SCM Slides

Supply chain management
Session 1: Introduction
Course objectives
• The course would help students in:
• Understanding strategic role of supply chain.
• Understanding the drivers of supply chain performance.
• Understanding the challenges of logistics/ transportation/ network

planning and managing supply chains in India.
• Developing capabilities for analytical analysis of supply chains.
2/2/2021 Confidential - Prof. Vasanth Kamath 2

Course contents
MID-TERM & END-TERM
Weightage Duration Open / Close
Evaluation CLO Tested
(%) (Minutes) Book
End Term 60% 120 Closed Book
OTHER ASSESSMENTS:
S. Evaluation Unit of
Weight Time CLO
No. Item* Evaluation
1 Quiz1 individual 10% After 5th Session
4 Simulation group 10% 18-19th Session

Important
• No query is a stupid query, if you have any doubts please ask.
• Don’t type your answers or queries in the chat box unless told
to.

What Is a Supply Chain?
• A supply-chain consists of all parties involved, directly or indirectly,
in fulfilling a customer request.
• Includes manufacturers, suppliers, transporters, warehouses,

retailers, and customers
• Within each organization, the supply chain includes all functions

involved in receiving and fulfilling a customer request (new product
development, marketing, operations, distribution, finance,
customer service)
What Is a Supply Chain?
• Customer is an integral part of the supply chain
• Includes movement of products from suppliers to manufacturers to

distributors and information, and products in both directions

Automotive supply chain

Flows in a supply chain

How Supply Chain Management
has shifted business focus?
From cross-functional integration to cross enterprise integration
• Old question: How do we get the various functional areas of our
company to work together to supply product to our immediate
customers?
• New Question: How do we co-ordinate activities across companies
as well as internal functions, to supply products to the market?
The Supply-Chain Management Effect (mit.edu)

From Physical Efficiency to market mediation
• Old question: How to minimize costs our company incurs in
production and distribution of our products?
• New Question: How do we minimize the costs of matching supply
and demand while continuing to reduce the costs of production
and distribution?

From supply focus to demand focus
• Old question: How can we improve the way we supply product in
order to match supply and demand better given the demand
pattern?
• New Question: How can we get earlier demand information of
affect the demand pattern to match supply with demand?

From single company product design to collaborative concurrent product,
process and supply chain design.
• Old question: How should our company design products to
minimize product cost (our cost of materials, production and
distribution)?
• New Question: How should collaborators design the product,
process and supply chain to minimize the cost?

Objective of supply chain
• To maximize the net value generated.
• The net value generated by a supply chain is the difference between
what the value of the final product is to the customer and the costs of
the entire supply chain.
• Also called as supply chain surplus.
• The value of the final product will be different for different customers
and can be estimated from the maximum amount the customer is
willing to pay for it.
• The difference between the value of the product and its price is called
as consumer surplus
• Supply chain profitability is the difference between the revenue

generated from the customer and the overall cost across supply chain.

• A customer purchases a wireless router from Retailer for Rs. 2000
• Supply chain costs incurred (convey information, produce components,
storage, transportation, transfer funds, etc.)
• Difference between Rs 2000 and the sum of all these costs is the supply
chain profitability.

• Successful supply chains must be able to share the total profits across all
the supply chain stages and intermediaries.
• Higher the supply chain profitability, more successful is the supply chain.
• Supply chain success must be measured across entire supply chain and not
at an individual stage.

Decision phases in supply chain
• Supply chain strategy or design
• How to structure the supply chain over the next several years
• Supply chain planning
• Decisions over the next quarter or year
• Supply chain operation
• Daily or weekly operational decisions

Supply Chain Strategy or Design
• Strategic supply chain decisions
• Outsource supply chain functions
• 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 consider market uncertainty
Supply Chain Planning
• Definition of a set of policies that govern short-term operations
• Goal is to maximize supply chain surplus given established constraints
• Starts with a forecast of demand in the coming year
• Planning decisions:
• Which markets will be supplied from which locations?
• Planned buildup of inventories, Inventory policies
• Subcontracting
• Must consider demand uncertainty, exchange rates, competition over the
time horizon in planning decisions
Supply Chain Operation
• Time horizon is weekly or daily
• Decisions regarding individual customer orders
• Supply chain configuration is fixed, and planning policies are defined
• Goal is to handle incoming customer orders 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

Process views of supply chains
Cycle View: The processes in a supply chain are divided into a series of
cycles, each performed at the interface between two successive stages of
the supply chain.
Push/Pull View: The processes in a supply chain are divided into two
categories, depending on whether they are executed in response to a
customer order or in anticipation of customer orders.
Pull processes are initiated by a customer order, whereas push processes
are initiated and performed in anticipation of customer orders.

Cycle View of Supply Chain
Processes
Cycle View: The processes in a

supply chain are divided into a series
of cycles, each performed at the
interface between two successive
stages of the supply chain.

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

Push-pull View of Supply Chain
Processes

Supply Chain macro process
• Supply chain processes discussed in the two views can be classified into
• 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

Supply Chain macro process

Next Session:
Achieving strategic fit in a Supply Chain

Session 2: SC Performance
Competitive and Supply Chain strategies
• A company’s competitive strategy defines, relative to its
competitors, the set of needs that it seeks to satisfy through
its product or services.
• Example: Walmart – High availability at low prices.
• Competitive strategy is defined based on how the customer

prioritizes product cost, delivery time, variety, and quality.

Relation between competitive and SC
strategies
• Value chain
• To execute a company’s competitive strategy, all the

functions play a role and must develop its own strategy.
strategies
• 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, 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.

strategies
• Supply chain strategy includes a specification of the broad
structure of the supply chain and what may call “Supplier
strategy”, “operations strategy”, and “logistics strategy”.
• Example: Dell changed its strategy in 2007 from direct
selling to selling through resellers.

7-Eleven: functional strategies
• Marketing: convenience in the form
of easy access and availability of wide
range of products and services.
• NPD: constantly adding new products
and services.
• Operations and distribution: high
density of stores, being responsive
and providing excellent information
infrastructure.

7-Eleven: the outcome
• The result: a virtuous cycle in
which supply chain infrastructure
is exploited to offer new products
and services that increase
demand, making it easy for
operations to improve store
density and responsiveness in
replenishment and information
infrastructure.

Achieving Strategic Fit
• Strategic fit – competitive and supply chain strategies have
aligned 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.

Achieving Strategic Fit
1. The competitive strategy and all functional strategies must
fit together to form a coordinated overall strategy.
2. The different functions in a company must appropriately
structure their processes and resources to be able to
execute these strategies successfully.
3. The design of the overall supply chain and the role of each
stage must be aligned to support the supply chain
strategy.
How is strategic fit achieved ?
Understanding the customer and

supply chain uncertainty
Understanding the supply chain
Achieving strategic fit

Step 1: Understanding the Customer and
Supply Chain Uncertainty
Customers go for convenience and
not necessarily looking for lowest
price.
Customers go for low price. He/ She is

willing to tolerate less variety and
even purchase a large package size.

Understanding the Customer and Supply
Chain Uncertainty
Customer demand from different segments varies along several
attributes. Example: emergency order vs. regular.
1. Quantity of product needed in each lot
2. Response time customers will tolerate:
3. Variety of products needed
4. Service level required
5. Price of the product
6. Desired rate of innovation in the product
Understanding the Customer and Supply
Chain Uncertainty
Demand uncertainty – uncertainty of customer

demand for a product.
Implied demand uncertainty – demand uncertainty

imposed on the supply chain because of the
customer needs it seeks to satisfy.

Customer Needs and Implied Demand
Uncertainty
Customer Need Causes Implied Demand Uncertainty to …
Range of quantity required Increase because a wider range of the quantity
increases required implies greater variance in demand
Lead time decreases Increase because there is less time in which to
react to orders
Variety of products required Increase because demand per product becomes
increases more disaggregate
Number of channels through Increase because the total customer demand is
which product may be acquired now disaggregated over more channels
increases
Rate of innovation increases Increase because new products tend to have
more uncertain demand
Required service level increases Increase because the firm now has to handle
unusual surges in demand
Implied Uncertainty and Other Attributes
(Fisher, 1997)
• Products with uncertain demand are often less mature and have
less direct competition. As a result, margins tend to be high.
• Forecasting is more accurate when demand has less uncertainty.
• Increased implied demand uncertainty leads to increased difficulty
in matching supply with demand. For a given product, this dynamic
can lead to either a stockout or an oversupply situation.
• Markdowns are high for products with greater implied demand
uncertainty because oversupply often results.
Implied Uncertainty and Other Attributes
Low Implied High Implied
Uncertainty Uncertainty
Product margin Low High
Average forecast error 10% 40% to 100%
Average stock out rate 1% to 2% 10% to 40%
Average forced season-end markdown 0% 10% to 25%

Impact of Supply Source Capability
Supply Source Capability Causes Supply Uncertainty to...

Frequent breakdowns Increase
Unpredictable and low yields Increase
Poor quality Increase
Limited supply capacity Increase
Inflexible supply capacity Increase
Evolving production process Increase

Step 2: Understanding Supply Chain
Capabilities
• How does the firm best meet demand?
• Supply chain responsiveness is the ability to:
1. Respond to wide ranges of quantities demanded
2. Meet short lead times
3. Handle a large variety of products
4. Build highly innovative products
5. Meet a very high service level
6. Handle supply uncertainty
Understanding Supply Chain Capabilities
• Responsiveness comes at a cost
• Supply chain efficiency is the inverse to the cost of making
and delivering the product to the customer
• The cost-responsiveness efficient frontier curve shows the
lowest possible cost for a given level of responsiveness

Cost-Responsiveness Efficient Frontier

Responsiveness Spectrum

Step 3: Achieving Strategic Fit
• Ensure that the degree of supply chain responsiveness is
consistent with the implied uncertainty
• Assign roles to different stages of the supply chain that
ensure the appropriate level of responsiveness
• Ensure that all functions maintain consistent strategies that
support the competitive strategy

Zone of Strategic Fit

Efficient and Responsive Supply Chains
Efficient Supply Chains Responsive Supply Chains
Primary goal Supply demand at the lowest cost Respond quickly to demand
Product design Maximize performance at a Create modularity to allow postponement

strategy minimum product cost of product differentiation
Lower margins because price is a Higher margins because price is not a
Pricing strategy
prime customer driver prime customer driver
Manufacturing Lower costs through high Maintain capacity flexibility to buffer
strategy utilization against demand/supply uncertainty
Maintain buffer inventory to deal with
Inventory strategy Minimize inventory to lower cost
demand/supply uncertainty
Reduce, but not at the expense of Reduce aggressively, even if the costs are
Lead-time strategy
costs significant
Select based on speed, flexibility,
Supplier strategy Select based on cost and quality
reliability, and quality
Tailoring the Supply Chain
• Achieve strategic fit while serving many customer segments
with a variety of products across multiple channels
• Example: Levi Strauss selling both customized and standard-
sized jeans (low demand uncertainty).
• Requires sharing operations for some links in the supply chain
with some products, while having separate operations for
other links.

