Supply Chain Management

(3rd Edition)

Chapter 1
Understanding the Supply Chain

© 2007 Pearson Education 1-1

 Traditional View: Logistics in the
Economy (1990, 1996)
 Freight Transportation $352, $455 Billion
 Inventory Expense $221, $311 Billion
 Administrative Expense $27, $31 Billion
 Logistics Related Activity 11%, 10.5% of GNP

Source: Cass Logistics

© 2007 Pearson Education 1-2

 Traditional View: Logistics in the
Manufacturing Firm

Profit
 Profit 4%
Logistics
Cost
 Logistics Cost 21% Marketing
Cost

 Marketing Cost 27%

Manufacturing
 Manufacturing Cost 48% Cost

© 2007 Pearson Education 1-3

 Supply Chain Management: The
Magnitude in the Traditional View
 Estimated that the grocery industry could save $30
billion (10% of operating cost) by using effective
logistics and supply chain strategies
– A typical box of cereal spends 104 days from factory to sale
– A typical car spends 15 days from factory to dealership

 Laura Ashley turns its inventory 10 times a year, five

times faster than 3 years ago

© 2007 Pearson Education 1-4

 Supply Chain Management:
The True Magnitude
 Compaq estimates it lost $.5 billion to $1 billion in
sales in 1995 because laptops were not available when
and where needed
 When the 1 gig processor was introduced by AMD,
the price of the 800 mb processor dropped by 30%
 P&G estimates it saved retail customers $65 million
by collaboration resulting in a better match of supply
and demand

© 2007 Pearson Education 1-5

 Outline
 What is a Supply Chain?
 Decision Phases in a Supply Chain
 Process View of a Supply Chain
 The Importance of Supply Chain Flows
 Examples of Supply Chains

© 2007 Pearson Education 1-6

 What is a Supply Chain?
 Introduction
 The objective of a supply chain

© 2007 Pearson Education 1-7

 What is a Supply Chain?
 All stages involved, directly or indirectly, in fulfilling
a customer request
 Includes manufacturers, suppliers, transporters,
warehouses, retailers, and customers
 Within each company, the supply chain includes all
functions involved in fulfilling a customer request
(product development, marketing, operations,
distribution, finance, customer service)
 Examples: Fig. 1.1 Detergent supply chain (Wal-
Mart), Dell
© 2007 Pearson Education 1-8
 What is a Supply Chain?
 Customer is an integral part of the supply chain
 Includes movement of products from suppliers to
manufacturers to distributors, but also includes
movement of information, funds, and products in both
directions
 Probably more accurate to use the term “supply
network” or “supply web”
 Typical supply chain stages: customers, retailers,
distributors, manufacturers, suppliers (Fig. 1.2)
 All stages may not be present in all supply chains
(e.g., no retailer or distributor for Dell)
© 2007 Pearson Education 1-9
 What is a Supply Chain?
Customer wants
P&G or other Jewel or third Jewel
detergent and goes
manufacturer party DC Supermarket
to Jewel

Chemical
Plastic Tenneco
manufacturer
Producer Packaging
(e.g. Oil Company)

Chemical
Paper Timber
manufacturer
Manufacturer Industry
(e.g. Oil Company)

© 2007 Pearson Education 1-10

 Flows in a Supply Chain

Information

Product
Customer
Funds

© 2007 Pearson Education 1-11

 The Objective of a Supply Chain
 Maximize overall value created
 Supply chain value: difference between what the final
product is worth to the customer and the effort the
supply chain expends in filling the customer’s request
 Value is correlated to supply chain profitability
(difference between revenue generated from the
customer and the overall cost across the supply chain)

© 2007 Pearson Education 1-12

 The Objective of a Supply Chain
 Example: Dell receives $2000 from a customer for a
computer (revenue)
 Supply chain incurs costs (information, storage,
transportation, components, assembly, etc.)
 Difference between $2000 and the sum of all of these
costs is the supply chain profit
 Supply chain profitability is total profit to be shared
across all stages of the supply chain
 Supply chain success should be measured by total
supply chain profitability, not profits at an individual
stage
© 2007 Pearson Education 1-13
 The Objective of a Supply Chain
 Sources of supply chain revenue: the customer
 Sources of supply chain cost: flows of information,
products, or funds between stages of the supply chain
 Supply chain management is the management of
flows between and among supply chain stages to
maximize total supply chain profitability

© 2007 Pearson Education 1-14

 Decision Phases of a Supply Chain
 Supply chain strategy or design
 Supply chain planning
 Supply chain operation

© 2007 Pearson Education 1-15

 Supply Chain Strategy or Design
 Decisions about the structure of the supply chain and
what processes each stage will perform
 Strategic supply chain decisions
– Locations and capacities of facilities
– Products to be made or stored at various locations
– Modes of transportation
– Information systems
 Supply chain design must support strategic objectives
 Supply chain design decisions are long-term and
expensive to reverse – must take into account market
uncertainty
© 2007 Pearson Education 1-16
 Supply Chain Planning
 Definition of a set of policies that govern short-term
operations
 Fixed by the supply configuration from previous
phase
 Starts with a forecast of demand in the coming year

© 2007 Pearson Education 1-17

 Supply Chain Planning
 Planning decisions:
– Which markets will be supplied from which locations
– Planned buildup of inventories
– Subcontracting, backup locations
– Inventory policies
– Timing and size of market promotions
 Must consider in planning decisions demand
uncertainty, exchange rates, competition over the time
horizon

© 2007 Pearson Education 1-18

 Supply Chain Operation
 Time horizon is weekly or daily
 Decisions regarding individual customer orders
 Supply chain configuration is fixed and operating
policies are determined
 Goal is to implement the operating policies as
effectively as possible
 Allocate orders to inventory or production, set order
due dates, generate pick lists at a warehouse, allocate
an order to a particular shipment, set delivery
schedules, place replenishment orders
 Much less uncertainty (short time horizon)
© 2007 Pearson Education 1-19
 Process View of a Supply Chain
 Cycle view: processes in a supply chain are divided
into a series of cycles, each performed at the
interfaces 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)

© 2007 Pearson Education 1-20

 Cycle View of Supply Chains
Customer
Customer Order Cycle

Retailer
Replenishment Cycle

Distributor

Manufacturing Cycle

Manufacturer
Procurement Cycle
Supplier
© 2007 Pearson Education 1-21
 Cycle View of a Supply Chain
 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)
 Figure 1.3
 Cycle view clearly defines processes involved and the
owners of each process. Specifies the roles and
responsibilities of each member and the desired outcome
of each process.
© 2007 Pearson Education 1-22
 Push/Pull View of Supply Chains
Procurement, Customer Order
Manufacturing and Cycle
Replenishment cycles

PUSH PROCESSES PULL PROCESSES

Customer
Order Arrives

© 2007 Pearson Education 1-23

 Push/Pull View of
Supply Chain Processes
 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

© 2007 Pearson Education 1-24

 Push/Pull View of
Supply Chain Processes
 Useful in considering strategic decisions relating to
supply chain design – more global view of how
supply chain processes relate to customer orders
 Can combine the push/pull and cycle views
– L.L. Bean (Figure 1.6)
– Dell (Figure 1.7)
 The relative proportion of push and pull processes can
have an impact on supply chain performance

© 2007 Pearson Education 1-25

 Supply Chain Macro Processes in
a Firm
 Supply chain processes discussed in the two views can
be classified into (Figure 1.8):
– Customer Relationship Management (CRM)
– Internal Supply Chain Management (ISCM)
– Supplier Relationship Management (SRM)
 Integration among the above three macro processes is
critical for effective and successful supply chain
management

© 2007 Pearson Education 1-26

 Examples of Supply Chains
 Gateway
 Zara
 McMaster Carr / W.W. Grainger
 Toyota
 Amazon / Borders / Barnes and Noble
 Webvan / Peapod / Jewel

What are some key issues in these supply chains?

© 2007 Pearson Education 1-27
 Gateway: A Direct Sales Manufacturer
 Why did Gateway have multiple production facilities in the
US? What advantages or disadvantages does this strategy offer
relative to Dell, which has one facility?
 What factors did Gateway consider when deciding which
plants to close?
 Why does Gateway not carry any finished goods inventory at
its retail stores?
 Should a firm with an investment in retail stores carry any
finished goods inventory?
 Is the Dell model of selling directly without any retail stores
always less expensive than a supply chain with retail stores?
 What are the supply chain implications of Gateway’s decision
to offer fewer configurations?
© 2007 Pearson Education 1-28
 7-Eleven
 What factors influence decisions of opening and closing stores?
Location of stores?
 Why has 7-Eleven chosen off-site preparation of fresh food?
 Why does 7-Eleven discourage direct store delivery from vendors?
 Where are distribution centers located and how many stores does
each center serve? How are stores assigned to distribution centers?
 Why does 7-Eleven combine fresh food shipments by temperature?
 What point of sale data does 7-Eleven gather and what information
is made available to store managers? How should information
systems be structured?

© 2007 Pearson Education 1-29

 W.W. Grainger and McMaster Carr
 How many DCs should there be and where should they be
located?
 How should product stocking be managed at the DCs? Should
all DCs carry all products?
 What products should be carried in inventory and what
products should be left at the supplier?
 What products should Grainger carry at a store?
 How should markets be allocated to DCs?
 How should replenishment of inventory be managed at various
stocking locations?
 How should Web orders be handled?
 What transportation modes should be used?

© 2007 Pearson Education 1-30

 Toyota
 Where should plants be located, what degree of
flexibility should each have, and what capacity should
each have?
 Should plants be able to produce for all markets?
 How should markets be allocated to plants?
 What kind of flexibility should be built into the
distribution system?
 How should this flexible investment be valued?
 What actions may be taken during product design to
facilitate this flexibility?

© 2007 Pearson Education 1-31

 Summary of Learning Objectives
 What are the cycle and push/pull views of a supply
chain?
 How can supply chain macro processes be classified?
 What are the three key supply chain decision phases
and what is the significance of each?
 What is the goal of a supply chain and what is the
impact of supply chain decisions on the success of the
firm?

© 2007 Pearson Education 1-32

 Amazon.com
 Why is Amazon building more warehouses as it grows? How many
warehouses should it have and where should they be located?
 What advantages does selling books via the Internet provide? Are
there disadvantages?
 Why does Amazon stock bestsellers while buying other titles from
distributors?
 Does an Internet channel provide greater value to a bookseller like
Borders or to an Internet-only company like Amazon?
 Should traditional booksellers like Borders integrate e-commerce
into their current supply?
 For what products does the e-commerce channel offer the greatest
benefits? What characterizes these products?

© 2007 Pearson Education 1-33

 Supply Chain Management
(3rd Edition)

Chapter 2
Supply Chain Performance:
Achieving Strategic Fit and Scope

© 2007 Pearson Education 2-34

 Outline
 Competitive and supply chain strategies
 Achieving strategic fit
 Expanding strategic scope

© 2007 Pearson Education 2-35

 What is Supply Chain Management?

 Managing supply chain flows and assets, to maximize

supply chain surplus

 What is supply chain surplus?

