industry because of periodic cycles of component shortages and surpluses).

Pricing Obstacles:

-- When pricing policies for a product lead to an increase in variability of orders placed.-- Lot-size based quantity decisions.-- Price fluctuations (resulting in forward buying) – Figure 17.3.

Behavioral Obstacles:

-- Problems in learning, often related to communication in the supply chain and how the supply chain is structured.-- Each stage of the supply chain views its actions locally and is unable to see the impact of its actions on other stages.-- Different stages react to the current local situation rather than trying to identify the root causes.-- Based on local analysis, different stages blame each other for the fluctuations, with successive stages becoming enemies rather than partners.-- No stage learns from its actions over time because the most significant consequences of the actions of any one stage occur elsewhere, resulting in a vicious cycle of actions and blame.-- Lack of trust results in opportunism, duplication of effort, and lack of information sharing.

17.4 Managerial Levers to Achieve Coordination

-- Aligning Goals and Incentives.-- Improving Information Accuracy.-- Improving Operational Performance.-- Designing Pricing Strategies to Stabilize Orders.-- Building Strategic Partnerships and Trust.

Aligning Goals and Incentives:

-- Align incentives so that each participant has an incentive to do the things that will maximize total supply chain profits.-- Align incentives across functions.-- Pricing for coordination.-- Alter sales force incentives from sell-in (to the retailer) to sell-through (by the retailer).

Improving Information Accuracy:

-- Sharing point of sale data.-- Collaborative forecasting and planning.-- Single stage control of replenishment:

– Continuous replenishment programs (CRP).– Vendor managed inventory (VMI).

Improving Operational Performance:

-- Reducing replenishment lead time:– Reduces uncertainty in demand.– EDI is useful.

-- Reducing lot sizes:– Computer-assisted ordering, B2B exchanges.– Shipping in LTL sizes by combining shipments.– Technology and other methods to simplify receiving.– Changing customer ordering behavior.

-- Rationing based on past sales and sharing information to limit gaming:– “Turn-and-earn”.– Information sharing.

Designing Pricing Strategies to Stabilize Orders:

-- Encouraging retailers to order in smaller lots and reduce forward buying.-- Moving from lot size-based to volume-based quantity discounts (consider total purchases over a specified time period).-- Stabilizing pricing:

– Eliminate promotions (everyday low pricing, EDLP).– Limit quantity purchased during a promotion.– Tie promotion payments to sell-through rather than amount purchased.

-- Building strategic partnerships and trust – easier to implement these approaches if there is trust.

17.5 Building Strategic Partnerships and Trust in a Supply Chain

-- Background.-- Designing a Relationship with Cooperation and Trust.-- Managing Supply Chain Relationships for Cooperation and Trust.-- Trust-based relationship:

– Dependability.– Leap of faith.

-- Cooperation and trust work because:– Alignment of incentives and goals.– Actions to achieve coordination are easier to implement.– Supply chain productivity improves by reducing duplication or allocation

of effort to appropriate stage.– Greater information sharing results.

Trust in the Supply Chain:

-- Table 17.2 shows benefits.-- Historically, supply chain relationships are based on power or trust.-- Disadvantages of power-based relationship:

– Results in one stage maximizing profits, often at the expense of other stages.

– Can hurt a company when balance of power changes.– Less powerful stages have sought ways to resist.

Building Trust into a Supply Chain Relationship:

-- Deterrence-based view:– Use formal contracts.– Parties behave in trusting manner out of self-interest.

-- Process-based view:– Trust and cooperation are built up over time as a result of a series of

interactions.– Positive interactions strengthen the belief in cooperation of other party.

-- Neither view holds exclusively in all situations.-- Initially more reliance on deterrence-based view, then evolves to a process-based

view.-- Co-identification: ideal goal.-- Two phases to a supply chain relationship:

– Design phase.– Management phase.

Partner Relatively Powerful

High Level of Interdependence

Effective Relationship

Low Level ofInterdependence

Organization Relatively Powerful

Designing a Relationship with Cooperation and Trust:

-- Assessing the value of the relationship and its contributions.-- Identifying operational roles and decision rights for each party.-- Creating effective contracts.-- Designing effective conflict resolution mechanisms.