Changes Over Product Life Cycle
Beginning stages
1. Demand is very uncertain, and supply may be unpredictable
2. Margins are often high, and time is crucial to gaining sales
3. Product availability is crucial to capturing the market
4. Cost is often a secondary consideration

Changes Over Product Life Cycle
Later stages
1. Demand has become more certain, and supply is predictable
2. Margins are lower as a result of an increase in competitive pressure
3. Price becomes a significant factor in customer choice

Tailoring the Supply Chain
• Achieve strategic fit while serving many customer segments
with a variety of products across multiple channels
• Example: Levi Strauss selling both customized and standard-
sized jeans (low demand uncertainty).
• Requires sharing operations for some links in the supply chain
with some products, while having separate operations for
other links.

Supply Chain Levers to deal with uncertainty
• Capacity: Combination of excess capacity and flexible
capacity. Example: Asian paints
• Inventory: Holding inventory when demand is uncertain.
Example: Cars in a showroom
• Time: combination of speedy supply and willingness to wait
can help supply chain deal with uncertainty.
• Information: “Target” identifying pregnant women and
sending designed ads during second trimester.
• Price: Prices in airlines and hotels are higher in busy days.

Next Session:
Supply Chain Drivers and Metrics

Session 4: SC drivers and metrics
Impellers of supply chain
• The empowered customer: 1960-70 buyer vs. current buyer
• Development in information technology tools: ERP, MRP, VMI
• Globalization

Supply chain concepts
SCM philosophy is rooted in the following inter-related concepts
• Systems concept: emphasizes on interdependence not only

between functions of an organization, but also among
multiple organizations that collectively deliver products and
services to the customer.
• Total cost concept: The value delivered to the customer can

be maximized only if the total cost incurred by all the links in
the chain or network serving the customer is minimized.
Supply chain concepts
• Trade-off concept: allows the decision makers to explore
the possibilities of choosing among the alternatives or a
combination of alternatives to fulfil a supply chain objective
to minimize costs.

Financial measures of performance
• Return on Equity (ROE): measures the return on investment
made by the firm’s shareholders.
Net Income
ROE =
Average Shareholder Equity

• Return on assets (ROA) measures the return earned on
each dollar invested by the firm in assets
Earnings before interest
ROA =
Average Total Assets
Net Income + Interest Expense  (1 − Tax Rate)
=
Average Total Assets
• Return on financial leverage (ROFL) is the difference

between ROE and ROA
• Accounts payable turnover (APT): measures the speed at which
the company pays its suppliers.
Cost of Goods Sold

APT =
Accounts Payable
• ROA can be written as the product of two ratios – profit margin and
asset turnover
Earnings before interest SalesRevenue

ROA = 
Sales Revenue Total Assets
= Profit Margin  Asset Turnover
• Key components of asset turnover are accounts receivable turnover
(ART-Measures the ability to collect cash from customers);
inventory turnover (INVT); and property, plant, and equipment
turnover (PPET)
Sales Revenue Cost of Goods sold

ART = ; INVT = ;
Accounts Receivable Inventories
Sales Revenue
PPET =
PP & E

• Cash-to-cash (C2C) cycle roughly measures the average amount
time from when cash enters the process as cost to when it returns
as collected revenue
 1 
C2C = − Weeks Payable  
 APT 
 1 
+ Weeks in Inventory  
 INVT 
 1 
+ Weeks Receivable  
 ART 

Financial Data for Amazon and Nordstrom
(1 of 6)
Table 3-1 Selected Financial Data for Amazon.com and Nordstrom Inc.
Blank Amazon.com Nordstrom Inc.
Period Ending 31-Dec-13 2-Feb-13
Total Revenue 74,452,000 12,148,000
Cost of Goods Sold 54,181,000 7,432,000
Gross Profit 20,271,000 4,716,000
Selling, General, and Administrative 19,526,000 3,371,000
Operating Income or Loss 745,000 1,345,000
Total Other Income/Expenses Net –98,000 –
Earnings Before Interest and Taxes 647,000 1,345,000
Interest Expense 141,000 160,000
(2 of 6)
Table 3-1 [Continued]
Income Before Tax 506,000 1,185,000
Income Tax Expense 161,000 450,000
Minority Interest – –
Net Income 274,000 613,000
Assets Blank Blank
Cash and Cash Equivalents 8,658,000 1,285,000
Short-Term Investments 3,789,000 –
Net Receivables 4,767,000 2,356,000
Inventory 7,411,000 1,360,000
(3 of 6)
Other Current Assets – 80,000
Total Current Assets 24,625,000 5,081,000
Property, Plant, and Equipment (PP&E) 10,949,000 2,579,000
Goodwill 2,655,000 175,000
Other Assets 1,930,000 254,000
Total Assets 40,159,000 8,089,000
Liabilities and Stockholder Equity Blank Blank
Accounts Payable 21,821,000 1,415,000

(4 of 6)
Short-/Current Long-Term Debt – 7,000
Other Current Liabilities 1,159,000 804,000
Long-Term Debt 3,191,000 3,124,000
Other Liabilities 4,242,000 341,000
Deferred Long-Term Liability Charges – 485,000
Total Liabilities 30,413,000 6,176,000
Total Stockholder Equity 9,746,000 1,913,000

(5 of 6)
Table 3-2 A Comparison of Financial Metrics for Amazon.com and Nordstrom
Inc. [Assume tax rate of 0.35]
Metric Amazon.com Nordstrom Inc.
ROE start
274fraction 274 over 9,746 end fraction = 2.81% start
735fraction 735 over 1,913 end fraction =
= 2.81% 38.42%= 38.42%
9,746 1913
ROA start
274fraction (
+141274 1−+ 0.35 )
141 times left parenthesis 1 +160 735
start fraction
735 (1−+0.35 ) = 10.37%
160 times left parenthesis 1
= over
minus 0.35 right parenthesis 0.91% 40,159 end minus 0.35 over 8,089 = 10.37%
40,159
fraction = 0.91% 8,089
start fraction 274 + 141 times left parenthesis 1 start fraction 735 + 160 times left parenthesis 1
 (parenthesis
1− 0.35 ) over 74,452 end  (112,148
− 0.35= )6.91%
Profit Margin
274 +0.35
141 735 +0.35160over
minus right = 0.49% minus = 6.91%
fraction =74,452
0.49% 12,148
Asset Turnover start fraction 74,452 over 40,159 end fraction =
74,452 start fraction 12,148 over 8,089 end fraction =
12,148
1.85 = 1.85 1.50 = 1.50
40,159 8,089

(6 of 6)
Metric Amazon.com Nordstrom Inc.
APT 54,181
start fraction 54,181 over 21,821 end fraction = 7,432
start fraction 7,432 over 1,011 end fraction =
2.48 = 2.48 7.35 = 7.35
21,821 1,011
ART 74,452
start fraction 74,452 over 4,767 end fraction = start fraction 12,148 over 2,129 end fraction =
12,148
15.62 = 15.62 5.71 = 5.71
4,767 2,129
INVT 54,181
start fraction 54,181 over 7,411 end fraction = start
7,432fraction 7,432 over 1,360 end fraction =
7.31 = 7.31 5.46 = 5.46
7,411 1,360
PPET 74,452
start fraction 74,452 over 10,949 end fraction = 12,148
start fraction 12,148 over 2,579 end fraction =
6.80 = 6.80 4.71 = 4.71
10,949 2,579
C2C start1fraction negative
1 11over 2.48 end fraction + 1
start fraction 1
negative 11over 7.35 end fraction +
−start fraction
+ 1 over+15.62 end fraction + start −
start7.35
+
fraction 5.71
+
1 over 15.71
2.48 15.62 7.31 5.46end fraction + start
fraction 1 over 7.31 end fraction = negative 0.20 fraction 1 over 5.46 end fraction = 0.22 years =
=years
−0.20 = −10.53
years10.53
= negative weeks weeks = 0.22
11.56 weeksyears = 11.56 weeks
SG&A / Revenue 19,526
start fraction 19,526 over 74,452 end fraction = start3,371
fraction 3,371 over 12,148 end fraction =
26.23%
= 26.23% 27.75%
= 27.75%
2/25/2021
74,452 Confidential - Prof. Vasanth Kamath
12,148 15
Analysis
• In 2013, Nordstrom had a higher Return on Equity (ROE) of
38.42 % against Amazon’s 2.81%.
• A portion of it can be explained by a higher Return on Assets
(ROA) in case on Nordstrom (10.37%) vs. Amazon (0.91%)
• In 2013, Amazon’s Accounts Payable Turnover (APT) (2.48)
was much lower than Nordstrom’s (7.35), indicating that
Amazon was able to use the money it owed to suppliers to
finance a considerable amount of its operations.
Analysis
• This means that Amazon was able to finance its operations
for 52/2.48 = 20.97 weeks with its supplier’s money in
comparison to Nordstrom (7.07 weeks).
• In 2013, Nordstrom had a much higher profit margin
(6.91%) in comparison to Amazon (0.49%). This allowed
Nordstrom to have a higher ROA than Amazon.

Analysis
• Amazon had collected its money from sales relatively
quickly with Accounts Receivables Turnover (ART) (15.62)
in comparison to Nordstrom (5.71).
• Nordstrom was quick enough to turn around its inventory
as fast as Amazon (5.46 vs. 7.31).
• Property, plant and equipment turnover (PPET) was $6.80
per dollar invested for Amazon vs. $4.71 for Nordstrom.

Analysis
• With a cash to cash (C2C) cycle of -10.53 weeks, Amazon
collected its money from sale of products more than 10
weeks before it had to pay to suppliers.