© 2007 Pearson Education 2-36

 Competitive and Supply
Chain Strategies
 Competitive strategy: defines the set of customer needs a firm
seeks to satisfy through its products and services
 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 strategy:
– determines the nature of material procurement, transportation of
materials, 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

© 2007 Pearson Education 2-37

 The Value Chain: Linking Supply
Chain and Business Strategy

Finance, Accounting, Information Technology, Human Resources

New Marketing
Product and Operations Distribution Service
Development Sales

© 2007 Pearson Education 2-38

 Achieving Strategic Fit
 Introduction
 How is strategic fit achieved?
 Other issues affecting strategic fit

© 2007 Pearson Education 2-39

 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

© 2007 Pearson Education 2-40

 How is Strategic Fit Achieved?
 Step 1: Understanding the customer and supply chain
uncertainty
 Step 2: Understanding the supply chain
 Step 3: Achieving strategic fit

© 2007 Pearson Education 2-41

 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

© 2007 Pearson Education 2-42

 Step 1: Understanding the Customer
and Supply Chain Uncertainty
 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

© 2007 Pearson Education 2-43

 Step 1: Understanding the Customer
and Supply Chain Uncertainty
 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

© 2007 Pearson Education 2-44

 Achieving Strategic Fit
 Understanding the Customer
– Lot size
– Response time
– Service level Implied
– Product variety Demand
– Price Uncertainty
– Innovation

© 2007 Pearson Education 2-45

 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 implies
greater variance in demand
Lead time decreases Less time to react to orders

Variety of products required Demand per product becomes more

increases 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

© 2007 Pearson Education 2-46

 Levels of Implied Demand
Uncertainty

Predictable Predictable supply and uncertain Highly uncertain

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

Salt at a An existing A new

supermarket automobile communication
model device

Figure 2.2: The Implied Uncertainty (Demand and Supply)

Spectrum

© 2007 Pearson Education 2-47

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

Attribute Low Implied High Implied

Uncertainty Uncertainty
Product margin Low High

Avg. forecast error 10% 40%-100%

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

Avg. forced season- 0% 10%-25%

end markdown

© 2007 Pearson Education 2-48

 Step 2: Understanding the
Supply Chain
 How does the firm best meet demand?
 Dimension describing the supply chain is supply chain
responsiveness
 Supply chain responsiveness -- ability to
– respond to wide ranges of quantities demanded
– meet short lead times
– handle a large variety of products
– build highly innovative products
– meet a very high service level

© 2007 Pearson Education 2-49

 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

© 2007 Pearson Education 2-50

 Understanding the Supply Chain: Cost-
Responsiveness Efficient Frontier
Responsiveness

High

Low
Cost
High Low
© 2007 Pearson Education 2-51
 Step 3: Achieving Strategic Fit
 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

© 2007 Pearson Education 2-52

 Responsiveness Spectrum
(Figure 2.4)

Highly Somewhat Somewhat Highly

efficient efficient responsive responsive

Integrated Hanes Most Dell

steel mill apparel automotive
production

© 2007 Pearson Education 2-53

 Achieving Strategic Fit Shown on the
Uncertainty/Responsiveness Map (Fig. 2.5)
Responsive
supply chain

Responsiveness e of it
n F
spectrum Zo egic
t
t ra
S

Efficient
supply chain

Certain Implied Uncertain

demand uncertainty demand
spectrum
© 2007 Pearson Education 2-54
 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

© 2007 Pearson Education 2-55

 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 Aggressively reduce even if
of greater cost costs are significant
Supplier selection strategy Cost and low quality Speed, flexibility, quality
Transportation strategy Greater reliance on low cost Greater reliance on
modes responsive (fast) modes

© 2007 Pearson Education 2-56

 Other Issues Affecting Strategic Fit
 Multiple products and customer segments
 Product life cycle
 Competitive changes over time

© 2007 Pearson Education 2-57

 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

© 2007 Pearson Education 2-58

 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
© 2007 Pearson Education 2-59
 Product Life Cycle
 Examples: pharmaceutical firms, Intel
 As the product goes through the life cycle, the supply
chain changes from one emphasizing responsiveness
to one emphasizing efficiency

© 2007 Pearson Education 2-60

 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

© 2007 Pearson Education 2-61

 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

© 2007 Pearson Education 2-62

 Different Scopes of Strategic Fit
Across a Supply Chain

Suppliers Manufacturer Distributor Retailer Customer

Competitive
Strategy
Product Intercompany
Development Interfunctional Intracompany
Strategy Intrafunctional
at Distributor
Supply Chain
Intracompany
Strategy Intracompany
Intraoperation
Interfunctional
at Distributor
Marketing at Distributor
Strategy

© 2007 Pearson Education 2-63

 Summary of Learning Objectives
 Why is achieving strategic fit critical to a company’s
overall success?
 How does a company achieve strategic fit between its
supply chain strategy and its competitive strategy?
 What is the importance of expanding the scope of
strategic fit across the supply chain?

© 2007 Pearson Education 2-64

 Supply Chain Management
(3rd Edition)

Chapter 3
Supply Chain Drivers and Obstacles

© 2007 Pearson Education 3-65

 Outline
 Drivers of supply chain performance
 A framework for structuring drivers
 Facilities
 Inventory
 Transportation
 Information
 Sourcing
 Pricing
 Obstacles to achieving fit
© 2007 Pearson Education 3-66
 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 chain

© 2007 Pearson Education 3-67

 A Framework for
Structuring Drivers
Competitive Strategy

Supply Chain
Strategy
Efficiency Responsiveness
Supply chain structure

Logistical Drivers

Facilities Inventory Transportation

Information Sourcing Pricing

Cross Functional Drivers

© 2007 Pearson Education 3-68

 Facilities
 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

© 2007 Pearson Education 3-69

 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

© 2007 Pearson Education 3-70

 Inventory
 Role in the supply chain
 Role in the competitive strategy
 Components of inventory decisions

© 2007 Pearson Education 3-71

 Inventory: 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

© 2007 Pearson Education 3-72

 Inventory: 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

© 2007 Pearson Education 3-73

 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

© 2007 Pearson Education 3-74

 Transportation
 Role in the supply chain
 Role in the competitive strategy
 Components of transportation decisions

© 2007 Pearson Education 3-75

 Transportation: 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

© 2007 Pearson Education 3-76

 Transportation:
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

© 2007 Pearson Education 3-77

 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

© 2007 Pearson Education 3-78

 Information
 Role in the supply chain
 Role in the competitive strategy
 Components of information decisions

© 2007 Pearson Education 3-79

 Information: 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

© 2007 Pearson Education 3-80

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

© 2007 Pearson Education 3-81

 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
© 2007 Pearson Education 3-82
 Sourcing
 Role in the supply chain
 Role in the competitive strategy
 Components of sourcing decisions

© 2007 Pearson Education 3-83

 Sourcing: 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

© 2007 Pearson Education 3-84

 Sourcing:
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

© 2007 Pearson Education 3-85

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

© 2007 Pearson Education 3-86

 Pricing
 Role in the supply chain
 Role in the competitive strategy
 Components of pricing decisions

© 2007 Pearson Education 3-87

 Pricing: 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

© 2007 Pearson Education 3-88

 Sourcing:
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

© 2007 Pearson Education 3-89

 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

© 2007 Pearson Education 3-90

 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

© 2007 Pearson Education 3-91

 Summary
 What are the major drivers of supply chain
performance?
 What is the role of each driver in creating strategic fit
between supply chain strategy and competitive strategy
(or between implied demand uncertainty and supply
chain responsiveness)?
 What are the major obstacles to achieving strategic fit?
 In the remainder of the course, we will learn how to
make decisions with respect to these drivers in order to
achieve strategic fit and surmount these obstacles
© 2007 Pearson Education 3-92
 Supply Chain Management
(3rd Edition)

Chapter 4
Designing the Distribution
Network in a Supply Chain

© 2007 Pearson Education 4-93

 Outline
 The Role of Distribution in the Supply Chain
 Factors Influencing Distribution Network Design
 Design Options for a Distribution Network
 E-Business and the Distribution Network
 Distribution Networks in Practice
 Summary of Learning Objectives

© 2007 Pearson Education 4-94

 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

© 2007 Pearson Education 4-95

 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

© 2007 Pearson Education 4-96

 Factors Influencing
Distribution Network Design
 Elements of customer service influenced by network structure:
– Response time
– Product variety
– Product availability
– Customer experience
– Order visibility
– Returnability
 Supply chain costs affected by network structure:
– Inventories
– Transportation
– Facilities and handling
– Information

© 2007 Pearson Education 4-97

 Service and Number of Facilities
(Fig. 4.1)

Number of
Facilities

Response Time
© 2007 Pearson Education 4-98
 The Cost-Response Time Frontier

Hi Local FG
Mix
Regional FG

Local WIP
Cost Central FG

Central WIP

Central Raw Material and Custom production

Custom production with raw material at suppliers

Low
Low Response Time Hi

© 2007 Pearson Education 4-99

 Inventory Costs and Number
of Facilities (Fig. 4.2)

Inventory
Costs

Number of facilities

© 2007 Pearson Education 4-100

 Transportation Costs and
Number of Facilities (Fig. 4.3)

Transportation
Costs

Number of facilities

© 2007 Pearson Education 4-101

 Facility Costs and Number
of Facilities (Fig. 4.4)

Facility
Costs

Number of facilities

© 2007 Pearson Education 4-102

 Total Costs Related to
Number of Facilities
Total Costs
Total Costs

Facilities
Inventory
Transportation

Number of Facilities
© 2007 Pearson Education 4-103
 Variation in Logistics Costs and Response
Time with Number of Facilities (Fig. 4.5)
Response Time

Total Logistics Costs

Number of Facilities
© 2007 Pearson Education 4-104
 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

© 2007 Pearson Education 4-105

 Manufacturer Storage with
Direct Shipping (Fig. 4.6)

Manufacturer

Retailer

Customers

Product Flow
Information Flow

© 2007 Pearson Education 4-106

 In-Transit Merge Network (Fig. 4.7)
Factories

Retailer In-Transit Merge by

Carrier

Customers

Product Flow
Information Flow

© 2007 Pearson Education 4-107

 Distributor Storage with
Carrier Delivery (Fig. 4.8)

Factories

Warehouse Storage by
Distributor/Retailer

Customers

Product Flow
Information Flow
© 2007 Pearson Education 4-108
 Distributor Storage with
Last Mile Delivery (Fig. 4.9)

Factories

Distributor/Retailer
Warehouse

Customers

Product Flow
Information Flow
© 2007 Pearson Education 4-109
 Manufacturer or Distributor Storage
with Customer Pickup (Fig. 4.10)
Factories

Retailer Cross Dock DC

Pickup Sites

Customers

Customer Flow
Product Flow
© 2007 Pearson Education Information Flow 4-110
 Comparative Performance of Delivery
Network Designs (Table 4.7)
Retail Storage Manufacturer Manufacturer Distributor Storage Distributor Manufacturer
with Customer Storage with Direct Storage with In- with Package storage with last storage with pickup
Pickup Shipping Transit Merge Carrier Delivery mile delivery

Response Time 1 4 4 3 2 4
Product Variety
4 1 1 2 3 1
Product Availability 2 3
4 1 1 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
© 2007 Pearson Education 4-111
 Linking Product Characteristics and
Customer Preferences to Network Design
Retail Storage Manufacturer Manufacturer Distributor Storage Distributor storage Manufacturer
with Storage with Storage with In- with Package Carrier with last mile delivery storage with
Customer Direct Shipping Transit Merge Delivery pickup
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

© 2007 Pearson Education 4-112

 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, Grainger

© 2007 Pearson Education 4-113

 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
© 2007 Pearson Education 4-114
 Summary of Learning Objectives
 What are the key factors to be considered when
designing the distribution network?
 What are the strengths and weaknesses of various
distribution options?
 What roles do distributors play in the supply chain?

