Trips Logistics
Trips Logistics, a third-party logistics firm that provides warehousing and other
logistics services, is facing a decision regarding the amount of space to lease
for the upcoming three-year period.
The general manager has forecast that Trips Logistics will need to handle a
demand of 100,000 units for each of the next three years. Historically, Trips
Logistics has required 1,000 square feet of warehouse space for every 1,000
units of demand.
For the purposes of this discussion, the only cost Trips Logistics faces is the cost
for the warehouse. Trips Logistics receives revenue of $ 1.22 for each unit of
demand. The general manager must decide whether to sign a three-year
lease or obtain warehousing space on the spot market each year.
The three-year lease will cost $ 1 per square foot per year, and the spot market
rate is expected to be $ 1.20 per square foot per year for each of the three
years. Trips Logistics has a discount rate of k = 0.1.
Trips Logistics: Spot Market
One thousand square feet of warehouse space is required for every 1,000
units of demand, and the current demand at Trips Logistics is for 100,000
units per year. The manager forecasts that from one year to the next,
demand may go up by 20 percent, with a probability of 0.5, or go down by
20 percent, with a probability of 0.5. The probabilities of the two outcomes
are independent and unchanged from one year to the next.
Trips Logistics: Spot Market
The general manager can sign a three-year lease at a price of $ 1 per
square foot per year. Warehouse space is currently available on the spot
market for $ 1.20 per square foot per year. From one year to the next, spot
prices for warehouse space may go up by 10 percent, with probability 0.5,
or go down by 10 percent, with probability 0.5. The probabilities of the two
outcomes are independent and unchanged from one year to the next.
The general manager believes that prices of warehouse space and
demand for the product fluctuate independently. Each unit Trips Logistics
handles results in revenue of $ 1.22, and Trips Logistics is committed to
handling all demand that arises. Trips Logistics uses a discount rate of k = 0.1
for each of the three years.
The general manager assumes that all costs are incurred at the beginning
of each year and thus constructs a decision tree with T = 2. The decision
tree shows each node representing demand (D) in thousands of units and
price (p) in dollars. The probability of each transition is 0.5 × 0.5 = 0.25
because price and demand fluctuate independently.
Trips Logistics: Fixed Lease Option
The manager next evaluates the alternative whereby the lease for 100,000 sq.
ft. of warehouse space is signed.
Trips Logistics: Flexible Lease Option
The general manager at Trips Logistics has been offered a contract in which,
for an upfront payment of $ 10,000, Trips Logistics will have the flexibility of using
between 60,000 square feet and 100,000 square feet of warehouse space at $
1 per square foot per year.
Trips Logistics must pay $ 60,000 per year for the first 60,000 square feet and
can then use up to another 40,000 square feet on demand at $ 1 per square
foot. The general manager decides to use decision trees to evaluate whether
this flexible contract is preferable to a fixed contract for 100,000 square feet.
Trips Logistics: Flexible Lease Option
The underlying decision tree for evaluating the flexible contract is exactly the
same. The profit at each node, however, changes because of the flexibility in
space used. If demand is larger than 100,000 units, Trips Logistics uses all
100,000 square feet of warehouse space at $ 1 and gets the rest at the spot
price. If demand is between 60,000 and 100,000 units, Trips Logistics uses and
pays $ 1 only for the exact amount of warehouse space required.