Drivers of supply chain performance
The physical locations in the supply
Facilities chain network where product is stored,
assembled, or fabricated
All raw materials, work in process, and

Inventory finished goods within a supply chain
Moving inventory from point to

Transportation point in the supply chain

Drivers of supply chain performance
Data and analysis concerning facilities,
Information inventory, transportation, costs, prices, and
customers throughout the supply chain
Who will perform a particular supply chain

Sourcing activity
How much a firm will charge for the goods

Pricing and services that it makes available in the
supply chain

A Framework for Structuring Drivers

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)
• Large number of smaller facilities (responsiveness
priority)

Facilities
•Components of facilities decisions
–Capability
• Flexible, dedicated, or a combination of the two
• Product focus (fabrication and assembly) or a
functional focus (only assembly)
–Location
• Where a company will locate its facilities
• Centralize/decentralize, macroeconomic factors,
quality of workers, cost of workers and facility,
availability of infrastructure, proximity to customers,
location of other facilities, tax effects

Facilities
• Components of facilities decisions
• Capacity
• A facility’s capacity to perform its intended function
or functions
• Excess capacity – responsive, costly
• Little excess capacity – more efficient, less
responsive

Facilities: Overall trade-off
•Responsiveness versus efficiency
• Cost of the number, location, capacity, and type of
facilities (efficiency)
• Level of responsiveness
• Increasing number of facilities increases facility and
inventory costs, decreases transportation costs and
reduces response time
• Increasing the flexibility or capacity of a facility
increases facility costs, decreases inventory costs
and response time

Inventory
• Role in the Supply Chain
• Exists because of mismatch between supply and demand
• Satisfy demand
• High inventory facilitates a reduction in production and
transportation costs because of improved economies of scale
• Impacts assets, costs, responsiveness, material flow time

Inventory
• Material flow time, the time that elapses between the
point at which material enters the supply chain to the point
at which it exits
• Throughput, the rate at which sales occur
• Little’s law
I=RXT
Where,
I = Inventory, T = Flow Time, R = Throughput rate

Inventory
• Little’s law
I = R X T == I/R =T
R = 1/5 (people/ minute) T = 25 (minute)
2/25/2021
I = Inventory = 5 (people)
Confidential - Prof. Vasanth Kamath 29
Inventory
• If an Amazon warehouse holds 100,000 units in inventory and
sells 1,000 units daily
• I = 100,000 ; D = 1000
• Average unit will spend T = (I/D) = 100,000/1,000 = 100 days in

inventory (Little’s Law)
• Now, if Amazon were able to reduce flow time to 50 days while

holding throughput constant
• Inventory = 1000*50 = 50,000 units (Reduction in
Inventory)

Inventory
• Role in Competitive Strategy
• Form, location, and quantity of inventory allow a supply
chain to range from being very low cost to very responsive
• Objective is to have right form, location, and quantity of
inventory that provides the right level of responsiveness at
the lowest possible cost

Components of Inventory Decisions
Cycle inventory
• Average amount of inventory used to satisfy demand

between shipments
• Function of lot size decisions
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
Level of product availability

• The fraction of demand that is served on time from product
held in inventory
• Trade off between cost of inventory to increase product
availability and the loss from not serving customers on time.

• Sample Inventory-related metrics
• Average inventory: Average amount of inventory carried.
• Inventory turns: Number of times inventory turns over in a
year
• Fill Rate (for Order): measures the fraction of orders that is
met on time from inventory.
• Fraction of time out of stock (for SKU): measures fraction of
time that a particular SKU had zero inventory.
• Obsolete inventory (Specified Obsolescence Date): fraction of
inventory that is older than a specified obsolescence date.

Inventory
• Overall trade-off: Responsiveness versus efficiency
• Increasing inventory generally makes the supply chain more
responsive
• A higher level of inventory facilitates a reduction in
production and transportation costs because of improved
economies of scale
• Inventory holding costs increase

Transportation
• 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

Transportation
• Role in the Competitive Strategy
• Allows a firm to adjust the location of its facilities and
inventory to find the right balance between responsiveness
and efficiency
• Components of Transportation Decisions

• Design of transportation network
• Modes, locations, and routes
• Direct or with intermediate consolidation points
• One or multiple supply or demand points in a single run

Transportation
• Choice of transportation mode
• Air, truck, rail, sea, and pipeline
• Information goods via. the Internet
• Each mode has different characteristics based on speed,
size of shipments, cost of shipping, and flexibility

Transportation
• Sample Transportation-related metrics
• Average inbound/outbound transportation cost: measures
the cost of bringing the product into a facility. Usually
measured as a percentage of COGS.
• Average inbound/outbound shipment size: measures the
average number of units or dollars in each incoming/
outgoing shipment at a facility.

Transportation
• Overall trade-off: Responsiveness versus efficiency
• The cost of transporting a given product (efficiency) and the
speed with which that product is transported
(responsiveness)
• Using fast modes of transport raises responsiveness and
transportation cost but lowers the inventory holding cost

Information
• Improve the utilization of supply chain assets and the
coordination of supply chain flows to increase
responsiveness and reduce cost
• Information is a key driver that can be used to provide
higher responsiveness while simultaneously improving
efficiency

Information
• Right information can help a supply chain better meet
customer needs at lower cost
• Improves visibility of transactions and coordination of
decisions across the supply chain
• Share the minimum amount of information required to
achieve coordination

Components of Information Decisions
• Push versus Pull
–Different information requirements and uses
• Coordination and information sharing
–Supply chain coordination, all stages of a supply chain work
toward the objective of maximizing total supply chain
profitability based on shared information
• Sales and operations planning (S&OP)
–The process of creating an overall supply plan (production
and inventories) to meet the anticipated level of demand
(sales)

Information
• Overall trade-off: Complexity versus value
–Good information helps a firm improve both efficiency
and responsiveness
–More information is not always better
–More information increases complexity and cost of both
infrastructure and analysis exponentially while marginal
value diminishes
–Evaluate the minimum information required to
accomplish the desired objectives

Sourcing
• Set of business processes required to purchase goods and
services
• Will tasks be performed by a source internal to the
company or a third party
• Globalization creates many more sourcing options with
both considerable opportunity and potential risk

Sourcing
• Sourcing decisions are crucial because they affect the level
of efficiency and responsiveness in a supply chain
• Outsource to responsive third parties if it is too expensive to
develop their own
• Keep responsive process in-house to maintain control

Components of Sourcing Decisions
In-house or • Perform a task in-house or outsource it to a

outsource third party
Supplier • Number of suppliers, evaluation and selection

selection criteria, direct negotiations or auction
• The supplier sends product in response to

Procurement customer orders

Components of Sourcing Decisions
• Sample Sourcing-related metrics
• Average purchase price: average price at which the goods
or service is purchased during a year.
• Supply quality: measures the quality of the product
supplied.
• Supply lead time: measures average time between an
order placed and the product arrival.
• Fraction of on-time deliveries: fraction of deliveries from
the supplier that were on time.
• Supplier reliability: measures the variability of the
supplier’s lead time as well as the delivered quantity
relative to a plan.
Pricing
• Pricing determines the amount to charge customers for
goods and services
• Affects the supply chain level of responsiveness required
and the demand profile the supply chain attempts to serve
• Pricing strategies can be used to match demand and supply

Pricing
• Firms can utilize optimal pricing strategies to improve
efficiency and responsiveness
• Pricing strategies vary to meet different customer
responsiveness requirements

Components of Pricing Decisions
• Pricing and economies of scale
• The provider of the activity must decide how to price it
appropriately to reflect these economies of scale
• Everyday low pricing versus high-low pricing
• Different pricing strategies lead to different demand
profiles that the supply chain must serve
• Fixed price versus menu pricing
• If marginal supply chain costs or the value to the
customer vary significantly along some attribute, it is
often effective to have a pricing menu

Pricing
• Overall trade-off: Increase firm profits
• Understand the cost structure of performing a supply chain
activity and the value this activity brings to the supply
chain
• Strategy may support efficiency in the supply chain, lower
supply chain costs, defend market share, or steal market
share
• Differential pricing may be used to attract customers with
varying needs
• Strategy should help either increase revenues or shrink
costs or preferably both

Next Session:
Designing Distribution Networks

Session 5: Designing distribution
networks
Distribution Network Design 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
• Drives profitability by directly affecting supply chain cost and the

customer value
• Choice of distribution network can achieve supply chain objectives

from low cost (Walmart) to high responsiveness (7-eleven)

Factors Affecting Distribution Network
Design (1 of 3)
• Distribution network performance evaluated along two
dimensions
• Value provided to the customer
• Cost of meeting customer needs
• Profitability of the delivery network determined by revenue

from met customer needs and network costs

Design (2 of 3)
• Service factors:
• Response time: time to receive an order by customer
• Product variety: different product configurations offered
• Product availability: probability of fulfilling an order
• Customer experience: ease of placing/ receiving orders
• Time to market: time to bring a new product to market
• Order visibility: ability to track the orders
• Returnability: ability to return unsatisfactory goods

Design (3 of 3)
• Cost factors:
• Inventories
• Transportation
• Facilities
• Information

Desired Response Time and Number of
Facilities
Notes: Increasing the number of
facilities moves firms closer to the
end consumer. This reduces the
response time.
Amazon has built warehouses, the
average time from the warehouse to
the end consumer has decreased.
McMaster-Carr provides 1–2-day
coverage of most of the U.S from 6
facilities.
W.W. Grainger can increase coverage
to same day delivery using about 370
facilities.

Inventory Costs and Number of Facilities
Amazon can turnaround its inventory about twice as frequently as Barnes & Noble
because it has far fewer facilities.

Transportation Costs and Number of Facilities
Notes: Amazon warehouse receives
FTL shipments on the inbound side,
but ships small packages on outbound
side.
Increasing number of warehouse
locations decreases the average
outbound distance .
As long as inbound transportation
economies of scale are maintained,
increasing number of facilities
decreases total transportation costs.
With increase in facilities, the
inbound sizes become small and
effect economies of scale and
increase cost.

Facility Costs and Number of Facilities
Barnes & Noble has higher facility costs as they have many facilities in comparison to
Amazon.
Logistics Cost, Response Time, and Number of
Facilities
Notes: As the number of facilities
increases, total logistics costs
decrease, and then increase.
If a firm wants to reduce the response
time, then it may have to increase the
number of facilities beyond the point
that minimizes the logistics cost.
Total logistics costs are the sum of inventory, transportation, and facility costs for a supply
chain network.
Design Options for a Distribution Network
(1 of 2)
• Distribution network choices from the manufacturer to the

end consumer
• Managers make two key decisions
• Will product be delivered to the customer location or
picked up from a prearranged site?
• Will product flow through an intermediary (or
intermediate location)?
Design Options for a Distribution Network
(2 of 2)
• One of six designs may be used
1. Manufacturer storage with direct shipping
2. Manufacturer storage with direct shipping and in-transit
merge
3. Distributor storage with carrier delivery
4. Distributor storage with last-mile delivery
5. Manufacturer/distributor storage with customer pickup
6. Retail storage with customer pickup

Manufacturer Storage with Direct Shipping:
Drop-shipping
Online retailers such as E-Bags,
Nordstrom.com, W.W. Grainger
use drop-shipping to deliver
goods to the end consumer. E-
Bags holds few bags in
inventory.
Nordstrom carries some
products in inventory and uses
the drop-ship model for slow-
moving footwear
In India, Indiamart, Justdial,
Shopify.in use this model.

Manufacturer Storage with Direct Shipping
Network (1 of 2)
Performance Characteristics of Manufacturer Storage with Direct Shipping Network
Cost Factor Performance
Inventory Lower costs because of aggregation.
Transportation Higher transportation costs because of increased distance and
disaggregate shipping.
Facilities and Lower facility costs because of aggregation.
handling
Information Significant investment in information infrastructure to
integrate manufacturer and retailer.

Manufacturer Storage with Direct Shipping
Network (2 of 2)
Performance Characteristics of Manufacturer Storage with Direct Shipping Network
Service Factor Performance
Response time Long response time of one to two weeks because of increased
distance and two stages for order processing
Product variety Easy to provide a high level of variety.
Product availability Easy to provide a high level of product availability because of
aggregation at manufacturer.
Customer experience Good in terms of home delivery but can suffer if order from several
manufacturers is sent as partial shipments.
Time to market Fast, with the product available as soon as the first unit is produced.
Order visibility More difficult but also more important from a customer service
perspective.
Returnability Expensive and difficult to implement.