© 2007 Pearson Education 4-115

 Supply Chain Management
(3rd Edition)
Chapter 5
Network Design in the Supply
Chain

© 2007 Pearson Education 5-116

 Outline
 A strategic framework for facility location
 Multi-echelon networks
 Gravity methods for location
 Plant location models

© 2007 Pearson Education 5-117

 Network Design Decisions
 Facility role
 Facility location
 Capacity allocation
 Market and supply allocation

© 2007 Pearson Education 5-118

 Factors Influencing
Network Design Decisions
 Strategic
 Technological
 Macroeconomic
 Political
 Infrastructure
 Competitive
 Logistics and facility costs

© 2007 Pearson Education 5-119

 The Cost-Response Time Frontier

Hi Local FG
Mix
Regional FG

Local WIP
Cost Central FG

Central WIP

Central Raw Material and Custom production

Custom production with raw material at suppliers

Low
Low Response Time Hi

© 2007 Pearson Education 5-120

 Service and Number of Facilities
Response
Time

Number of Facilities

© 2007 Pearson Education 5-121

Where inventory needs to be for a one week order response time - typical results --> 1 DC

Customer
DC

© 2007 Pearson Education

Where inventory needs to be for a 5 day order response time - typical results --> 2 DCs

Customer
DC

© 2007 Pearson Education

Where inventory needs to be for a 3 day order response time - typical results --> 5 DCs

Customer
DC

© 2007 Pearson Education

Where inventory needs to be for a next day order response time - typical results --> 13 DCs

Customer
DC

© 2007 Pearson Education

Where inventory needs to be for a same day / next day order response time - typical results --> 26 DCs

Customer
DC

© 2007 Pearson Education

 Costs and Number of Facilities

Inventory

Costs Facility costs

Transportation

Number of facilities

© 2007 Pearson Education 5-127

 Cost Buildup as a Function of Facilities
Total Costs
Cost of Operations

Percent Service
Level Within
Promised Time
Facilities
Inventory
Transportation
Labor

Number of Facilities
© 2007 Pearson Education 5-128
 A Framework for
Global Site Location
Competitive STRATEGY GLOBAL COMPETITION
PHASE I
Supply Chain
INTERNAL CONSTRAINTS Strategy
Capital, growth strategy, TARIFFS AND TAX
existing network INCENTIVES

PRODUCTION TECHNOLOGIES REGIONAL DEMAND

Cost, Scale/Scope impact, support PHASE II Size, growth, homogeneity,
required, flexibility
Regional Facility local specifications
Configuration
COMPETITIVE
ENVIRONMENT POLITICAL, EXCHANGE
RATE AND DEMAND RISK

PHASE III
Desirable Sites AVAILABLE
INFRASTRUCTURE
PRODUCTION METHODS
Skill needs, response time

FACTOR COSTS PHASE IV LOGISTICS COSTS

Labor, materials, site specific Location Choices Transport, inventory, coordination

© 2007 Pearson Education 5-129

 Conventional Network

Materials Customer
Vendor Finished Customer
DC Store
DC Goods DC DC

Customer
Component Store
Vendor Manufacturing
DC Plant Customer Customer
Warehouse DC Store
Components
DC Customer
Vendor Store
DC Finished
Customer
Goods DC
Final DC Customer
Assembly Store

© 2007 Pearson Education 5-130

 Tailored Network: Multi-Echelon
Finished Goods Network
Local DC
Cross-Dock Store 1
Regional Customer 1
Finished DC
Goods DC Store 1
Local DC
Cross-Dock
National Store 2
Customer 2
Finished
DC
Goods DC
Local DC Store 2
Cross-Dock
Regional
Finished Store 3
Goods DC

Store 3

© 2007 Pearson Education 5-131

 Gravity Methods for Location
 Ton Mile-Center Solution
( x  x n)  ( y  y n)
2
– x,y: Warehouse Coordinates 2
d n

– xn, yn : Coordinates of delivery
D nx F
k
location n
 d
n n

– dn : Distance to delivery x n 1 n

D nF
k
location n
 d
n

– Fn : Annual tonnage to delivery n 1 n

D ny F
location n k

 d
n n

y n 1 n

D nF
k

Min  d n Dn F n  dn 1
n

© 2007 Pearson Education 5-132

 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?

© 2007 Pearson Education 5-133

 Demand Allocation Model
 Which market is served n m

by which plant? Min cij xij

i 1 j 1

 Which supply sources s.t.

are used by a plant? n

x  D ij j
, j  1,..., m
xij = Quantity shipped from i 1
m

plant site i to customer j x  K

j 1
ij i
, i  1,..., n

x ij
0

© 2007 Pearson Education 5-134

 Plant Location with Multiple Sourcing
 yi = 1 if plant is located n n m

at site i, 0 otherwise Min f y   c x ij ij

i i
i 1 i 1 j 1
 xij = Quantity shipped s.t.
from plant site i to n

customer j  x  D , j  1,..., m
i 1
ij j

 x  K y , i  1,..., n
j 1
ij i i

 y  k ; y {0,1}
i 1
i i

© 2007 Pearson Education 5-135

 Plant Location with Single Sourcing
 yi = 1 if plant is located n n m
Min f y   D j c x
at site i, 0 otherwise i 1
i i
i 1 j 1
ij ij

 xij = 1 if market j is s.t.

n
supplied by factory i, 0 x  1, j  1,..., m
ij
otherwise i 1
n

 D j x  K y , i  1,..., n
j 1
ij i i

xij , y {0,1}i

© 2007 Pearson Education 5-136

 Summary of Learning Objectives
 What is the role of network design decisions in
the supply chain?
 What are the factors influencing supply chain
network design decisions?
 Describe a strategic framework for facility
location.
 How are the following optimization methods used
for facility location and capacity allocation
decisions?
– Gravity methods for location
– Network optimization models

© 2007 Pearson Education 5-137

 Supply Chain Management
(3rd Edition)

Chapter 6
Network Design in an
Uncertain Environment

© 2007 Pearson Education 6-138

 Outline
 The Impact of Uncertainty on Network Design Decisions
 Discounted Cash Flow Analysis
 Representations of Uncertainty
 Evaluating Network Design Decisions Using Decision
Trees
 AM Tires: Evaluation of Supply Chain Design Decisions
Under Uncertainty
 Making Supply Chain Decisions Under Uncertainty in
Practice
 Summary of Learning Objectives

© 2007 Pearson Education 6-139

 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
© 2007 Pearson Education 6-140
 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

© 2007 Pearson Education 6-141

 Discounted Cash Flow Analysis
1
Discount factor 
1 k
t
T
 1 
NPV  C0     Ct
t 1  1  k 

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
© 2007 Pearson Education 6-142
 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

© 2007 Pearson Education 6-143

 NPV Example: Trips Logistics
For leasing warehouse space on the spot market:
Expected annual profit = 100,000 x $1.22 – 100,000 x
$1.20 = $2,000
Cash flow = $2,000 in each of the next three years
C1 C2
NPV (no lease)  C0  
1  k 1  k  2
2000 2000
 2000   2
 $5,471
1.1 1.1

© 2007 Pearson Education 6-144

 NPV Example: Trips Logistics
For leasing warehouse space with a three-year lease:
Expected annual profit = 100,000 x $1.22 – 100,000 x $1.00 = $22,000
Cash flow = $22,000 in each of the next three years
C1 C2
NPV (no lease)  C0  
1  k 1  k  2
22000 22000
 22000   2
 $60,182
1.1 1.1

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

© 2007 Pearson Education 6-145

 Representations of Uncertainty
 Binomial Representation of Uncertainty
 Other Representations of Uncertainty

© 2007 Pearson Education 6-146

 Binomial Representations
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

© 2007 Pearson Education 6-147

 Binomial Representations
of Uncertainty
 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)
 Represented as the binomial tree shown in Figure 6.1
(p. 140)

© 2007 Pearson Education 6-148

 Binomial Representations
of Uncertainty
 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

© 2007 Pearson Education 6-149

 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
© 2007 Pearson Education 6-150
 Decision Tree Methodology
1. Identify the duration of each period (month, quarter, etc.) and
the number of periods T over the 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.
© 2007 Pearson Education 6-151
 Decision Tree Methodology:
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
© 2007 Pearson Education 6-152
 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

© 2007 Pearson Education 6-153

 Trips Logistics
 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

© 2007 Pearson Education 6-154

 Trips Logistics Decision Tree
(Fig. 6.2)
Period 2
Period 1 D=144
Period 0 p=$1.45
0.25
D=144
0.25
p=$1.19
D=120
0.25
p=$1.32 D=96
0.25
p=$1.45
0.25
D=144
0.25 D=120 p=$0.97
p=$1. 08
D=100 D=96
p=$1.20 0.25 p=$1.19

D=80 D=96
p=$1.32 p=$0.97

0.25 D=64
p=$1.45
D=80
p=$1.32 D=64
p=$1.19

D=64
p=$0.97
© 2007 Pearson Education 6-155
 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 = $208,800
P(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

© 2007 Pearson Education 6-156

 Trips Logistics Example
 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 in Period 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

© 2007 Pearson Education 6-157

 Trips Logistics Example
 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 node D=120, p=$1.32 in Period 1 to be
EP(D=120,p=1.32,1) = 0.25xP(D=144,p=1.45,2) +
0.25xP(D=144,p=1.19,2) +
0.25xP(D=96,p=1.45,2) +
0.25xP(D=96,p=1.19,2)
= 0.25x(-33,120)+0.25x4,320+0.25x(-22,080)+0.25x2,880
= -$12,000

© 2007 Pearson Education 6-158

 Trips Logistics Example
 The present value of this expected value in Period 1 is
PVEP(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

© 2007 Pearson Education 6-159

 Trips Logistics Example
 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
= $3,818
PVEP(D=100,p=1.20,0) = EP(D=100,p=1.20,0) / (1+k)
= $3,818 / (1 + 0.1) = $3,471
© 2007 Pearson Education 6-160
 Trips Logistics Example
P(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

© 2007 Pearson Education 6-161

 Trips Logistics Example
 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 for 100,000 sq. ft. because
this option has the higher expected profit

© 2007 Pearson Education 6-162

 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 between 60,000 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)

© 2007 Pearson Education 6-163

 AM Tires: Evaluation of Supply Chain
Design Decisions Under Uncertainty
 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

© 2007 Pearson Education 6-164

 Evaluating Facility Investments:
AM Tires
Plant Dedicated Plant Flexible Plant
Fixed Cost Variable Cost Fixed Cost Variable Cost
US 100,000 $1 million/yr. $15 / tire $1.1 million $15 / tire
/ year
Mexico 4 million 110 pesos / 4.4 million 110 pesos /
50,000 pesos / year tire pesos / year tire
U.S. Expected Demand = 100,000;
Mexico Expected Demand = 50,000
1US$ = 9 pesos
Demand goes up or down by 20 percent with probability 0.
exchange rate goes up or down by 25 per cent with probabi
© 2007 Pearson Education 6-165
 AM Tires
Period 0 Period 1 Period 2
RU=144
RM = 72
E=14.06
RU=120
RM = 60 RU=144
E=11.25 RM = 72
E=8.44
RU=120
RM = 60 RU=144
E=6.75 RM = 48
E=14.06
RU=120
RM = 40 RU=144
E=11.25 RM = 48
E=8.44
RU=100 RU=120
RM=50 RM = 40 RU=96
E=9 E=6.75 RM = 72
E=14.06
RU=80
RM = 60 RU=96
E=11.25 RM = 72
E=8.44
RU=80
RM = 60 RU=96
E=6.75 RM = 48
E=14.06
RU=80
RM = 40 RU=96
E=11.25 RM = 48
E=8.44
RU=80
RM = 40
E=6.75

© 2007 Pearson Education 6-166

 AM Tires
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

© 2007 Pearson Education 6-167

 AM Tires: Demand Allocation for
RU = 144; RM = 72, E = 14.06
Source Destination Variable Shipping E Sale price Margin
cost cost ($)
U.S. U.S. $15 0 14.06 $30 $15
U.S. Mexico $15 $1 14.06 240 pesos $1.1
Mexico U.S. 110 pesos $1 14.06 $30 $21.2
Mexico Mexico 110 pesos 0 14.06 240 pesos $9.2

Plants Markets
100,000
100,000 Profit (flexible) =
U.S. U.S.
, 000 $1,075,055
44 Profit (dedicated) =
Mexico Mexico $649,360
6,000
50,000
© 2007 Pearson Education 6-168
 Facility Decision at AM Tires

Plant Configuration NPV

United States Mexico
Dedicated Dedicated $1,629,319
Flexible Dedicated $1,514,322
Dedicated Flexible $1,722,447
Flexible Flexible $1,529,758

© 2007 Pearson Education 6-169

 Making Supply Chain Design Decisions
Under Uncertainty in Practice
 Combine strategic planning and financial planning
during network design
 Use multiple metrics to evaluate supply chain
networks
 Use financial analysis as an input to decision making,
not as the decision-making process
 Use estimates along with sensitivity analysis

© 2007 Pearson Education 6-170

 Summary of Learning Objectives
 What are the uncertainties that influence supply chain
performance and network design?
 What are the methodologies that are used to evaluate
supply chain decisions under uncertainty?
 How can supply chain network design decisions in an
uncertain environment be analyzed?