Assessing the Value of the Relationship and its Contributions:

-- Identify the mutual benefit provided.-- Identify the criteria used to evaluate the relationship (equity is important).-- Important to share benefits equitably.-- Clarify contribution of each party and the benefits each party will receive.

Identifying Operational Roles and Decision Rights for Each Party:

-- Recognize interdependence between parties:– Sequential interdependence: activities of one partner precede the other.– Reciprocal interdependence: the parties come together, exchange

information and inputs in both directions.-- Sequential interdependence is the traditional supply chain form.-- Reciprocal interdependence is more difficult but can result in more benefits.-- Figure 17.4.

Effects of Interdependence on Supply Chain Relationships (Figure 17.4)

Or ga niz ati on’ sDe pe nd enc e

High

Low

Low High

Partner’s Dependence

Creating Effective Contracts:

-- Create contracts that encourage negotiation when unplanned contingencies arise.-- It is impossible to define and plan for every possible occurrence.-- Informal relationships and agreements can fill in the “gaps” in contracts.-- Informal arrangements may eventually be formalized in later contracts.

Designing Effective Conflict Resolution Mechanisms:

-- Initial formal specification of rules and guidelines for procedures and transactions.-- Regular, frequent meetings to promote communication.-- Courts or other intermediaries.

Managing Supply Chain Relationships for Cooperation and Trust:

-- Effective management of a relationship is important for its success.-- Top management is often involved in the design but not management of a relationship.-- Figure 17.5 -- process of alliance evolution.-- Perceptions of reduced benefits or opportunistic actions can significantly impair a supply chain partnership.

17.6 Achieving Coordination in Practice

-- Quantify the bullwhip effect.-- Get top management commitment for coordination.-- Devote resources to coordination.-- Focus on communication with other stages.-- Try to achieve coordination in the entire supply chain network.-- Use technology to improve connectivity in the supply chain.-- Share the benefits of coordination equitably.

Books and References:

Books

W.J. Hopp and M.L. Spearman. Factory Physics: Foundations of ManufacturingManagement. Irwin, McGraw-Hill, 1996.

N. Viswanadham. Analysis of Manufacturing Enterprises. Kluwer AcademicPublishers, 2000.

Sridhar Tayur, Ram Ganeshan, Michael Magazine (editors). Quantitative Models forSupply Chain Management. Kluwer Academic Publishers, 1999.

R.B. Handfield and E.L. Nochols, Jr. Introduction to Supply Chain Management. Prentice Hall, 1999.

N. Viswanadham and Y. Narahari. Performance Modeling of Automated manufacturing Systems. Prentice Hall of India, 1998.

Sunil Chopra and Peter Meindel. Supply Chain Management: Strategy, Planning, andOperation, Prentice Hall of India, 2002.

Jeremy F. Shapiro. Modeling the Supply Chain. Duxbury Thomson Learning, 2001. David Simchi Levi, Philip kaminsky, and Edith Simchi Levi. Designing and Managing

the Supply Chain: Concepts, Strategies, and Case Studies. Irwin McGrawHill, 2000.

Articles

Y. Narahari and S. Biswas. Supply C hain Management: Models and Decision Making Ram Ganeshan and Terry P. Harrison. An Introduction to Supply Chain Management D. Connors, D. An, S. Buckley, G. Feigin, R. Jayaraman, A. Levas, N. Nayak, R.

Petrakian, R. Srinivasan. Dynamic modelling for business process reengineerin g . IBM Research Report 19944, 1995

Anthony Chavez, Pattie Maes, Kasbah: An Agent Marketplace for Buying and SellingGoods .

Anthony Chavez, Daniel Dreilinger, Robert Guttman, Pattie Maes, A Real-LifeExperiment in Creat i ng an Agent Marketplac e .

Gaurav Tewari, Pattie Maes, Design and Implementation of an Agent-BasedIntermedi ar y Infra s tru c ture for Electronic Ma r k e t s .