In-Transit Merge Network
In-transit merge has been used
by Dell and can be used by
companies implementing drop-
shipping.
Apple in Europe: Computers
are shipped from China,
whereas the other accessories
come from a different location
to the Apple DC and then sent
as a single delivery to the
customer.

In-Transit Merge (1 of 2)
Performance Characteristics of In-Transit Merge

Inventory Similar to drop-shipping.
Transportation Somewhat lower transportation costs than drop-shipping.
Facilities and handling Handling costs higher than drop-shipping at carrier;
receiving costs lower at customer.
Information Investment is somewhat higher than for drop-shipping.

In-Transit Merge (2 of 2)
Performance Characteristics of In-Transit Merge

Response time Similar to drop-shipping; may be marginally higher.
Product variety Similar to drop-shipping.
Product availability Similar to drop-shipping.
Customer Better than drop-shipping because only a single delivery is
experience received.
Time to market Similar to drop-shipping.
Order visibility Similar to drop-shipping.
Returnability Similar to drop-shipping.

Distributor Storage with Carrier Delivery
Makes sense for products with somewhat higher demand.

Seen by both Amazon and W.W. Grainger
Distributor Storage with Carrier Delivery (1 of 2)
Performance Characteristics of Distributor Storage with Carrier Delivery

Inventory Higher than manufacturer storage.
Transportation Lower than manufacturer storage.
Facilities and Somewhat higher than manufacturer storage.
handling
Information Simpler infrastructure compared to manufacturer
storage.

Distributor Storage with Carrier Delivery (2 of 2)
Performance Characteristics of Distributor Storage with Carrier Delivery

Response time Faster than manufacturer storage.
Product variety Lower than manufacturer storage.
Product availability Higher cost to provide the same level of availability as
manufacturer storage.
Customer Better than manufacturer storage with drop-shipping.
experience
Time to market Higher than manufacturer storage.
Order visibility Easier than manufacturer storage.
Returnability Easier than manufacturer storage.

Distributor Storage with Last Mile Delivery
Note: Reliance Digital procures TV from

companies like Samsung, LG, Philips, etc and
ships them via. 3PL carrier.

Distributor Storage with Last Mile Delivery (1 of
2)
Performance Characteristics of Distributor Storage with Last-Mile Delivery
Inventory Higher than distributor storage with package carrier
delivery.
Transportation Very high cost given minimal scale economies. Higher than
any other distribution option.
Facilities and handling Facility costs higher than manufacturer storage or
distributor storage with package carrier delivery, but lower
than a chain of retail stores.
Information Similar to distributor storage with package carrier delivery.

Distributor Storage with Last Mile Delivery (2 of
2)
Performance Characteristics of Distributor Storage with Last-Mile Delivery
Response time Very quick. Same day to next-day delivery.
Product variety Somewhat less than distributor storage with package carrier delivery
but larger than retail stores.
Product availability More expensive to provide availability than any other option except
retail stores.
Customer experience Very good, particularly for bulky items.
Time to market Slightly longer than distributor storage with package carrier delivery.
Order visibility Less of an issue and easier to implement than manufacturer storage
or distributor storage with package carrier delivery.
Returnability Easier to implement than other previous options. Harder and more
expensive than a retail network.
Manufacturer or Distributor Storage with
Customer Pickup
Walmart’s “Site to
Store” facility

Customer Pickup (1 of 2)
Performance Characteristics of Network with Customer Pickup Sites

Inventory Can match any other option, depending on the location of
inventory.
Transportation Lower than the use of package carriers, especially if using
an existing delivery network.
Facilities and handling Facility costs can be high if new facilities have to be built.
Costs are lower if existing facilities are used.
Information Significant investment in infrastructure required.

Customer Pickup (2 of 2)
Performance Characteristics of Network with Customer Pickup Sites
Response time Similar to package carrier delivery with manufacturer or distributor
storage. Same-day pickup is possible for items stored at regional DC.
Product variety Similar to other manufacturer or distributor storage options.

Product availability Similar to other manufacturer or distributor storage options.
Customer experience Lower than other options because of the lack of home delivery.
Experience is sensitive to capability of pickup location.
Time to market Similar to manufacturer or distributor storage options.

Order visibility Difficult but essential.
Returnability Somewhat easier, given that pickup location can handle returns.

Retail Storage with Customer Pickup

Retail Storage with Customer Pickup (1 of 2)
Performance Characteristics of Retail Storage with Customer Pickup Sites

Inventory Higher than all other options.
Transportation Lower than all other options.
Facilities and handling Higher than other options.
Information Some investment in infrastructure required for online and
phone orders.

Retail Storage with Customer Pickup (2 of 2)
Performance Characteristics of Retail Storage with Customer Pickup Sites
Response time Same-day (immediate) pickup possible for items stored locally
at pickup site.
Product variety Lower than all other options.
Product availability More expensive to provide than all other options.
Customer experience Related to whether shopping is viewed as a positive or
negative experience by customer.
Time to market Highest among distribution options.
Order visibility Trivial for in-store orders. Difficult, but essential, for online and
phone orders.
Returnability Easier than other options because retail store can provide a
substitute.
Next Session:
Designing Distribution Networks

Session 6: Blue Nile & diamond
retailing
Description
• The case highlights the supply chain structures and performances of
three firms in the diamond retailing industry: Blue Nile, Zales, and
Tiffany.
• Blue Nile’s supply chain structure is geared toward a pure centralized e-
business
• Zales sells merchandise primarily through stores but recently added an

online channel
• Tiffany also uses an online channel but most of its diamond and other
high-end products are sold through stores.

What are some key success factors in
diamond retailing? How do Blue Nile,
Zales, and Tiffany compare on those
dimensions? How do they compare on
various financial measures discussed in
Chapter 3?

Key success factors
Customer service factors Cost factors

• Response time • Inventories
• Product variety • Transportation
• Product availability • Facilities
• Customer experience • Information
• Time to market
• Order visibility
• Returnability

Blue Nile Zales Tiffany
Product variety High:"Build their own ring" by Limited variety available at the Limited variety available at the
choosing from an inventory over store store
125,000 stones
Brand image Moderate Low Very High: Established brand,
associated with glamour, trust and
customer service
Product prices Moderate Low Very High: sells the jewelry at a
premium. Customer to trade off
other factors for Tiffany experience
Production Make to order system: clients Make to Stock system Make to stock system
system willing to wait to receive the
orders
Mode of Online purchase: low pressure Offline purchase, but Offline purchase: Customers would
purchase purchase, educational website, omnichannel since 2014 like to see and feel what they are
salaried support staff, 30-day buying as the items are very costly.
return guarantee.
Inventory Single warehouse in the US, Low Multiple stores in the US, high Multiple stores in the US, high
inventoy of costly, slow moving inventory of costly, slow moving inventory of costly, slow moving
items items items
Transportation Higher, totally inbound Low, economies of scale can be Low, economies of scale can be
costs realized via. Inbound logistics, realized via. Inbound logistics,
outbound taken care by the outbound taken care by the
customers customers
People 3/17/2021
costs Low High - Prof. Vasanth Kamath
Confidential High 5
Calculate financial performance metrics and compare for the three companies

What do you think of the fact that Blue Nile
carries many stones priced at $2,500 or higher
whereas almost 60 percent of the products
sold from the Tiffany website are priced
around $200? Which of the two product
categories is better suited to the online
channel?

What do you think of Tiffany’s decision to not
sell engagement rings online? What do you
think of Blue Nile’s growth into the non-
engagement category?

Given that Tiffany stores have thrived with
their focus on selling high-end jewelry, what
do you think caused the failure of Zales
upscale strategy in 2006? What products
should Zales focus on?

Which of the three companies do you think
was best structured to deal with weak
economic times?

What advice would you give to each of the
three companies regarding their strategy and
structure? How can they best use omni-
channel retail?

Next Session:
Network Design in the Supply Chain

Session 7: Network design in SC
Network Design Decisions (NDD)
• Facility role
• What role, what processes?
• Facility location
• Where should facilities be located?
• Capacity allocation
• How much capacity at each facility?
• Market and supply allocation
• Which markets? Which supply sources?

Factors Influencing NDD
• Strategic factors
• Technological factors
• Macroeconomic factors
• Tariffs and tax incentives/ Exchange-rate and demand risk/
Freight and fuel costs
• Political factors
• Infrastructure factors
• Competitive factors
• Positive externalities between firms/ Locating to split the
market
• Customer response time and local presence
• Logistics and facility costs
Framework for NDD
• Phase I: Define a Supply Chain Strategy/Design
• Clear definition of the firm’s competitive strategy
• Forecast the likely evolution of global competition
• Identify constraints on available capital
• Determine growth strategy

Framework for NDD

Framework for NDD
• Phase II: Define the Regional Facility Configuration
• Forecast of the demand by country or region
• Economies of scale or scope
• Identify demand risk, exchange-rate risk, political risk,
tariffs, requirements for local production, tax incentives,
and export or import restrictions
• Identify competitors

Framework for NDD
• Phase III: Select a Set of Desirable Potential Sites
• Hard infrastructure requirements
• Soft infrastructure requirements
• Phase IV: Location Choices

Models for designing a regional
network configuration
• To obtain a regional network configuration while accounting for
demand and costs at a regional level.

Example 1: Sun-Oil
• Sun-Oil is a manufacturer of petrochemical products with worldwide sales.
The Vice President of supply chain is considering several options to meet
demand. Views the worldwide demand in five regions—North America,
South America, Europe, Africa, and Asia.
• There are fixed as well as variable costs associated with facilities,
transportation, and inventories at each facility
• Sun-Oil is considering two plant sizes in each location.
• Low-capacity plants can produce 10 million units a year, and High-capacity
plants can produce 20 million units a year.
• High-capacity plants exhibit some economies of scale and have fixed costs
that are less than twice the fixed costs of a low-capacity plant. All fixed
costs are annualized.
• The vice president is looking for the lowest-cost network.

Example 1: Sun-Oil

Capacitated Plant Location Model
subject to
n
x
i =1
ij = D j for j = 1,..., m
n n m
Minå f i yi + å åc x m
i=1 i=1 j=1

ij ij xj =1
ij  K i yi for i = 1,..., n
yi  0,1 for i = 1,..., n, x ij  0
n = number of potential plant locations/capacity yi = 1 if plant i is open, 0 otherwise

m = number of markets or demand points xij = quantity shipped from plant i to market j
D j = annual demand from market j
K i = potential capacity of plant i
f i = annualized fixed cost of keeping plant i open
cij = cost of producing and shipping one unit from plant i to market j (cost includes production,
inventory, transportation, and tariffs)





Models for identifying potential
sites in a region
• Having obtained a regional configuration, next challenge is to identify
potential location in each region to locate the plant.
• Gravity models are used to find locations that minimize the cost of
transporting raw materials from suppliers and finished goods to the
markets served.