© 2007 Pearson Education 6-171

 Supply Chain Management
(3rd Edition)

Chapter 7
Demand Forecasting
in a Supply Chain

© 2007 Pearson Education 7-172

 Outline
 The role of forecasting in a supply chain
 Characteristics of forecasts
 Components of forecasts and forecasting methods
 Basic approach to demand forecasting
 Time series forecasting methods
 Measures of forecast error
 Forecasting demand at Tahoe Salt
 Forecasting in practice

© 2007 Pearson Education 7-173

 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

© 2007 Pearson Education 7-174

 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

© 2007 Pearson Education 7-175

 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

© 2007 Pearson Education 7-176

 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 deviates
from the systematic component
• Forecast error: difference between forecast and actual demand

© 2007 Pearson Education 7-177

 Time Series Forecasting
Quarter Demand Dt
II, 1998 8000
III, 1998 13000 Forecast demand for the
IV, 1998 23000 next four quarters.
I, 1999 34000
II, 1999 10000
III, 1999 18000
IV, 1999 23000
I, 2000 38000
II, 2000 12000
III, 2000 13000
IV, 2000 32000
I, 2001 41000
© 2007 Pearson Education 7-178
 Time Series Forecasting

50,000
40,000
30,000
20,000
10,000
0

7, 2 7, 3 7, 4 8, 1 8, 2 8, 3 8, 4 9, 1 9, 2 9, 3 9, 4 0, 1
9 9 9 9 9 9 9 9 9 9 9 0

© 2007 Pearson Education 7-179

 Forecasting Methods
 Static
 Adaptive
– Moving average
– Simple exponential smoothing
– Holt’s model (with trend)
– Winter’s model (with trend and seasonality)

© 2007 Pearson Education 7-180

 Basic Approach to
Demand Forecasting
 Understand the objectives of forecasting
 Integrate demand planning and forecasting
 Identify major factors that influence the demand
forecast
 Understand and identify customer segments
 Determine the appropriate forecasting technique
 Establish performance and error measures for the
forecast

© 2007 Pearson Education 7-181

 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

© 2007 Pearson Education 7-182

 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

© 2007 Pearson Education 7-183

 Static Methods
 Estimating level and trend
 Estimating seasonal factors

© 2007 Pearson Education 7-184

 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

© 2007 Pearson Education 7-185

 Time Series Forecasting
(Table 7.1)
Quarter Demand Dt
II, 1998 8000
III, 1998 13000 Forecast demand for the
IV, 1998 23000 next four quarters.
I, 1999 34000
II, 1999 10000
III, 1999 18000
IV, 1999 23000
I, 2000 38000
II, 2000 12000
III, 2000 13000
IV, 2000 32000
I, 2001 41000
© 2007 Pearson Education 7-186
 Time Series Forecasting
(Figure 7.1)

50,000
40,000
30,000
20,000
10,000
0

7, 2 7, 3 7, 4 8, 1 8, 2 8, 3 8, 4 9, 1 9, 2 9, 3 9, 4 0, 1
9 9 9 9 9 9 9 9 9 9 9 0

© 2007 Pearson Education 7-187

 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

© 2007 Pearson Education 7-188

 Deseasonalizing Demand

[Dt-(p/2) + Dt+(p/2) +  2Di] / 2p for p even

Dt = (sum is from i = t+1-(p/2) to t+1+(p/2))

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

© 2007 Pearson Education 7-189

 Deseasonalizing Demand
For the example, p = 4 is even
For t = 3:
D3 = {D1 + D5 + Sum(i=2 to 4) [2Di]}/8
= {8000+10000+[(2)(13000)+(2)(23000)+(2)(34000)]}/8
= 19750
D4 = {D2 + D6 + Sum(i=3 to 5) [2Di]}/8
= {13000+18000+[(2)(23000)+(2)(34000)+(2)(10000)]/8
= 20625

© 2007 Pearson Education 7-190

 Deseasonalizing Demand
Then include trend
Dt = L + tT
where Dt = deseasonalized demand in period t
L = 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

© 2007 Pearson Education 7-191

 Time Series of Demand
(Figure 7.3)

50000
40000
Demand

30000 Dt
20000 Dt-bar

10000
0
1 2 3 4 5 6 7 8 9 10 11 12
Period

© 2007 Pearson Education 7-192

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

© 2007 Pearson Education 7-193

 Estimating Seasonal Factors
(Fig. 7.4)
t Dt Dt-bar S-bar
1 8000 18963 0.42 = 8000/18963
2 13000 19487 0.67 = 13000/19487
3 23000 20011 1.15 = 23000/20011
4 34000 20535 1.66 = 34000/20535
5 10000 21059 0.47 = 10000/21059
6 18000 21583 0.83 = 18000/21583
7 23000 22107 1.04 = 23000/22107
8 38000 22631 1.68 = 38000/22631
9 12000 23155 0.52 = 12000/23155
10 13000 23679 0.55 = 13000/23679
11 32000 24203 1.32 = 32000/24203
12 41000 24727 1.66 = 41000/24727

© 2007 Pearson Education 7-194

 Estimating Seasonal Factors
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 is
Si = [Sum(j=0 to r-1) Sjp+i]/r
In the example, there are 3 seasonal cycles in the data and p=4, so
S1 = (0.42+0.47+0.52)/3 = 0.47
S2 = (0.67+0.83+0.55)/3 = 0.68
S3 = (1.15+1.04+1.32)/3 = 1.17
S4 = (1.66+1.68+1.66)/3 = 1.67

© 2007 Pearson Education 7-195

 Estimating the Forecast
Using the original equation, we can forecast the next
four periods of demand:

F13 = (L+13T)S1 = [18439+(13)(524)](0.47) = 11868

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

© 2007 Pearson Education 7-196

 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)

© 2007 Pearson Education 7-197

 Basic Formula for
Adaptive Forecasting
Ft+1 = (Lt + lT)St+1 = forecast for period t+l in period t
Lt = 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 t
Ft = Forecast of demand for period t (made period t-1 or earlier)
Dt = Actual demand observed in period t
Et = Forecast error in period t
At = Absolute deviation for period t = |Et|
MAD = Mean Absolute Deviation = average value of At

© 2007 Pearson Education 7-198

 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

© 2007 Pearson Education 7-199

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

© 2007 Pearson Education 7-200

 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 = 19500
F5 = 19500 = F6 = F7 = F8
Observe demand in period 5 to be D5 = 10000
Forecast error in period 5, E5 = F5 - D5 = 19500 - 10000 = 9500
Revise estimate of level in period 5:
L5 = (D5+D4+D3+D2)/4 = (10000+34000+23000+13000)/4 = 20000
F6 = L5 = 20000

© 2007 Pearson Education 7-201

 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]/n
Current 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 = Lt
After observing demand Dt+1, revise the estimate of the level:
Lt+1 = Dt+1 + (1-)Lt
Lt+1 = Sum(n=0 to t+1)[(1-)nDt+1-n ]

© 2007 Pearson Education 7-202

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

© 2007 Pearson Education 7-203

 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 + b
T0 = a
L0 = b
In period t, the forecast for future periods is expressed as follows:
Ft+1 = Lt + Tt
Ft+n = Lt + nTt

© 2007 Pearson Education 7-204

 Trend-Corrected Exponential
Smoothing (Holt’s Model)
After observing demand for period t, revise the estimates for level and trend as
follows:
Lt+1 = Dt+1 + (1-)(Lt + Tt)
Tt+1 = (Lt+1 - Lt) + (1-)Tt
 = smoothing constant for level
 = smoothing constant for trend
Example: 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)

© 2007 Pearson Education 7-205

 Holt’s Model Example (continued)
Forecast for period 1:
F1 = L0 + T0 = 12015 + 1549 = 13564
Observed demand for period 1 = D1 = 8000
E1 = F1 - D1 = 13564 - 8000 = 5564
Assume  = 0.1,  = 0.2
L1 = D1 + (1-)(L0+T0) = (0.1)(8000) + (0.9)(13564) = 13008
T1 = (L1 - L0) + (1-)T0 = (0.2)(13008 - 12015) + (0.8)(1549)
= 1438
F2 = L1 + T1 = 13008 + 1438 = 14446
F5 = L1 + 4T1 = 13008 + (4)(1438) = 18760

© 2007 Pearson Education 7-206

 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

© 2007 Pearson Education 7-207

 Trend- and Seasonality-Corrected
Exponential Smoothing (continued)
After observing demand for period t+1, revise estimates for level, trend, and
seasonal factors as follows:
Lt+1 = (Dt+1/St+1) + (1-)(Lt+Tt)
Tt+1 = (Lt+1 - Lt) + (1-)Tt
St+p+1 = (Dt+1/Lt+1) + (1-)St+1
 = smoothing constant for level
 = smoothing constant for trend
 = 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

© 2007 Pearson Education 7-208

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

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

© 2007 Pearson Education 7-209

 Measures of Forecast Error
 Forecast error = Et = Ft - Dt
 Mean squared error (MSE)
MSEn = (Sum(t=1 to n)[Et2])/n
 Absolute deviation = At = |Et|
 Mean absolute deviation (MAD)
MADn = (Sum(t=1 to n)[At])/n
 = 1.25MAD

© 2007 Pearson Education 7-210

 Measures of Forecast Error
 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

© 2007 Pearson Education 7-211

 Forecasting Demand at Tahoe Salt
 Moving average
 Simple exponential smoothing
 Trend-corrected exponential smoothing
 Trend- and seasonality-corrected exponential
smoothing

© 2007 Pearson Education 7-212

 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

© 2007 Pearson Education 7-213

 Summary of Learning Objectives
 What are the roles of forecasting for an enterprise and
a supply chain?
 What are the components of a demand forecast?
 How is demand forecast given historical data using
time series methodologies?
 How is a demand forecast analyzed to estimate
forecast error?

© 2007 Pearson Education 7-214

 Supply Chain Management
(3rd Edition)

Chapter 8
Aggregate Planning
in the Supply Chain

© 2007 Pearson Education 8-215

 Outline
 Role of aggregate planning in a supply chain
 The aggregate planning problem
 Aggregate planning strategies
 Implementing aggregate planning in practice

© 2007 Pearson Education 8-216

 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, stockouts, 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?