Example 2: Steel Appliances (SA)
• Steel Appliances (SA) is a manufacturer of high-quality refrigerators and
cooking ranges. SA has one assembly factory located near Denver, from
which it has supplied the entire United States. Demand has grown rapidly
and the CEO of SA has decided to set up another factory to serve its eastern
markets.
• The supply chain manager is asked to find a suitable location for the new
factory. Three parts plants are located in Buffalo, Memphis, and St. Louis, will
supply parts to the new factory, which will serve markets in Atlanta, Boston,
Jacksonville, Philadelphia, and New York.
• The coordinate location, the demand in each market, the required supply
from each parts plant, and the shipping cost for each supply source or
market are shown in Table.

Gravity Location Model
xn, yn: coordinate location of either a market or supply source n
Fn: cost of shipping one unit for one mile between the facility and either
market or supply source n
Dn: quantity to be shipped between facility and market or supply source n
(x, y) is the location selected for the facility, the distance dn between the
facility at location (x, y) and the supply source or market n is given by
(x – x ) + ( y – y )
2 2
dn = n n

Transportation Cost Quantity in Tons Coordinates
Sources/Markets $/Ton Mile (Fn) (Dn) xn yn
Supply sources
Buffalo 0.90 500 700 1,200
Memphis 0.95 300 250 600
St. Louis 0.85 700 225 825
Markets
Atlanta 1.50 225 600 500
Boston 1.50 150 1,050 1,200
Jacksonville 1.50 250 800 300
Philadelphia 1.50 175 925 975
New York 1.50 300 1,000 1,080
k
Total transportation cost TC = å d n Dn Fn
n=1


Models for demand allocation and
plant allocation
• Having obtained the potential sites, a manager must decide on the
location and capacity allocation of each facility.
• Besides locating the facilities, the manager also decides how the
demand from each market is to be allocated to the facilities.

Example 3: Telecom-One &High-Optic
• Telecom-One has focused on the eastern half of the United States. It has
manufacturing plants located in Baltimore, Memphis, and Wichita and
serves markets in Atlanta, Boston, and Chicago
• High-Optic has targeted the western half of the United States and serves
markets in Denver, Omaha, and Portland from plants located in
Cheyenne and Salt Lake City.
• Plant capacities, market demand, variable production and transportation
cost per thousand units shipped, and fixed costs per month at each plant
are shown in the following table.
• If the two companies plan to merge, should they be continuing to serve
the existing markets as it is or is redesigning an effective option ?

Network Optimization Models
• Allocating demand to production facilities
n m subject to
Minå å cij xij n
i=1 j=1 x
i =1
ij = D j for j = 1,..., m
m
xj =1
ij = K i for i = 1,..., n
n = number of factory locations

m = number of markets or demand points xij = quantity shipped from factory i to market j
D j = annual demand from market j
K i = capacity of factory i
cij = cost of producing and shipping one unit from factory i to market j

Demand City
Monthly
Production and Transportation Cost
Capacity Monthly Fixed
per Thousand Units (Thousand $)
(Thousand Cost (Thousand
Supply City Atlanta Boston Chicago Denver Omaha Portland Units) K $) f
Baltimore 1,675 400 985 1,630 1,160 2,800 18 7,650
Cheyenne 1,460 1,940 970 100 495 1,200 24 3,500
Salt Lake 1,925 2,400 1,450 500 950 800 27 5,000
City
Memphis 380 1,355 543 1,045 665 2,321 22 4,100
Wichita 922 1,646 700 508 311 1,797 31 2,200
Monthly 10 8 14 6 7 11
demand
(thousand
units) Dj

• Optimal demand allocation
Atlanta Boston Chicago Denver Omaha Portland
TelecomOne Baltimore 0 8 2
Memphis 10 0 12
Wichita 0 0 0
HighOptic Salt Lake 0 0 11
Cheyenne 6 7 0

• Merge the companies
• Solve using location-specific costs
yi = 1 if factory i is open, 0 otherwise
xij = quantity shipped from factory i to market j
n n m
Minå f i yi + å åc x ij ij
i=1 i=1 j=1





Total Cost
(Thousand $ )
High-Optic 21365
Telecom-One 28836
Total cost before merger (High-Optic & Telecom-One) 50201
Total cost after merger with plant shutdowns 47401

Making NDD in Practice
• Do not underestimate the life span of facilities
• Do not gloss over the cultural implications
• Do not ignore quality-of-life issues
• Focus on tariffs and tax incentives when locating facilities

Next Session:
Network Design in the Supply Chain

Session 8-9: Designing Global
SC Networks
Impact of Globalization on SC Networks
Opportunities to simultaneously increase revenues and decrease
costs. Example: Apparel industry, Bangladesh
Accompanied by significant additional risk and uncertainty. Example:

Tsunami of 2011 disrupting Toyota production.
Difference between success and failure is often the ability to

incorporate suitable risk mitigation into supply chain design. Example:
Crocs Clogs
Uncertainty of demand and price drives the value of building flexible

production capacity. Example: Honda car plant producing small cars.
Importance of Total Cost
• Offshoring to low-cost countries.
• While seen as an advantage for some companies, others have
not been able to see the benefits.
• Example: Rising transportation costs has significant negative
impact on the benefits of offshoring.
• Two reasons offshoring fails
1. Focusing exclusively on unit cost rather than total cost
2. Ignoring critical risk factors

The Offshoring Decision: Total Cost
• A global supply chain with offshoring increases the length
and duration of information, product, and cash flows.
• The complexity and cost of managing the supply chain can be
significantly higher than anticipated.
• Big challenges with offshoring is increased risk and its
potential impact on cost.
• Quantify factors and track them over time.

Key elements of total cost
• Companies should evaluate the impact of off-shoring on the
following key elements
• Supplier price: should link to costs from direct materials, direct
and indirect labor, management, overhead, local taxes etc.
• Terms: costs are also affected by net payment terms and
volume discounts
• Delivery costs: include in-country transportation, and freight.
• Inventory and warehousing includes inventory keeping and
handline
• Cost of quality includes cost of validation; performance drop
due to poor quality and repair and rework.

• Customer duties, value added-taxes, local tax incentives
• Cost of risk, procurement staff, broker fees, infrastructure, and
tooling and mold costs
• Exchange rate trends and their impact on cost

• It is critical that global sourcing decisions be made while
accounting for total cost.
• Besides unit cost, total cost should include the impact of
global sourcing on freight, inventories, lead time, quality, on-
time delivery, minimum order quantity, working capital, and
stockouts.
• Other factors to be considered include the impact on supply
chain visibility, order communication, and invoicing errors.
• Offshoring typically lowers labor and fixed costs but increases
risk, freight costs, and working capital.

• In general, offshoring to low-cost countries is likely to be most
attractive for products with high labour content, large
production volumes, relatively low variety, and low
transportation costs relative to product value.

Risk Management in Global SC
• Risks include supply disruption, supply delays, demand
fluctuations, price fluctuations, and exchange-rate
fluctuations
• Critical for global supply chains to be aware of the relevant
risk factors and build in suitable mitigation strategies

Category Risk Drivers
Disruptions Natural disaster, war, terrorism, Labor disputes,

Supplier bankruptcy
Delays High-capacity utilization at supply source, Inflexibility of

supply source, Poor quality or yield at supply source
Systems risk Information infrastructure breakdown, System integration or

extent of systems being networked.
Forecast risk Inaccurate forecasts due to long lead times, seasonality,

product variety, short life cycles, small customer base
Information distortion

Category Risk Drivers
IP risk Vertical integration of SC, Global outsourcing and markets
Procurement Exchange-rate risk, Price of inputs, Fraction purchased from

risk a single source, Industry-wide capacity utilization
Receivable Number of customers, Financial strength of customers

risk
Inventory risk Rate of product obsolescence, Inventory holding cost,

Product value, Demand and supply uncertainty
Capacity risk Cost of capacity, capacity flexibility

• Good network design can play a significant role in mitigating
supply chain risk
• Every mitigation strategy comes at a price and may increase
other risks
• Global supply chains should generally use a combination of
rigorously evaluated mitigation strategies along with financial
strategies to hedge uncovered risks

Tailored Risk Mitigation Strategies During Network Design
Risk Mitigation Tailored Strategies
Strategy
Increase Focus on low-cost, decentralized capacity for predictable

capacity demand. Build centralized capacity for unpredictable
demand. Increase decentralization as cost of capacity drops.
Get redundant More redundant supply for high-volume products, less

suppliers redundancy for low-volume products. Centralize redundancy
for low-volume products in a few flexible suppliers.
Increase Favor cost over responsiveness for commodity products.

responsiveness Favor responsiveness over cost for short–life cycle products.
Tailored Risk Mitigation Strategies During Network Design
Increase Decentralize inventory of predictable, lower value products. Centralize
inventory inventory of less predictable, higher value products.
Increase Favor cost over flexibility for predictable, high-volume products. Favor
flexibility flexibility for unpredictable, low-volume products. Centralize flexibility
in a few locations if it is expensive.
Pool or Increase aggregation as unpredictability grows.

aggregate
demand
Increase Prefer capability over cost for high-value, high-risk products. Favor cost
source over capability for low-value commodity products. Centralize high
capability capability in flexible source if possible.

Flexibility : Chaining, and Containment
▪ Three broad categories of flexibility
▪ New product flexibility
▪ Ability to introduce new products into the market at a
rapid rate
▪ Mix flexibility
▪ Ability to produce a variety of products within a short
period of time
▪ Volume flexibility
▪ Ability to operate profitably at different levels of
output

Flexibility : Chaining, and Containment
Different Flexibility Configurations in Network

Discounted Cash Flow Analysis
• Supply chain decisions should be evaluated as a sequence of
cash flows over time
• 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

Discounted Cash Flow Analysis
1
discount factor =
1+ k
T æ t
1 ö
NPV = C0 + åç ÷ Ct
t=1 è 1+ k ø
where
C0, C1,…,CT is stream of cash flows over T periods
NPV = net present value of this stream
k = rate of return
• Compare NPV of different supply chain design options

• The option with the highest NPV will provide the greatest
financial return
Example: Total Cost of Ownership Model
Cost Elements Cost Measures for 1,000 PCs
Purchase price:
• Hardware • $1,200/PC – supplier quote
• Software licenses A, B, and C • $450/PC – supplier quotes (3)
Acquisition costs:
• Sourcing • 2 FTE employees @ $85K and $170K for 2 months
• Administration • 1 P.O. @ $150, 12 invoices each year(for 3 yrs) @ $40 each
Usage costs:
• Installation • $700/PC
• Equipment support • $120/month/PC payable annually – supplier quote
• Network support • $100/month/PC payable annually– supplier quote
• Warranty • $120/PC for 3-year warranty
• Opportunity cost – lost • Downtime: 15 hours/PC/year @ $30/hour
productivity
End-of-life costs
• Salvage value • $36/PC
Cost Elements Present Year 1 Year 2 Year 3
Purchase price:
• Hardware 1200000
• Software licenses A, B, and C 450000
Acquisition costs:
• Sourcing 42500
• Administration 150 480 480 480
Usage costs:
• Installation 700000
• Equipment support 1440000 1440000 1440000
• Network support 1200000 1200000 1200000
• Warranty 120000
• Opportunity cost – lost productivity 450000 450000 450000
End-of-life costs
• Salvage value -36000
Total 2512650 3090480 3090480 3054480
Present Value @ 12% 2512650 2759357 2463712 2174119
Total Cost of ownership 99,09,837.41
Example: Trips Logistics
• Trips Logistics, a third-party logistics firm that provides
warehousing and other logistics services, is facing a decision
regarding the amount of space to lease for the upcoming
three-year period.
• The general manager has forecast that Trips Logistics will
need to handle a demand of 100,000 units for each of the
next three years.
• Historically, Trips Logistics has required 1,000 square feet of
warehouse space for every 1,000 units of demand.
• Trips Logistics receives revenue of $1.22 for each unit of
demand.