© 2007 Pearson Education 8-217

 Role of Aggregate Planning
in a Supply Chain
 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

© 2007 Pearson Education 8-218

 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

© 2007 Pearson Education 8-219

 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

© 2007 Pearson Education 8-220

 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

© 2007 Pearson Education 8-221

 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

© 2007 Pearson Education 8-222

 Chase Strategy
 Production rate is synchronized with demand by varying
machine capacity or hiring and laying 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

© 2007 Pearson Education 8-223

 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

© 2007 Pearson Education 8-224

 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

© 2007 Pearson Education 8-225

 Aggregate Planning at
Red Tomato Tools

Month Demand Forecast

January 1,600
February 3,000
March 3,200
April 3,800
May 2,200
June 2,200

© 2007 Pearson Education 8-226

 Fundamental Tradeoffs in
Aggregate Planning
 Capacity (regular time, overtime, subcontract)
 Inventory
 Backlog / lost sales

Basic Strategies
 Chase strategy
 Time flexibility from workforce or capacity
 Level strategy

© 2007 Pearson Education 8-227

 Aggregate Planning
Item Cost
Materials $10/unit
Inventory holding cost $2/unit/month
Marginal cost of a stockout $5/unit/month
Hiring and training costs $300/worker
Layoff cost $500/worker
Labor hours required 4/unit
Regular time cost $4/hour
Over time cost $6/hour
Cost of subcontracting $30/unit

© 2007 Pearson Education 8-228

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

© 2007 Pearson Education 8-229

 Aggregate Planning
(Define Objective Function)
6 6
Min  640W t   300 H t
t 1 t 1
6 6 6
  500 Lt   6 Ot   2 I t
t 1 t 1 t 1
6 6 6
  5 S t  10 Pt   30 C t
t 1 t 1 t 1

© 2007 Pearson Education 8-230

 Aggregate Planning (Define
Constraints Linking Variables)
 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, where W 0  80.
© 2007 Pearson Education 8-231
 Aggregate Planning (Constraints)
 Production for each month cannot exceed capacity

Pt  40W t  Ot 4 ,
40W t  Ot 4  Pt  0,
for t  1,...,6.
© 2007 Pearson Education 8-232
 Aggregate Planning (Constraints)
 Inventory balance for each month

I t 1  Pt  C t  Dt  S t 1  I t  S t ,
I t 1  Pt  C t  Dt  S t 1  I t  S t  0,
for t  1,...,6,where I 0  1,000,
S 0  0,and I 6  500.
© 2007 Pearson Education 8-233
 Aggregate Planning (Constraints)
 Over time for each month

Ot  10W t,
10W t  Ot  0,
for t  1,...,6.

© 2007 Pearson Education 8-234

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

© 2007 Pearson Education 8-235

 Increased Demand Fluctuation

Month Demand Forecast

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

© 2007 Pearson Education 8-236

 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

© 2007 Pearson Education 8-237

 Summary of Learning Objectives
 What types of decisions are best solved by aggregate
planning?
 What is the importance of aggregate planning as a
supply chain activity?
 What kinds of information are needed to produce an
aggregate plan?
 What are the basic trade-offs a manager makes to
produce an aggregate plan?
 How are aggregate planning problems formulated and
solved using Microsoft Excel?
© 2007 Pearson Education 8-238
 Supply Chain Management
(3rd Edition)

Chapter 9
Planning Supply and Demand
in a Supply Chain: Managing
Predictable Variability
© 2007 Pearson Education 9-239
 Outline
 Responding to predictable variability in a supply chain
 Managing supply
 Managing demand
 Implementing solutions to predictable variability in
practice

© 2007 Pearson Education 9-240

 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

© 2007 Pearson Education 9-241

 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

© 2007 Pearson Education 9-242

 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

© 2007 Pearson Education 9-243

 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)

© 2007 Pearson Education 9-244

 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

© 2007 Pearson Education 9-245

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

Month Demand Forecast

January 3,000
February 2,400
March 2,560
April 3,800
May 2,200
June 2,200

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

© 2007 Pearson Education 9-246

 Peak (April) Discount
from $40 to $39

Month Demand Forecast

January 1,600
February 3,000
March 3,200
April 5,060
May 1,760
June 1,760

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

© 2007 Pearson Education 9-247

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

Month Demand Forecast

January 4,440
February 2,400
March 2,560
April 3,800
May 2,200
June 2,200

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

© 2007 Pearson Education 9-248

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

Month Demand Forecast

January 1,600
February 3,000
March 3,200
April 8,480
May 1,760
June 1,760

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

© 2007 Pearson Education 9-249

 Performance Under
Different Scenarios
Regular Promotion Promotion Percent Percent Profit Average

Price Price Period increase in forward Inventory

demand buy

$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

© 2007 Pearson Education 9-250

 Factors Affecting
Promotion Timing
Factor Favored timing
High forward buying Low demand period
High stealing share High demand period
High growth of market High demand period
High margin High demand period
Low margin Low demand period
High holding cost Low demand period
Low flexibility Low demand period

© 2007 Pearson Education 9-251

 Factors Influencing Discount Timing
 Impact of discount on consumption
 Impact of discount on forward buy
 Product margin

© 2007 Pearson Education 9-252

 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

© 2007 Pearson Education 9-253

 Summary of Learning Objectives
 How can supply be managed to improve
synchronization in the supply chain in the face of
predictable variability?
 How can demand be managed to improve
synchronization in the supply chain in the face of
predictable variability?
 How can aggregate planning be used to maximize
profitability when faced with predictable variability
in the supply chain?

© 2007 Pearson Education 9-254

 Supply Chain Management
(3rd Edition)

Chapter 10
Managing Economies of Scale in the
Supply Chain: Cycle Inventory

© 2007 Pearson Education 10-255

 Outline
 Role of Cycle Inventory in a Supply Chain
 Economies of Scale to Exploit Fixed Costs
 Economies of Scale to Exploit Quantity Discounts
 Short-Term Discounting: Trade Promotions
 Managing Multi-Echelon Cycle Inventory
 Estimating Cycle Inventory-Related Costs in
Practice

© 2007 Pearson Education 10-256

 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

Supply / Demand Seasonal

Economies of Scale Variability Variability

Cycle Inventory Safety Inventory Seasonal Inventory

Figure Error! No text of

© 2007 Pearson Education 10-257

 Role of Cycle Inventory
in a Supply Chain
 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)

© 2007 Pearson Education 10-258

 Role of Cycle Inventory
in a Supply Chain
Q = 1000 units
D = 100 units/day
Cycle inventory = Q/2 = 1000/2 = 500 = Avg inventory level from
cycle inventory
Avg 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

© 2007 Pearson Education 10-259

 Role of Cycle Inventory
in a Supply Chain
 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

© 2007 Pearson Education 10-260

 Economies of Scale
to Exploit Fixed Costs
 How do you decide whether to go shopping at a
convenience store or at Sam’s Club?
 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

© 2007 Pearson Education 10-261

 Economies of Scale
to Exploit Fixed Costs
Annual demand = D
Number of orders per year = D/Q
Annual material cost = CR
Annual order cost = (D/Q)S
Annual holding cost = (Q/2)H = (Q/2)hC
Total annual cost = TC = CD + (D/Q)S + (Q/2)hC
Figure 10.2 shows variation in different costs for
different lot sizes

© 2007 Pearson Education 10-262

 Fixed Costs: Optimal Lot Size
and Reorder Interval (EOQ)
D: Annual demand
S: Setup or Order Cost H  hC
C: Cost per unit
h: Holding cost per year as a 2 DS
fraction of product cost Q* 
H: Holding cost per unit per year H
Q: Lot Size
T: Reorder interval 2S
Material cost is constant and n* 
therefore is not considered in
this model
DH

© 2007 Pearson Education 10-263

 Example 10.1
Demand, D = 12,000 computers per year
d = 1000 computers/month
Unit cost, C = $500
Holding cost fraction, h = 0.2
Fixed cost, S = $4,000/order
Q* = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980 computers
Cycle inventory = Q/2 = 490
Flow time = Q/2d = 980/(2)(1000) = 0.49 month
Reorder interval, T = 0.98 month

© 2007 Pearson Education 10-264

 Example 10.1 (continued)
Annual ordering and holding cost =
= (12000/980)(4000) + (980/2)(0.2)(500) = $97,980
Suppose 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) = $250,000
To make it economically feasible to reduce lot size, the
fixed cost associated with each lot would have to be
reduced

© 2007 Pearson Education 10-265

 Example 10.2
If desired lot size = Q* = 200 units, what would S have
to be?
D = 12000 units
C = $500
h = 0.2
Use EOQ equation and solve for S:
S = [hC(Q*)2]/2D = [(0.2)(500)(200)2]/(2)(12000) = $166.67
To reduce optimal lot size by a factor of k, the fixed order cost
must be reduced by a factor of k2

© 2007 Pearson Education 10-266

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

 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.

 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.

© 2007 Pearson Education 10-267

 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

© 2007 Pearson Education 10-268

 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

© 2007 Pearson Education 10-269

 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

© 2007 Pearson Education 10-270

 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

© 2007 Pearson Education 10-271

 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

© 2007 Pearson Education 10-272

 No Aggregation: Order Each
Product Independently
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Fixed cost / $5,000 $5,000 $5,000
order
Optimal 1,095 346 110
order size
Order 11.0 / year 3.5 / year 1.1 / year
frequency
Annual cost $109,544 $34,642 $10,954

Total cost = $155,140

© 2007 Pearson Education 10-273
 Aggregation: Order All
Products Jointly
S* = S + sL + sM + sH = 4000+1000+1000+1000 = $7000
n* = Sqrt[(DLhCL+ DMhCM+ DHhCH)/2S*]
= 9.75
QL = DL/n* = 12000/9.75 = 1230
QM = DM/n* = 1200/9.75 = 123
QH = DH/n* = 120/9.75 = 12.3
Cycle inventory = Q/2
Average flow time = (Q/2)/(weekly demand)

© 2007 Pearson Education 10-274

 Complete Aggregation:
Order All Products Jointly
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Order 9.75/year 9.75/year 9.75/year
frequency
Optimal 1,230 123 12.3
order size
Annual $61,512 $6,151 $615
holding cost
Annual order cost = 9.75 × $7,000 = $68,250
Annual total cost = $136,528
© 2007 Pearson Education 10-275
 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

© 2007 Pearson Education 10-276

 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

© 2007 Pearson Education 10-277

 Quantity Discounts
 Lot size based
– All units
– Marginal unit
 Volume based

 How should buyer react?

 What are appropriate discounting schemes?

© 2007 Pearson Education 10-278

 All-Unit Quantity Discounts
 Pricing schedule has specified quantity break points q 0, q1,
…, qr, where q0 = 0
 If an order is placed that is at least as large as q i but smaller
than qi+1, then each unit has an average unit cost of C i
 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

© 2007 Pearson Education 10-279

 All-Unit Quantity Discount Procedure
(different from what is in the textbook)
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 EOQ is found.

© 2007 Pearson Education 10-280

 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

© 2007 Pearson Education 10-281

 All-Unit Quantity Discount:
Example
Order quantity Unit Price
0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92

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

© 2007 Pearson Education 10-282

 All-Unit Quantity Discount:
Example
Step 1: Calculate Q2* = Sqrt[(2DS)/hC2]
= Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410
Not feasible (6410 < 10001)
Calculate TC2 using C2 = $2.92 and q2 = 10001
TC2 = (120000/10001)(100)+(10001/2)(0.2)(2.92)+(120000)(2.92)
= $354,520
Step 2: Calculate Q1* = Sqrt[(2DS)/hC1]
=Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367
Feasible (5000<6367<10000)  Stop
TC1 = (120000/6367)(100)+(6367/2)(0.2)(2.96)+(120000)(2.96)
= $358,969
TC2 < TC1  The optimal order quantity Q* is q2 = 10001

© 2007 Pearson Education 10-283

 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?

© 2007 Pearson Education 10-284

 Why Quantity Discounts?
 Coordination in the supply chain
– Commodity products
– Products with demand curve
» 2-part tariffs
» Volume discounts

© 2007 Pearson Education 10-285

 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 bottles

Retailer cost = $3,795; Supplier cost = $6,009
Supply chain cost = $9,804

© 2007 Pearson Education 10-286

 Coordination for
Commodity Products
 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 from 6,324 to 9,165)

© 2007 Pearson Education 10-287

 Quantity Discounts When
Firm Has Market Power
 No inventory related costs
 Demand curve
360,000 - 60,000p
What 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

© 2007 Pearson Education 10-288

 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

© 2007 Pearson Education 10-289

 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
– Volume based discounts are better over rolling horizon

© 2007 Pearson Education 10-290

 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

© 2007 Pearson Education 10-291

 Short Term Discounting
Q*: Normal order quantity
C: Normal unit cost
d: Short term discount
D: Annual demand *
d dD CQ
h: Cost of holding $1 per year
Qd: Short term order quantity
Q = +
(C - d )h C - d

Forward buy = Qd - Q*

© 2007 Pearson Education 10-292

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

Qd =
Forward buy =

© 2007 Pearson Education 10-293

 Promotion Pass Through
to Consumers
Demand curve at retailer: 300,000 - 60,000p
Normal 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%

© 2007 Pearson Education 10-294

 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

© 2007 Pearson Education 10-295

 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.

© 2007 Pearson Education 10-296

 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

© 2007 Pearson Education 10-297

 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

© 2007 Pearson Education 10-298

 Summary of Learning Objectives
 How are the appropriate costs balanced to choose the
optimal amount of cycle inventory in the supply
chain?
 What are the effects of quantity discounts on lot size
and cycle inventory?
 What are appropriate discounting schemes for the
supply chain, taking into account cycle inventory?
 What are the effects of trade promotions on lot size
and cycle inventory?
 What are managerial levers that can reduce lot size
and cycle inventory without increasing costs?
© 2007 Pearson Education 10-299
 Supply Chain Management
(3rd Edition)

Chapter 11
Managing Uncertainty in the
Supply Chain: Safety Inventory

© 2007 Pearson Education 11-300

 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

Supply / Demand Seasonal

Economies of Scale Variability Variability

Cycle Inventory Safety Inventory Seasonal Inventory

Figure Error! No text of

© 2007 Pearson Education 11-301

 Outline
 The role of safety inventory in a supply chain
 Determining the appropriate level of safety inventory
 Impact of supply uncertainty on safety inventory
 Impact of aggregation on safety inventory
 Impact of replenishment policies on safety inventory
 Managing safety inventory in a multi-echelon supply
chain
 Estimating and managing safety inventory in practice

© 2007 Pearson Education 11-302

 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
 Safety inventory: Inventory carried for the purpose of
satisfying demand that exceeds the amount forecasted in a
given period

© 2007 Pearson Education 11-303

 Role of Safety Inventory
 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

© 2007 Pearson Education 11-304

 Two Questions to Answer in
Planning Safety Inventory
 What is the appropriate level of safety inventory
to carry?
 What actions can be taken to improve product
availability while reducing safety inventory?

© 2007 Pearson Education 11-305

 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

© 2007 Pearson Education 11-306

 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

© 2007 Pearson Education 11-307

 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
D = 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

© 2007 Pearson Education 11-308

 Measuring Demand Uncertainty
 P = demand during k periods = kD
  = std dev of demand during k periods = RSqrt(k)
 Coefficient of variation = cv =  = mean/(std dev)
= size of uncertainty relative to demand

© 2007 Pearson Education 11-309

 Measuring Product Availability
 Product availability: 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 fill rate (fr): fraction of demand that is satisfied from
product in inventory
 Order fill rate: fraction of orders that are filled from available
inventory
 Cycle service level: fraction of replenishment cycles that end
with all customer demand met

© 2007 Pearson Education 11-310

 Replenishment Policies
 Replenishment policy: decisions regarding when to
reorder and how much to reorder
 Continuous review: inventory is continuously
monitored and an order of size Q is placed when the
inventory level reaches the reorder point ROP
 Periodic review: 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)

© 2007 Pearson Education 11-311

 Continuous Review Policy: Safety
Inventory and Cycle Service Level
L: Lead time for replenishment
D: Average demand per unit time D L
 DL

 D
D:Standard deviation of demand
per period L
 L
DL: Mean demand during lead
ss  F S (CSL)  L
1
time
L: Standard deviation of demand
during lead time
CSL: Cycle service level
ROP  D L  ss
ss: Safety inventory
ROP: Reorder point
CSL  F ( ROP, D L , L )
Average Inventory = Q/2 + ss
© 2007 Pearson Education 11-312
 Example 11.1: Estimating Safety
Inventory (Continuous Review Policy)
D = 2,500/week; D = 500
L = 2 weeks; Q = 10,000; ROP = 6,000

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

© 2007 Pearson Education 11-313

 Example 11.2: Estimating Cycle Service
Level (Continuous Review Policy)
D = 2,500/week; D = 500
L = 2 weeks; Q = 10,000; ROP = 6,000

  L R
L  (500) 2  707
Cycle service level, CSL = F(DL + ss, DL, L) =
= NORMDIST (DL + ss, DL, L) = NORMDIST(6000,5000,707,1)
= 0.92 (This value can also be determined from a Normal
probability distribution table)

© 2007 Pearson Education 11-314

 Fill Rate
 Proportion of customer demand
ESC
satisfied from stock fr  1 
 Stockout occurs when the demand Q
during lead time exceeds the
reorder point  ss 
 ESC is the expected shortage per ESC   ss{1  F S  }
cycle (average demand in excess of  L 
reorder point in each replenishment  ss 
cycle)   L f S  
 ss is the safety inventory  L 
 Q is the order quantity

ESC = -ss{1-NORMDIST(ss/L, 0, 1, 1)} + L NORMDIST(ss/L, 0, 1, 0)

© 2007 Pearson Education 11-315
 Example 11.3: Evaluating Fill Rate
ss = 1,000, Q = 10,000, L = 707, Fill Rate (fr) = ?
ESC = -ss{1-NORMDIST(ss/L, 0, 1, 1)} +
L NORMDIST(ss/L, 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

© 2007 Pearson Education 11-316

 Factors Affecting Fill Rate
 Safety inventory: Fill rate increases if safety
inventory is increased. This also increases the
cycle service level.
 Lot size: Fill rate increases on increasing the lot
size even though cycle service level does not
change.

© 2007 Pearson Education 11-317

 Example 11.4: Evaluating
Safety Inventory Given CSL
D = 2,500/week; D = 500
L = 2 weeks; Q = 10,000; CSL = 0.90
DL = 5000, L = 707 (from earlier example)

ss = FS-1(CSL)L = [NORMSINV(0.90)](707) = 906

(this value can also be determined from a Normal
probability distribution table)

ROP = DL + ss = 5000 + 906 = 5906

© 2007 Pearson Education 11-318

 Evaluating Safety Inventory
Given Desired Fill Rate
D = 2500, D = 500, Q = 10000
If desired fill rate is fr = 0.975, how much safety
inventory should be held?
ESC = (1 - fr)Q = 250
Solve   ss   ss 
ESC  250   ss 1  F S    σ L f S  
  σ L   σL 

  ss   ss 
250   ss 1  NORMSDIST   σ L NORMDIST  ,1,1,0 
  σ L   σL 

© 2007 Pearson Education 11-319

 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

© 2007 Pearson Education 11-320

 Impact of Required Product Availability
and Uncertainty on Safety Inventory
 Desired product availability (cycle service level or fill
rate) increases, required safety inventory increases
 Demand uncertainty (L) 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, L (better forecasts, better
information collection and use)

© 2007 Pearson Education 11-321

 Impact of Supply Uncertainty
 D: Average demand per period
 D: Standard deviation of demand per period
 L: Average lead time
 sL: Standard deviation of lead time

DL  DL

 
2 2 2
L
 L D
 D s L
© 2007 Pearson Education 11-322
 Impact of Supply Uncertainty
D = 2,500/day; D = 500
L = 7 days; Q = 10,000; CSL = 0.90; sL = 7 days
DL = DL = (2500)(7) = 17500

 L
 L   D sL
2
D
2 2

2 2
 (7) 500  (2500) (7)  17500
2
ss = F s(CSL)L = NORMSINV(0.90) x 17550
-1

= 22,491

© 2007 Pearson Education 11-323

 Impact of Supply Uncertainty

Safety inventory when sL = 0 is 1,695

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

© 2007 Pearson Education 11-324

 Impact of Aggregation
on Safety Inventory
 Models of aggregation
 Information centralization
 Specialization
 Product substitution
 Component commonality
 Postponement

© 2007 Pearson Education 11-325

 Impact of Aggregation
n

D D
C
i
i 1
n

 
C 2
D
 i
i 1

  L D
C C
L

ss  F s (CSL)  L
1 C

© 2007 Pearson Education 11-326

 Impact of Aggregation
(Example 11.7)
Car Dealer : 4 dealership locations (disaggregated)
D = 25 cars; D = 5 cars; L = 2 weeks; desired CSL=0.90
What 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, L = 7.07 cars
ss = Fs-1(CSL) x L = Fs-1(0.9) x 7.07 = 9.06
Each outlet must carry 9 cars as safety stock inventory, so
safety inventory for the 4 outlets in total is (4)(9) = 36 cars

© 2007 Pearson Education 11-327

 Impact of Aggregation
(Example 11.7)
One outlet (aggregated option):
RC = D1 + D2 + D3 + D4 = 25+25+25+25 = 100 cars/wk
RC = Sqrt(52 + 52 + 52 + 52) = 10
LC = DC Sqrt(L) = (10)Sqrt(2) = (10)(1.414) = 14.14
ss = Fs-1(CSL) x LC = Fs-1(0.9) x 14.14 =18.12
or about 18 cars
If  does not equal 0 (demand is not completely independent),
the impact of aggregation is not as great (Table 11.3)

© 2007 Pearson Education 11-328

 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

© 2007 Pearson Education 11-329

 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

© 2007 Pearson Education 11-330

 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

© 2007 Pearson Education 11-331

 Value of Aggregation at Grainger
(Table 11.4)
Motors Cleaner
Mean demand 20 1,000
SD of demand 40 100
Disaggregate cv 2 0.1
Value/Unit $500 $30
Disaggregate ss $105,600,000 $15,792,000
Aggregate cv 0.05 0.0025
Aggregate ss $2,632,000 $394,770
Holding Cost $25,742,000 $3,849,308
Saving
Saving / Unit $7.74 $0.046
© 2007 Pearson Education 11-332
 Product Substitution
 Substitution: use of one product to satisfy the demand
for another product
 Manufacturer-driven one-way substitution
 Customer-driven two-way substitution

© 2007 Pearson Education 11-333

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

© 2007 Pearson Education 11-334

 Example 11.9: Value of Component
Commonality
450000
400000
350000
300000
250000
SS
200000
150000
100000
50000
0
1 2 3 4 5 6 7 8 9

© 2007 Pearson Education 11-335

 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

© 2007 Pearson Education 11-336

 Impact of Replenishment
Policies on Safety Inventory
 Continuous review policies
 Periodic review policies

© 2007 Pearson Education 11-337

 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

© 2007 Pearson Education 11-338

 Summary of Learning Objectives
 What is the role of safety inventory in a supply chain?
 What are the factors that influence the required level
of safety inventory?
 What are the different measures of product
availability?
 What managerial levers are available to lower safety
inventory and improve product availability?