• The general manager must decide whether to sign a three-
year lease or obtain warehousing space on the spot market
each year.
• The three-year lease will cost $1 per square foot per year,
and the spot market rate is expected to be $1.20 per square
foot per year for each of the three years. Trips Logistics has a
discount rate of k = 0.1.

• Demand = 100,000 units
• 1,000 sq. ft. of space for every 1,000 units of demand
• Revenue = $1.22 per unit of demand
• 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.
• Discount rate k = 0.1

Expected annual profit if warehouse space is = 100,000 x $1.22
obtained from the spot market – 100,000 x $1.20
= $2,000
C1 C2
NPV(No lease) = C0 + +
1+ k (1+ k)2
2,000 2,000
= 2,000 + + 2
= $5,471
1.1 1.1

Expected annual profit with three- = 100,000 x $1.22
year lease – 100,000 x $1.00
= $22,000
C1 C2
NPV(Lease) = C0 + +
1+ k (1+ k)2
22,000 22,000
= 22,000 + + 2
= $60,182
1.1 1.1
• NPV of signing lease is $60,182 – $5,471 = $54,711 higher

than spot market
Trips Logistics - Uncertainty
• The manager must decide whether to lease warehouse
space for the coming three years and the quantity to lease.
• The manager anticipates uncertainty in demand and spot
prices for warehouse space over the coming three years.
• The long-term lease is cheaper, but the space could go
unused if demand is lower than anticipated. The long-term
lease may also end up being more expensive if future spot
market prices come down.

• The manager is considering 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 charge that allows
variable usage of warehouse space up to a limit, with
additional requirements from the spot market.

• One thousand square feet of warehouse space is required
for every 1,000 units of demand, and the current demand at
Trips Logistics is for 100,000 units per year.
• The manager forecasts that from one year to the next,
demand may go up by 20 percent, with a probability of 0.5,
or go down by 20 percent, with a probability of 0.5.
• The general manager can sign a three-year lease at a price
of $1 per square foot per year. Warehouse space is currently
available on the spot market for $1.20 per square foot per
year. From one year to the next, spot prices for warehouse
space may go up by 10 percent, with probability 0.5, or go
down by 10 percent, with probability 0.5.
Using Decision Trees
• Many different decisions
–Should the firm sign a long-term contract for warehousing
space or get space from the spot market as needed?
–What should the firm’s mix of long-term and spot market be
in the portfolio of transportation capacity?
–How much capacity should various facilities have? What
fraction of this capacity should be flexible?

Basics: Decision Tree Analysis
• A decision tree is a graphic device used to evaluate decisions
under uncertainty
• Identify the number and duration of time periods that will
be considered
• Identify factors that will affect the value of the decision and
are likely to fluctuate over the time periods
• Evaluate decision using a decision tree

Methodology: Decision Tree Analysis
1. Identify the duration of each period (month, quarter, etc.)
and the number of periods T over which the decision is to
be evaluated
2. Identify factors whose fluctuation will be considered
3. Identify representations of uncertainty for each factor
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

Trips Logistics -1st Case: Spot Market
• 1000 sq. ft. of warehouse space needed for 1000 units of
demand
• Current demand = 100,000 units per year
• Binomial uncertainty: Demand can go up by 20% with
probability = 0.5 or down by 20% with 1 – probability = 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 probability = 0.5 or down by
10% with 1 – probability = 0.5
• Revenue = $1.22 per unit of demand
• Discount factor k = 0.1

Period 0 Period 1 Period 2
D = 144
p = $1.45
0.25
D = 120
p = $1.32 0.25
D = 144
0.25 p = $1.19
0.25
D = 100 0.25 D = 120
p = $1.2 p = $1.08 0.25
D = 96
p = $1.45
0.25
D = 96
0.25 D = 80 p = $1.19
p = $1.32
D = 80
p = $1.08

Trips Logistics -1st Case:
Spot Market

• Start with Period 2 and calculate the profit at each node
For Demand = 144, Spot market price p = $1.45, in Period 2:
Cost (D = 144, p = 1.45,2) = 144,000 x 1.45

= $208,800
Profit (D = 144, p = 1.45,2) = 144,000 x 1.22

– Cost (D = 144, p = 1.45, 2)
= 175,680 – 208,800
= –$33,120

Cost Profit
Revenue C(D =, p =, 2) P(D =, p =, 2)
D = 144, p = 1.45 144,000 × 1.22 144,000 × 1.45 –$33,120
D = 144, p = 1.19 144,000 × 1.22 144,000 × 1.19 $4,320
D = 144, p = 0.97 144,000 × 1.22 144,000 × 0.97 $36,000
D = 96, p = 1.45 96,000 × 1.22 96,000 × 1.45 –$22,080
D = 96, p = 1.19 96,000 × 1.22 96,000 × 1.19 $2,880
D = 96, p = 0.97 96,000 × 1.22 96,000 × 0.97 $24,000
D = 64, p = 1.45 64,000 × 1.22 64,000 × 1.45 –$14,720
D = 64, p = 1.19 64,000 × 1.22 64,000 × 1.19 $1,920
D = 64, p = 0.97 64,000 × 1.22 64,000 × 0.97 $16,000

Period 1 –$33,120
0.25
D = 120
0.25
p = $1.32
$4,320
Period 0 0.25 0.25
D = 100 0.25 D = 120

p = $1.08 0.25
p = $1.2
–$22,080
0.25
0.25 D = 80 $2,880
p = $1.32
Period 2
D = 80
3/17/2021
p =Confidential
$1.08 - Prof. Vasanth Kamath 37
Period 1 –$33,120
0.25
–$22,909 0.25
$4,320
0.25 0.25
Period 0
D = 100 0.25 –$22,080

0.25
p = $1.2
0.25
$2,880
0.25
Expected Profit Period 2
EP(D = 120, p =1.32,1) = 0.25 x [–33,120 + 4,320 – 22,080 + 2,880] = –$12,000
Present Value of Expected Profit
PVEP(D = 120, p = 1.32,1) = EP(D = 120, p = 1.32,1) / (1 + k) = –$12,000 / (1.1)
= –$10,909
Total Profit
P(D = 120, p = 1.32,1)= 120,000 x 1.22 – 120,000 x 1.32 + PVEP(D = 120, p = 1.32,1)
= –$12,000 – $10,909 = –$22,909
Period 1
Period 0 -$ 22,909
0.25
0.25 $32,073
$5,471
0.25
EP(D = 100, p =1.20,0) 0.25 – $15,273

= 0.25 x [–22,909 + 32,073 – 15,273 + 21,382]
= $3,818
21,382
PVEP(D = 100, p = 1.20,1)= EP(D = 100, p = 1.20,0) / (1 + k) =
$3,818 / (1.1) = $3,471
P(D = 100, p = 1.20,0)= 100,000 x 1.22 – 100,000 x 1.20 + PVEP(D

= 100, p = 1.20,0)
= $2,000 + $3,471 = $5,471
Trips Logistics -2nd Case: Fixed lease
• The manager evaluates the alternative whereby the lease for
100,000 sq. ft. of warehouse space is signed at $1 per sq. ft.
• Any number above 100,000 sq. ft. will be charged at $1.45 per
sq. ft.
For D = 144, p = $1.45, in Period 2:
Cost (D = 144, p = 1.45,2)= 100,000 x 1 + 44,000 x 1.45 = $163,800
Profit (D = 144, p = 1.45,2)= 144,000 x 1.22

– Cost (D = 144, p = 1.45, 2)
= 175,680 – 163,800
= $11,880

Period 1 $11,880
0.25
D = 120
0.25
p = $1.32
$23,320
Period 0 0.25 0.25
D = 100 0.25 D = 120

p = $1.08 0.25
p = $1.2
$17,120
0.25
0.25 D = 80 $17,120
p = $1.32
Period 2
D = 80
p = $1.08
Profit P(D =, p =, 2)
Warehouse Space = D x 1.22 – (100,000 x 1
Node Leased Space at Spot Price (S) + S x p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880
D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320
D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000
D = 96, p = 1.45 100,000 sq. ft. 0 sq. ft. $17,120
D = 96, p = 1.19 100,000 sq. ft. 0 sq. ft. $17,120
D = 96, p = 0.97 100,000 sq. ft. 0 sq. ft. $17,120
D = 64, p = 1.45 100,000 sq. ft. 0 sq. ft. –$21,920
D = 64, p = 1.19 100,000 sq. ft. 0 sq. ft. –$21,920
D = 64, p = 0.97 100,000 sq. ft. 0 sq. ft. –$21,920

Trips Logistics -3rd Case: Flexible lease
• The general manager at Trips Logistics has been offered a
contract in which, for an upfront payment of $10,000, Trips
Logistics will have the flexibility of using between 60,000
square feet and 100,000 square feet of warehouse space at
$1 per square foot per year.
• Trips Logistics must pay $60,000 per year for the first 60,000
square feet and can then use up to another 40,000 square
feet on demand at $1 per square foot.