© 2007 Pearson Education 11-339

 Supply Chain Management
(3rd Edition)

Chapter 12
Determining Optimal Level of
Product Availability

© 2007 Pearson Education 12-340

 Outline
 The importance of the level of product availability
 Factors affecting the optimal level of product
availability
 Managerial levers to improve supply chain
profitability
 Supply chain contracts and their impact on
profitability
 Setting optimal levels of product availability in
practice

© 2007 Pearson Education 12-341

 Mattel, Inc. & Toys ‘R Us
Mattel was hurt last year by inventory cutbacks at Toys ‘R Us, and
officials are also eager to avoid a repeat of the 1998 Thanksgiving
weekend. Mattel had expected to ship a lot of merchandise after the
weekend, but retailers, wary of excess inventory, stopped ordering
from Mattel. That led the company to report a $500 million sales
shortfall in the last weeks of the year ... For the crucial holiday
selling season this year, Mattel said it will require retailers to place
their full orders before Thanksgiving. And, for the first time, the
company will no longer take reorders in December, Ms. Barad said.
This will enable Mattel to tailor production more closely to demand
and avoid building inventory for orders that don't come.
- Wall Street Journal, Feb. 18, 1999

© 2007 Pearson Education 12-342

 Key Questions
 How much should Toys ‘R Us order given
demand uncertainty?
 How much should Mattel order?
 Will Mattel’s action help or hurt profitability?
 What actions can improve supply chain
profitability?

© 2007 Pearson Education 12-343

 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  increased responsiveness and higher
revenues
– High levels of product availability  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?

© 2007 Pearson Education 12-344

 Factors Affecting the Optimal
Level of Product Availability
 Cost of overstocking
 Cost of understocking
 Possible scenarios
– Seasonal items with a single order in a season
– Continuously stocked items
– Demand during stockout is backlogged
– Demand during stockout is lost

© 2007 Pearson Education 12-345

 Managerial Levers to Improve
Supply Chain Profitability
 “Obvious” actions
– Increase salvage value of each unit
– Decrease the margin lost from a stockout
 Improved forecasting
 Quick response
 Postponement
 Tailored sourcing

© 2007 Pearson Education 12-346

 Improved Forecasts
 Improved forecasts result in reduced uncertainty
 Less uncertainty (lower R) 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

© 2007 Pearson Education 12-347

 Impact of Improving Forecasts
(Example)
Demand: Normally distributed with a mean of R =
350 and standard deviation of R = 100
Purchase price = $100
Retail price = $250
Disposal value = $85
Holding cost for season = $5

How many units should be ordered as R changes?

© 2007 Pearson Education 12-348

 Impact of Improving Forecasts
R O* Expected Expected Expected
Overstock Understock 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
© 2007 Pearson Education 12-349
 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  less inventory, same product availability
– Less overstock
– Higher profits

© 2007 Pearson Education 12-350

 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

© 2007 Pearson Education 12-351

 Impact of Quick Response
Single Order Two Orders in Season
Service Order Ending Expect. Initial OUL Average Ending Expect.
Level Size Invent. Profit Order for 2nd Total Invent. Profit
Order Order
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

© 2007 Pearson Education 12-352

 Forecast Improves for Second
Order (SD=3 Instead of 15)
Single Order Two Orders in Season
Service Order Ending Expect. Initial OUL Average Ending Expect.
Level Size Invent. Profit Order for 2nd Total Invent. Profit
Order Order
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

© 2007 Pearson Education 12-353

 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
 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

© 2007 Pearson Education 12-354

 Value of Postponement: Benetton
 For each color
– Mean demand = 1,000; SD = 500
 For each garment
– Sale price = $50
– Salvage value = $10
– Production cost using Option 1 (long lead time) = $20
– Production cost using Option 2 (uncolored thread) = $22
 What is the value of postponement?
– Expected profit increases from $94,576 to $98,092

© 2007 Pearson Education 12-355

 Value of Postponement
with Dominant Product
 Color with dominant demand: Mean = 3,100, SD = 800
 Other three colors: Mean = 300, SD = 200
 Expected profit without postponement = $102,205
 Expected profit with postponement = $99,872

© 2007 Pearson Education 12-356

 Tailored Postponement: Benetton
 Produce Q1 units for each color using Option 1 and QA units
(aggregate) using Option 2
 Results:
– 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

© 2007 Pearson Education 12-357

 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
 Depends on being able to have one source that faces
very low uncertainty and can therefore reduce costs
 Increase profits, better match supply and demand

© 2007 Pearson Education 12-358

 Tailored Sourcing
 Sourcing alternatives
– Low cost, long lead time supplier
» Cost = $245, Lead time = 9 weeks
– High cost, short lead time supplier
» Cost = $250, Lead time = 1 week

© 2007 Pearson Education 12-359

 Tailored Sourcing Strategies
Fraction of demand from Annual Profit
overseas supplier
0% $37,250

50% $51,613

60% $53,027

100% $48,875

© 2007 Pearson Education 12-360

 Tailored Sourcing: Multiple
Sourcing Sites
Characteristic Primary Site Secondary Site
Manufacturing High Low
Cost
Flexibility High Low
(Volume/Mix)
Responsiveness High Low
Engineering High Low
Support

© 2007 Pearson Education 12-361

 Dual Sourcing Strategies
Strategy Primary Site Secondary Site

Volume based Fluctuation Stable demand

dual sourcing
Product based Unpredictable Predictable,
dual sourcing products, large batch
Small batch products
Model based Newer Older stable
dual sourcing products products

© 2007 Pearson Education 12-362

 Supply Chain Contracts and
Their Impact on Profitability
 Contract
 Returns policy: Buyback contracts
 Quantity flexibility contracts
 Vendor-managed inventories

© 2007 Pearson Education 12-363

 Contracts
 Specifies the parameters within which a buyer places
orders and a supplier fulfills them
 Example parameters: quantity, price, time, quality
 Double marginalization: buyer and seller make
decisions acting independently instead of acting
together – gap between potential total supply chain
profits and actual supply chain profits results
 Buyback contracts can be offered that will increase
total supply chain profit

© 2007 Pearson Education 12-364

 Returns Policy:
Buyback Contracts
 A manufacturer specifies a wholesale price and a buyback
price at which the retailer can return any unsold items at
the end of the season
 Results in an increase in the salvage value for the retailer,
which induces the retailer to order a larger quantity
 The manufacturer is willing to take on some of the cost of
overstocking because the supply chain will end up selling
more on average
 Manufacturer profits and supply chain profits can increase

© 2007 Pearson Education 12-365

 Impact of Supply Chain Contracts
on Profitability: Buyback Contracts
 Buybacks by publishers
 Tech Fiber produces jacket at v = $10 and charges
a wholesale price of c = $100. Ski Adventure sells
jacket for p = $200. Unsold jackets have no
salvage value. Should TF be willing to buy back
unsold jackets? Why?

© 2007 Pearson Education 12-366

 Buyback Contracts
Wholesale Buy Optimal Expected Expected Expected Expected
Price c Back Order size Profit for Returns Profit for Supply
Price b for SA SA to TF TF Chain Profit
$100 $0 1,000 $76,063 120 $90,000 $166,063
$100 $30 1,067 $80,154 156 $91,338 $171,492
$100 $60 1,170 $85,724 223 $91,886 $177,610
$100 $95 1,501 $96,875 506 $86,935 $183,810
$110 $78 1,191 $78,074 239 $100,480 $178,555
$110 $105 1,486 $86,938 493 $96,872 $183,810
$120 $96 1,221 $70,508 261 $109,225 $179,733
$120 $116 1,501 $77,500 506 $106,310 $183,810

© 2007 Pearson Education 12-367

 Revenue Sharing Contracts
 The manufacturer charges the retailer a low wholesale
price and shares a fraction of the revenue generated
by the retailer
 The lower wholesale price decreases the cost to the
retailer in case of an overstock
 The retailer therefore increases the level of product
availability, which results in higher profits for both
the manufacturer and the retailer

© 2007 Pearson Education 12-368

 Quantity Flexibility Contracts
 Manufacturer allows retailer to change order
quantity after observing demand
 No returns are required
 The manufacturer bears some of the risk of excess
inventory
 Retailer increases order quantity
 Can result in higher manufacturer and supply
chain profits

© 2007 Pearson Education 12-369

 Quantity Flexibility Contracts
 If a retailer order O units, the manufacturer
commits to supplying up to (1+)O and the
retailer commits to buying (1-)O
 How can quantity flexibility contracts help
increase profitability?

© 2007 Pearson Education 12-370

 Quantity Flexibility Contracts
  Wholesale Order Expected Expected Expected Expected Expected
price c size O purchase sale by profits profits for supply
by SA SA for SA TF chain profit
0.00 0.00 $100 1,000 1,000 880 $76,063 $90,000 $166,063
0.20 0.20 $100 1,050 1,024 968 $91,167 $89,830 $180,997
0.40 0.40 $100 1,070 1,011 994 $97,689 $86,122 $183,811
0.00 0.00 $110 962 962 860 $66,252 $96,200 $162,452
0.15 0.15 $110 1,014 1,009 945 $78,153 $99,282 $177,435
0.42 0.42 $110 1,048 1,007 993 $87,932 $95,879 $183,811
0.00 0.00 $120 924 924 838 $56,819 $101,640 $158,459
0.2 0.2 $120 1,000 1,000 955 $70,933 $108,000 $178,933
0.5 0.5 $120 1,040 1,003 996 $78,874 $104,803 $183,677

© 2007 Pearson Education 12-371

 Vendor-Managed Inventories (VMI)
 Manufacturer or supplier is responsible for all decisions regarding
inventory at the retailer
 Control of replenishment decisions moves to the manufacturer
 Requires that the retailer share demand information with the
manufacturer
 Manufacturer can increase its profits and total supply chain profits
by reducing effects of double marginalization
 Having final customer demand data also helps manufacturer plan
production more effectively
 Campbell’s Soup, Proctor & Gamble
 Potential drawback – when retailers sell products that are substitutes
in customers’ minds

© 2007 Pearson Education 12-372

 Setting Optimal Levels of
Product Availability in Practice
 Use an analytical framework to increase profits
 Beware of preset levels of availability
 Use approximate costs because profit-maximizing
solutions are very robust
 Estimate a range for the cost of stocking out
 Ensure that levels of product availability fit with
the strategy

© 2007 Pearson Education 12-373

 Summary of Learning Objectives
 What are the factors affecting the optimal level of
product availability?
 How is the optimal cycle service level estimated?
 What are the managerial levers that can be used to
improve supply chain profitability through
optimal service levels?
 How can contracts be structured to increase
supply chain profitability?

© 2007 Pearson Education 12-374

 Supply Chain Management
(3rd Edition)

Chapter 13
Transportation in the Supply Chain

© 2007 Pearson Education 14-375

 Outline
 The role of transportation in the supply chain
 Factors affecting transportation decisions
 Modes of transportation and their performance
characteristics
 Design options for a transportation network
 Trade-offs in transportation design
 Tailored transportation
 Routing and scheduling in transportation
 Making transportation decisions in practice

© 2007 Pearson Education 14-376

 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

© 2007 Pearson Education 14-377

 Transportation Modes
 Trucks
– TL
– LTL
 Rail
 Air
 Package Carriers
 Water
 Pipeline

© 2007 Pearson Education 14-378

 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

© 2007 Pearson Education 14-379

 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

© 2007 Pearson Education 14-380

 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

© 2007 Pearson Education 14-381

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

© 2007 Pearson Education 14-382

 Package Carriers
 Companies like FedEx, UPS, 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)

© 2007 Pearson Education 14-383

 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.)

© 2007 Pearson Education 14-384

 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?)

© 2007 Pearson Education 14-385

 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

© 2007 Pearson Education 14-386

 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

© 2007 Pearson Education 14-387

 Trade-offs in Transportation Design
 Transportation and inventory cost trade-off
– Choice of transportation mode
– Inventory aggregation
 Transportation cost and responsiveness trade-off

© 2007 Pearson Education 14-388

 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

© 2007 Pearson Education 14-389

 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
© 2007 Pearson Education 14-390
 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

© 2007 Pearson Education 14-391

 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

© 2007 Pearson Education 14-392

 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

© 2007 Pearson Education 14-393

 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

© 2007 Pearson Education 14-394

 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

© 2007 Pearson Education 14-395

 Summary of Learning Objectives
 What is the role of transportation in a supply chain?
 What are the strengths and weaknesses of different
transport modes?
 What are the different network design options and
what are their strengths and weaknesses?
 What are the trade-offs in transportation network
design?

© 2007 Pearson Education 14-396

 Supply Chain Management
(3rd Edition)

Chapter 14
Sourcing Decisions in a Supply Chain

© 2007 Pearson Education 13-397

 Outline
 The Role of Sourcing in a Supply Chain
 Supplier Scoring and Assessment
 Supplier Selection and Contracts
 Design Collaboration
 The Procurement Process
 Sourcing Planning and Analysis
 Making Sourcing Decisions in Practice
 Summary of Learning Objectives

© 2007 Pearson Education 13-398

 The 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

© 2007 Pearson Education 13-399

 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
© 2007 Pearson Education 13-400
 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

© 2007 Pearson Education 13-401

 Supplier Assessment Factors
 Replenishment Lead Time  Pricing Terms
 On-Time Performance  Information Coordination
 Supply Flexibility Capability
 Delivery Frequency /  Design Collaboration
Minimum Lot Size Capability
 Supply Quality  Exchange Rates, Taxes,
 Inbound Transportation Cost Duties
 Supplier Viability

© 2007 Pearson Education 13-402

 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

© 2007 Pearson Education 13-403

 Contracts and Supply Chain
Performance
 Contracts for Product Availability and Supply
Chain Profits
– Buyback Contracts
– Revenue-Sharing Contracts
– Quantity Flexibility Contracts
 Contracts to Coordinate Supply Chain Costs
 Contracts to Increase Agent Effort
 Contracts to Induce Performance Improvement

© 2007 Pearson Education 13-404

 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
© 2007 Pearson Education 13-405
 Contracts for Product Availability and
Supply Chain Profits: Buyback Contracts
 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

© 2007 Pearson Education 13-406

 Contracts for Product Availability and Supply
Chain Profits: Revenue Sharing 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

© 2007 Pearson Education 13-407

 Contracts for Product Availability and Supply
Chain Profits: Quantity Flexibility 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

© 2007 Pearson Education 13-408

 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
© 2007 Pearson Education 13-409
 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

© 2007 Pearson Education 13-410

 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 with
a 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
© 2007 Pearson Education 13-411
 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
© 2007 Pearson Education 13-412
 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
© 2007 Pearson Education 13-413
 Product Categorization by Value
and Criticality (Figure 14.2)
High

Critical Items Strategic Items

Criticality

General Items Bulk Purchase Items

Low

Low High

Value/Cost
© 2007 Pearson Education 13-414
 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
© 2007 Pearson Education 13-415
 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

© 2007 Pearson Education 13-416

 Summary of Learning Objectives
 What is the role of sourcing in a supply chain?
 What dimensions of supplier performance affect
total cost?
 What is the effect of supply contracts on supplier
performance and information distortion?
 What are different categories of purchased
products and services? What is the desired focus
for procurement for each of these categories?

© 2007 Pearson Education 13-417

 Supply Chain Management
(3rd Edition)

Chapter 15
Pricing and Revenue Management
in the Supply Chain

© 2007 Pearson Education 15-418

 Outline
 The Role of Revenue Management in the
Supply Chain
 Revenue Management for Multiple Customer
Segments
 Revenue Management for Perishable Assets
 Revenue Management for Seasonable Demand
 Revenue Management for Bulk and Spot Customers
 Using Revenue Management in Practice
 Summary of Learning Objectives

© 2007 Pearson Education 15-419

 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
© 2007 Pearson Education 15-420
 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 at Amazon.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)
© 2007 Pearson Education 15-421
 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

© 2007 Pearson Education 15-422

 Revenue Management for
Multiple Customer Segments
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
H = 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) = pL
Probability(demand from higher price segment > CH) = pL / pH
CH = F-1(1- pL/pH, DH,H) = NORMINV(1- pL/pH, DH,H)

© 2007 Pearson Education 15-423

 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
Std dev of segment A demand = A = 1,000 cubic ft
CA = NORMINV(1- pB/pA, DA,A)
= 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,A)
= NORMINV(1- (2.00/5.00), 3000, 1000)
= 3,253 cubic ft
© 2007 Pearson Education 15-424
 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

© 2007 Pearson Education 15-425

 Revenue Management
for Perishable Assets
 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

© 2007 Pearson Education 15-426

 Revenue Management
for Perishable Assets
p = price at which each unit of the asset is sold
c = cost of using or producing each unit of the asset
b = cost per unit at which a backup can be used in the
case of asset shortage
Cw = p – c = marginal cost of wasted capacity
Cs = b – c = marginal cost of a capacity shortage
O* = optimal overbooking level
s* = Probability(cancellations < O*) = Cw / (Cw + Cs)

© 2007 Pearson Education 15-427

 Revenue Management
for Perishable Assets
If the distribution of cancellations is known to be normal
with mean c and standard deviation c then
O* = F-1(s*, c, c) = NORMINV(s*, c, c)
If the distribution of cancellations is known only as a
function of the booking level (capacity L +
overbooking O) to have a mean of (L+O) and std
deviation of (L+O), the optimal overbooking level is
the solution to the following equation:
O = F-1(s*,L+O),(L+O))
= NORMINV(s*,L+O),(L+O))

© 2007 Pearson Education 15-428

 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) = 0.667
c = 800; c = 400
O* = NORMINV(s*, c,c)
= NORMINV(0.667,800,400) = 973
If 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

© 2007 Pearson Education 15-429

 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 in December (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

© 2007 Pearson Education 15-430

 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

© 2007 Pearson Education 15-431

 Revenue Management for
Bulk and Spot Customers
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 of not purchasing another
unit in bulk and then purchasing it in the spot market is
(1-p*)cS.
© 2007 Pearson Education 15-432
 Revenue Management for
Bulk and Spot Customers
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, or
cB = (1-p*)cS
Solving for p* yields p* = (cS – cB) / cS
If demand is normal with mean  and std deviation , the
optimal amount Q* to be purchased in bulk is
Q* = F-1(p*,,) = NORMINV(p*,,)

© 2007 Pearson Education 15-433

 Example 15.6
Bulk contract cost = cB = $10,000 per million units
Spot market cost = cS = $12,500 per million units
 = 10 million units
 = 4 million units
p* = (cS – cB) / cS = (12,500 – 10,000) / 12,500 = 0.2
Q* = NORMINV(p*,,) = 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
© 2007 Pearson Education 15-434
 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

© 2007 Pearson Education 15-435

 Summary of Learning Objectives
 What is the role of revenue management in a
supply chain?
 Under what conditions are revenue management
tactics effective?
 What are the trade-offs that must be considered
when making revenue management decisions?

© 2007 Pearson Education 15-436

 Supply Chain Management
(3rd Edition)

Chapter 16
Information Technology
and the Supply Chain

© 2007 Pearson Education 17-437

 Outline
 The Role of Information Technology in the Supply
Chain
 The Supply Chain IT Framework
 Customer Relationship Management
 Internal Supply Chain Management
 Supplier Relationship Management
 The Transaction Management Foundation
 The Future of IT in the Supply Chain
 Supply Chain Information Technology in Practice

© 2007 Pearson Education 17-438

 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

© 2007 Pearson Education 17-439

 Characteristics of Useful
Supply Chain Information
 Accurate
 Accessible in a timely manner
 The right kind
 Provides supply chain visibility

© 2007 Pearson Education 17-440

 Use of Information
in a Supply Chain
 Information used at all phases of decision making:
strategic, planning, operational
 Examples:
– Strategic: location decisions
– Operational: what products will be produced during
today’s production run

© 2007 Pearson Education 17-441

 Use of Information
in a Supply Chain
 Inventory: demand patterns, carrying costs,
stockout 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.

© 2007 Pearson Education 17-442

 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

© 2007 Pearson Education 17-443

 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

© 2007 Pearson Education 17-444

 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

© 2007 Pearson Education 17-445

 Macro Processes in a Supply Chain
(Figure 16.1)

Supplier Internal Customer

Relationship Supply Chain Relationship
Management Management Management
(SRM) (ISCM) (CRM)

Transaction Management Foundation (TFM)

© 2007 Pearson Education 17-446

 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

© 2007 Pearson Education 17-447

 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
© 2007 Pearson Education 17-448
 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
© 2007 Pearson Education 17-449
 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

© 2007 Pearson Education 17-450

 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

© 2007 Pearson Education 17-451

 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

© 2007 Pearson Education 17-452

 Summary of Learning Objectives
 What is the importance of information and IT in the
supply chain?
 How does each supply chain driver use information?
 What are the major applications of supply chain IT
and what processes do they enable?

© 2007 Pearson Education 17-453

 Supply Chain Management
(3rd Edition)

Chapter 17
Coordination in the Supply Chain

© 2007 Pearson Education 16-454

 Objectives
 Describe supply chain coordination, the bullwhip
effect, and their impact on performance
 Identify causes of the bullwhip effect and obstacles to
coordination in the supply chain
 Discuss managerial levers that help achieve
coordination in the supply chain
 Describe actions that facilitate the building of strategic
partnerships and trust within the supply chain

© 2007 Pearson Education 16-455

 Outline
 Lack of Supply Chain Coordination and the
Bullwhip Effect
 Effect of Lack of Coordination on Performance
 Obstacles to Coordination in the Supply Chain
 Managerial Levers to Achieve Coordination
 Building Strategic Partnerships and Trust Within
a Supply Chain
 Achieving Coordination in Practice

© 2007 Pearson Education 16-456

 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

© 2007 Pearson Education 16-457

 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)

© 2007 Pearson Education 16-458

 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

© 2007 Pearson Education 16-459

 Obstacles to Coordination
in a Supply Chain
 Incentive Obstacles
 Information Processing Obstacles
 Operational Obstacles
 Pricing Obstacles
 Behavioral Obstacles

© 2007 Pearson Education 16-460

 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

© 2007 Pearson Education 16-461

 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

© 2007 Pearson Education 16-462

 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 lead times
 Rationing and shortage gaming (common in the
computer industry because of periodic cycles of
component shortages and surpluses)

© 2007 Pearson Education 16-463

 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

© 2007 Pearson Education 16-464

 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

© 2007 Pearson Education 16-465

 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

© 2007 Pearson Education 16-466

 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)

© 2007 Pearson Education 16-467

 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)

© 2007 Pearson Education 16-468

 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

© 2007 Pearson Education 16-469

 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

© 2007 Pearson Education 16-470

 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

© 2007 Pearson Education 16-471

 Building Strategic Partnerships
and Trust in a Supply Chain
 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

© 2007 Pearson Education 16-472

 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

© 2007 Pearson Education 16-473

 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

© 2007 Pearson Education 16-474

 Building Trust into a
Supply Chain Relationship
 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

© 2007 Pearson Education 16-475

 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

© 2007 Pearson Education 16-476

 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

© 2007 Pearson Education 16-477

 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

© 2007 Pearson Education 16-478

 Effects of Interdependence on Supply
Chain Relationships (Figure 17.4)

Partner Relatively High Level of

Organization’s Dependence

Powerful
Interdependence
High
Effective Relationship

Organization
Relatively Powerful
Low Low Level of
Interdependence

Low High

Partner’s Dependence
© 2007 Pearson Education 16-479
 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

© 2007 Pearson Education 16-480

 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

© 2007 Pearson Education 16-481

 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

© 2007 Pearson Education 16-482

 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

© 2007 Pearson Education 16-483

 Summary of Learning Objectives
 What are supply chain coordination and the bullwhip
effect, and what are their effects on supply chain
performance?
 What are the causes of the bullwhip effect, and what
are obstacles to coordination in the supply chain?
 What are the managerial levers that help achieve
coordination in the supply chain?
 What are actions that facilitate the building of
strategic partnerships and trust in the supply chain?

© 2007 Pearson Education 16-484