For D = 144, p = $1.45, in Period 2:
Cost (D = 144, p = 1.45,2)= 100,000 x 1 + 44,000 x 1.45 = $163,800
Profit (D = 144, p = 1.45,2)= 144,000 x 1.22 – Cost (D = 144, p = 1.45, 2)

= 175,680 – 163,800
= $11,880

Period 1 $11,880
0.25
D = 120
0.25
p = $1.32
$23,320
Period 0 0.25 0.25
D = 100 0.25 D = 120

p = $1.08 0.25
p = $1.2
$21,120
0.25
0.25 D = 80 $21,120
p = $1.32
Period 2
D = 80
p = $1.08
Profit P(D =, p =, 2)
Warehouse Space Warehouse Space = D x 1.22 – (W x 1 + S x
Node at $1 (W) at Spot Price (S) p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880
D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320
D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000
D = 96, p = 1.45 96,000 sq. ft. 0 sq. ft. $21,120
D = 96, p = 1.19 96,000 sq. ft. 0 sq. ft. $21,120
D = 96, p = 0.97 96,000 sq. ft. 0 sq. ft. $21,120
D = 64, p = 1.45 64,000 sq. ft. 0 sq. ft. $14,080
D = 64, p = 1.19 64,000 sq. ft. 0 sq. ft. $14,080
D = 64, p = 0.97 64,000 sq. ft. 0 sq. ft. $14,080

Trips Logistics –Comparison of scores
Option NPV
All warehouse space from the spot market $5,471
Lease 100,000 sq. ft. for three years $38,364
Flexible lease to use between 60,000 and 100,000 sq. ft. $46,545

Next Session:
Aggregate Planning in a Supply Chain

Session 10: Aggregate planning
Role of Aggregate Planning in SC
• Capacity has a cost and lead times are often long. Therefore,
companies must take decisions regarding capacity levels,
production levels, outsourcing, and promotions before a
demand is known.
• Aggregate planning:
• process by which a company determines levels of capacity,
production, subcontracting, inventory, stockouts, and
pricing over a specified time horizon
• time frame of 3 to 18 months
• decisions made at a product family level
• how can a firm best use the facilities it has?
• goal is to maximize profit
Role of Aggregate Planning in SC
• Specify operational parameters over the time horizon
• Production rate – Subcontracting
• Workforce – Backlog
• Overtime – Inventory on hand
• Machine capacity level
• All supply chain stages should work together on an
aggregate plan that will optimize supply chain
performance

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

Information Needed for an Aggregate Plan
• Aggregate demand forecast Ft for each Period t over T periods
• Production costs
• Labor costs, regular time ($/hr) and overtime ($/hr)
• Subcontracting costs ($/hr or $/unit)
• Cost of changing capacity – hiring or layoff ($/worker), adding or
reducing machine capacity ($/machine)
• Labor/machine hours required per unit
• Inventory holding cost ($/unit/period)
• Stockout or backlog cost ($/unit/period)
• Constraints – overtime, layoffs, capital available, stockouts,
backlogs, from suppliers

Outputs of Aggregate Plan
• Production quantity from regular time, overtime, and
subcontracted time
• Inventory held
• Backlog/stockout quantity
• Machine capacity increase/decrease
• A poor aggregate plan can result in lost sales, lost profits,

excess inventory, or excess capacity

Example 1: Red Tomato tools
• A small manufacturer of gardening equipment with
manufacturing facilities in Mexico. The company makes six
product families at its manufacturing plant. The costs,
revenues, production times, setup times, and historical batch
sizes of production for each family are as shown in Table.
Setup Net
Material Time/ Average Production Production Percentage
Cost/ Revenue/ Batch Batch Time/ Unit Time/Unit Share of
Family Unit ($) Unit ($) (hour) Size (hour) (hour) Units Sold
A 15 54 8 50 5.60 5.76 10
B 7 30 6 150 3.00 3.04 25
C 9 39 8 100 3.80 3.88 20
D 12 49 10 50 4.80 5.00 10
E 9 36 6 100 3.60 3.66 20
F 13 48 5 75 4.30 4.37 15
• Weighted average approach
• Material cost per aggregate unit
= (15 x 0.10) + (7 x 0.25) + (9 x 0.20) + (12 x 0.10) + (9 x 0.20) + (13 x 0.15)
= $10
• Similarly
• Revenue per aggregate unit = $40
• Net production time per aggregate unit = 4.00 hours

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
• Tailored or hybrid strategy – a combination of strategies

Chase Strategy
• Vary machine capacity or hire and lay off workers as demand
varies
• 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
• Used when inventory holding costs are high and costs of
changing capacity are low
• Example: Workers at Mc Donald's.

Time Flexibility Strategy
• Use excess machine capacity
• Workforce stable, number of hours worked varies
• Use overtime or a flexible work schedule
• Flexible workforce, avoids morale problems
• Low levels of inventory, lower utilization
• Used when inventory holding costs are high and capacity is
relatively inexpensive
• Example: Overtime operations during large infrastructure
projects.

Level Strategy
• Stable machine capacity and workforce levels, constant
output rate
• Inventory levels fluctuate over time
• Inventories carried over from high to low demand periods
• Better for worker morale
• Large inventories and backlogs may accumulate
• Used when inventory holding, and backlog costs are relatively
low
• Example: Production of Umbrellas

• The demand for Red Tomato’s gardening tools from consumers is highly
seasonal, peaking in the spring as people plant their gardens. This
seasonal demand ripples up the supply chain from the retailer to Red
Tomato, the manufacturer.
• The options Red Tomato has for handling the seasonality are adding
workers during the peak season, subcontracting out some of the work,
building up inventory during the slow months, or building up a backlog of
orders that will be delivered late to customers.
• To determine how to best use these options through an aggregate plan,
Red Tomato’s vice president of supply chain starts with the first task—
building a demand forecast.
• Although Red Tomato could attempt to forecast this demand itself, a much
more accurate forecast come from a collaborative process used by both
Red Tomato and its retailers to produce the forecast shown in next slide.

Aggregate Planning Using LPP
Month Demand Forecast
January 1,600
February 3,000
March 3,200
April 3,800
May 2,200
June 2,200

• Red Tomato sells each tool through retailers for $40.
• The company has a starting inventory in January of 1,000 tools.
• At the beginning of January, the company has a workforce of 80
employees.
• The plant has a total of 20 working days in each month, and each
employee earns $4 per hour regular time.
• Each employee works 8 hours per day on straight time and the rest on
overtime.
• The capacity of the production operation is determined primarily by the
total labor hours worked. Therefore, machine capacity does not limit the
capacity of the production operation.
• Because of labor rules, no employee works more than 10 hours of
overtime per month. The various costs are shown in next slide.

Item Cost
Material cost $10/unit
Inventory holding cost $2/unit/month
Marginal cost of stock-out/backlog $5/unit/month
Hiring and training costs $300/worker
Layoff cost $500/worker
Labor hours required 4/unit
Regular time cost $4/hour
Overtime cost $6/hour
Cost of subcontracting $30/unit

• Currently, Red Tomato has no limits on subcontracting, inventories, and
stockouts/ backlog. All stockouts are backlogged and supplied from the
following months’ production.
• Inventory costs are incurred on the ending inventory in the month. The
supply chain manager’s goal is to obtain the optimal aggregate plan that
allows Red Tomato to end June with at least 500 units (i.e., no stockouts at
the end of June and at least 500 units in inventory).

• The optimal aggregate plan is one that results in the highest profit over
the 6-month planning horizon.
• For now, given Red Tomato’s desire for a high level of customer service,
assume all demand is to be met, although it can be met late.
• Therefore, the revenues earned over the planning horizon are fixed. As a
result, minimizing cost over the planning horizon is the same as
maximizing profit.
• In many instances, a company has the option of not meeting certain
demand, or price itself may be a variable that a company must determine
based on the aggregate plan. In such a scenario, minimizing cost is not
equivalent to maximizing profits

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

Red Tomato tools – Objective function
• Minimize
(Regular-time labor cost* + Overtime labor cost + Cost of
hiring and layoffs + Cost of holding inventory and stock out +
Cost of Materials and subcontracting)
6 6 6 6
Minå 640Wt + å 6Ot + å 300H t + å 500Lt
t=1 t=1 t=1 t=1
6 6 6 6
+å 2I t + å 5St + å10Pt + å 30Ct
t=1 t=1 t=1 t=1
*Regular Time Cost = $4/hour * 20 days * 8 hours/day

Red Tomato tools – Constraints
1. Workforce, hiring, and layoff constraints
Wt = W t–1+H t – Lt
2. Capacity constraints*
Ot
Pt £ 40Wt +
4 All for t = 1,..., 6
3. Inventory balance constraints**
I t–1 + Pt + Ct = Dt + St–1 + I t – St
4. Overtime limit constraints
Ot £ 10Wt
*Number of units made by each worker per month is 20*8/4 = 40
** I(t-1) – S(t-1) + P(t) + C(t) – D(t) = I(t) – S(t)
1. Workforce, hiring, and layoff constraints
Wt = W t–1+H t – Lt
The workforce size 𝑊𝑡 in a period t is obtained by adding the
number hired 𝐻𝑡 in period t to the workforce size 𝑊𝑡−1 in
period t-1, and subtracting the number laid off 𝐿𝑡 in period t.
The starting workforce size is given by 𝑊0 = 80

2. Capacity constraints*
Ot
Pt £ 40Wt +
4
In each period, the amount produced cannot exceed the
available capacity.
As each worker can produce 40 units per month on regular time
(four hours per unit as in table) and one unit for every 4 hours
of overtime.

3. Inventory balance constraints
I t–1 + Pt + Ct = Dt + St–1 + I t – St
This constraint balances the inventory at the end of each period.
Net demand for period t is obtained as the current demand 𝐷𝑡 ,
and the previous backlog 𝑆𝑡−1 . This demand is either filled from
the production (inhouse) 𝑃𝑡 or subcontracted production 𝐶𝑡 and
previous inventory 𝐼𝑡−1 .
𝐼𝑡 may be left over inventory at the end of period or a part of it
is backlogged 𝑆𝑡 .
** I(t-1) – S(t-1) + P(t) + C(t) – D(t) = I(t) – S(t)

4. Overtime limit constraints
Ot £ 10Wt
No employee works more than 10 hours of overtime each
month.

Total cost over planning horizon = $422,660
No.
No. Laid Total
Hired, Off, Workforce Overtime, Inventory, Stockout, Subcontract, Production, Demand,
Period, t Ht Lt Size, Wt Ot It St Ct Pt Dt
0 0 0 80 0 1,000 0 0
1 0 16 64 0 1,960 0 0 2,560 1,600
2 0 0 64 0 1,520 0 0 2,560 3,000
3 0 0 64 0 880 0 0 2,560 3,200
4 0 0 64 0 0 220 140 2,560 3,800
5 0 0 64 0 140 0 0 2,560 2,200
6 0 0 64 0 500 0 0 2,560 2,200

• Higher demand variability
Month Demand Forecast

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

No.
No. Laid
Hired, Off, Workforce Overtime, Total Demand
Period, t Ht Lt Size, Wt Ot Inventory, It Stockout, St Subcontract, Ct Production, Pt , Dt
0 0 0 80 0 1,000 0 0
1 0 16 64 0 2,560 0 0 2,560 1,000
2 0 0 64 0 2,120 0 0 2,560 3,000
3 0 0 64 0 880 0 0 2,560 3,800
4 0 0 64 0 0 1,220 140 2,560 4,800
5 0 0 64 0 0 660 0 2,560 2,000
6 0 0 64 0 500 0 0 2,560 1,400

• Lower hiring and layoff costs – $50

No.
No. Laid Total
Hired, Off, Workforce Overtime, Inventory, Stockout, Subcontract, Production, Demand,
Period, t Ht Lt Size, Wt Ot It St Ct Pt Dt
0 0 0 80 0 1,000 0 0
1 0 35 45 0 1,200 0 0 1,800 1,600
2 0 0 45 0 0 0 0 1,800 3,000
3 42 0 87 0 280 0 0 3,480 3,200
4 1 0 88 0 0 0 0 3,520 3,800
5 0 27 61 0 240 0 0 2,440 2,200
6 0 0 61 0 500 0 20 2,440 2,200

Forecast Error in Aggregate Plans
• Forecast errors must be considered
• Safety inventory
• Safety capacity
• Use overtime as a form of safety capacity
• Carry extra workforce permanently as a form of safety
capacity
• Use subcontractors as a form of safety capacity
• Build and carry extra inventories as a form of safety
inventory
• Purchase capacity or product from an open or spot market
as a form of safety capacity

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



• Set Target Cell: C22
• Equal to: Select Min
• By Changing Cells: B5:I10
• Subject to the constraints:
• B5:C10 = integer {Number of workers hired or laid off is integer}
• B5:I10 ≥ 0 {All decision variables are nonnegative}
• F10 ≥ 500 {Inventory at end of Period 6 is at least 500}
• G10 = 0 {Stockout at end of Period 6 equals 0}
• M5:M10 = 0 {W1 – Wt–1 –Ht + Lt = 0 for t = 1,...,6}
• N5:N10 ≥ 0{40Wt + Ot/4 – Pt ≥ 0 for t = 1, . . . , 6}
• O5:O10 = 0{It–1 – St–1 + Pt + Ct – Dt – It + St = 0 for t = 1, . . . , 6}
•3/22/2021
P5:P10 ≥ 0{10Wt – Ot ≥ 0 forConfidential
t = 1,…, 6} Kamath
- Prof. Vasanth 34



Building a Rough MPS
MPS: Master Production Schedule
• Disaggregate an aggregate plan
Setup
Time/Ba Production Number Setup
tch Average Time/Unit Production of Time Production
Family (hour) Batch Size (hour) Quantity Setups (hours) Time (hours)
A 8 50 5.60 256 5 40 1,433.6
B 6 150 3.00 640 4 24 1,920.0
C 8 100 3.80 512 5 40 1,945.6
D 10 50 4.80 256 5 50 1,228.8
E 6 100 3.60 512 5 30 1,843.2
F 5 75 4.30 384 5 25 1,651.2

Implementing Aggregate Planning
in Practice
1. Think beyond the enterprise to the entire supply chain
2. Make plans flexible because forecasts are always
inaccurate (Sensitivity Analysis)
3. Rerun the aggregate plan as new data emerge
4. Use aggregate planning as capacity utilization increases

Next Session:
Mid-course Review

Session 12: Sales & operations
planning
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
• Two broad approaches
1. Manage supply using capacity, inventory,
subcontracting, and backlogs
2. Manage demand using short-term price discounts and
trade promotions

Managing Supply
• Managing capacity
• Time flexibility from workforce
• Use of seasonal workforce
• Use of subcontracting
• Use of dual facilities – specialized and flexible
• Designing product flexibility into production processes
• Managing inventory
• Using common components across multiple products
• Build inventory of high demand or predictable demand
products

Managing Demand
• Promotion at Red Tomato and Green Thumb
Item Cost
Material cost $10/unit
Inventory holding cost $2/unit/month
Marginal cost of stock-out/backlog $5/unit/month
Hiring and training costs $300/worker
Layoff cost $500/worker
Labor hours required 4/unit
Regular time cost $4/hour
Overtime cost $6/hour
Cost of subcontracting $30/unit
Exercise 1: Red Tomato Tools
• Green Thumb Gardens is a large retail chain that has signed
an exclusive contract to sell all products made by Red Tomato
Tools.
• Demand for garden tools peaks in the spring months of March
and April, as gardeners prepare to begin planting.
• In planning, the goal of both firms should be to maximize
supply chain profits, because this outcome leaves them more
money to share.
• Red Tomato and Green Thumb are exploring how the timing
of retail promotions affects profitability.

• Are they in a better position if they offer the price promotion
during the peak period of demand or during a low-demand
period?
• Green Thumb’s vice president of sales favors a promotion
during the peak period because this increases revenue by the
largest amount.
• In contrast, Red Tomato’s vice president of manufacturing is
against such a move because it increases manufacturing costs.
She favors a promotion during the low-demand season
because it levels demand and lowers production costs. S&OP
allows the two to collaborate and make the optimal trade-
offs.
• Green Thumb estimates that discounting a Red Tomato tool
from $40 to $39 (a $1 discount) in any period results in the
period demand increasing by 10 percent because of increased
consumption or substitution.
• Further, 20 percent of each of the two following months’
demand is moved forward.
• Management would like to determine whether it is more
effective to offer the discount in January or April.


The Timing of a Promotion
• Impact of the promotion on demand
• Cost of holding inventory
• Cost of changing the level of capacity
• Product margins
• Increase in demand from
• Market growth
• Stealing share
• Forward buying

When to Promote
• Is it more effective to promote during the peak period or
off-peak?
• Analyze the impact of a promotion on demand and the
resulting optimal aggregate plan

Promotion in January

Promotion in January
• Total cost over planning horizon = $422,080
• Revenue over planning horizon = $643,400
• Profit over planning horizon = $221,320
• Lower seasonal inventory

• A somewhat lower total cost
• A higher total profit

Promotion in April

Promotion in April
• Higher seasonal inventory

• A somewhat higher total cost
• A slightly smaller total profit

Discount Leads to
Large Increase in Consumption
• Promotion in January

Discount Leads to
• Higher total profit than base case

Discount Leads to
• Promotion in April

Discount Leads to
• Much higher level of seasonal inventory

• Uses more stockouts and subcontracting
• Revenues increase
• Overall profits higher

Supply Chain Performance
Percentage
Regular Promotion Promotion of Increase Percentage of Average
Price Price Period in Demand Forward Buy Profit Inventory
$40 $40 NA NA NA $217,340 875
$40 $39 January 10% 20% $221,320 515
$40 $39 April 10% 20% $211,220 932
$40 $39 January 100% 20% $242,680 232
$40 $39 April 100% 20% $247,320 1,492
$31 $31 NA NA NA $73,340 875
$31 $30 January 100% 20% $84,280 232
$31 $30 April 100% 20% $69,120 1,492

Conclusions on Promotion
• Average inventory increases if promotion is run during the peak
period and decreases if the promotion is run during the off-peak
period
• Promoting during a peak-demand month may decrease overall
profitability if there is a small increase in consumption and a
significant fraction of the demand increase results from a forward
buy.
• As consumption increase from discounting grows and forward
buying becomes a smaller fraction of the demand increase from
a promotion, it is more profitable to promote during the peak
period
• As the product margin declines, promoting during the peak-
demand period becomes less profitable
Next Session:
Inventory management in a Supply Chain

Session 13-14: Inventory
management
Water tank analogy for inventory
Inventory
Level
Supply
Rate
Inventory Level
Demand
Rate
𝑡
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑡 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑎𝑡 𝑡𝑜 + න (𝐼𝑛𝑓𝑙𝑜𝑤 − 𝑂𝑢𝑡𝑓𝑙𝑜𝑤)
0
Definitions
• Inventory: a stock of materials used to facilitate production or satisfy
customer demand
• Types of inventory
– Raw materials, purchased parts (RM)
– Work in process (WIP)
– Finished goods (FG)
– Maintenance, repair & operating supplies (MRO)

Inventory and supply chains
• Balance the advantages and disadvantages of small and large inventories
• Pressures for small inventories
• Inventory holding cost
• Cost of capital
• Storage and handling costs
• Taxes, insurance, and shrinkage

Inventory and supply chains
• Pressures for large inventories
• Customer service
• Ordering cost
• Setup cost
• Labor and equipment utilization
• Transportation cost
• Payments to suppliers

Inventory classifications
Process Number and Demand Others

stage value type
Raw materials ABC items Dependent Maintenance

WIP VED items Independent Operating
Finished goods

Inventory classifications

Role of Cycle Inventory in a SC
• Lot or batch size is the quantity that a stage of a supply chain
either produces or purchases at a time
• Cycle inventory is the average inventory in a supply chain due
to either production or purchases in lot sizes that are larger
than those demanded by the customer
Q: Quantity in a lot or batch size
D: Demand per unit time

Inventory Profile
D: Demand throughout the year
Q: Quantity ordered in one cycle

lot size Q
Cycle inventory = =
2 2
average inventory
Average flow time =
average flow rate
Average flow time cycle inventory Q

resulting from = =
demand 2D
cycle inventory

• Lower cycle inventory has
• Shorter average flow time
• Lower working capital requirements
• Lower inventory holding costs
• Cycle inventory is held to

• Take advantage of economies of scale
• Reduce costs in the supply chain
• Average price paid per unit purchased is a key cost in the lot-
sizing decision
Material cost = C
• Fixed ordering cost includes all costs that do not vary with the
size of the order but are incurred each time an order is placed
Fixed ordering cost = S
• Holding cost is the cost of carrying one unit in inventory for a

specified period
Holding cost = H = hC

• 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
• In practice, each stage generally makes its own supply chain
decisions
• Increases total cycle inventory and total costs in the supply
chain

• Economies of scale exploited in three typical situations
1. A fixed cost is incurred each time an order is placed or
produced
2. The supplier offers price discounts based on the quantity
purchased per lot
3. The supplier offers short-term price discounts or holds
trade promotions

Estimating Cycle Inventory Related
Costs in Practice
• Inventory Holding Cost
• Cost of Capital
• Obsolescence cost
• Handling cost
• Occupancy cost
• Miscellaneous costs
• Theft, security, damage, tax, insurance
Estimating Cycle Inventory Related
Costs in Practice
• Ordering Cost
• Buyer time
• Transportation costs
• Receiving costs

Economies of Scale to Exploit
Fixed Costs
• Lot sizing for a single product (EOQ)
D = Annual demand of the product
S = Fixed cost incurred per order
C = Cost per unit of product
H = Holding cost per year as a fraction of product cost
• Basic assumptions
–Demand is steady at D units per unit time
–No shortages are allowed
–Replenishment lead time is fixed
Economies of Scale to Exploit Fixed
Costs
• Minimize
– Annual material cost
– Annual ordering cost
– Annual holding cost

Lot Sizing for a Single Product
Annual material cost = CD
D
Number of orders per year =
Q
æ Dö
Annual ordering cost = ç ÷ S
èQø
æQ ö æQö
Annual holding cost = ç ÷ H = ç ÷ hC
è2ø è2ø
æ Dö æQ ö
Total annual cost, TC = CD + ç ÷ S + ç ÷ hC
èQø è2ø

• The economic order quantity (EOQ)
2DS
Optimal lot size, Q* =
hC
• The optimal ordering frequency
D DhC
n* = =
Q* 2S

EOQ Example
• Demand for the Deskpro computer at Best Buy is 1,000 units per
month.
• Best Buy incurs a fixed order placement, transportation, and
receiving cost of $4,000 each time an order is placed.
• Each computer costs Best Buy $500 and the retailer has a
holding cost of 20 percent.
• Evaluate the number of computers that the store manager
should order in each replenishment lot.

EOQ Example
Annual demand, D = 1,000 x 12 = 12,000 units
Order cost per lot, S = $4,000
Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2
2 ´12,000 ´ 4,000
Optimal order size = Q* = = 980
0.2 ´ 500

EOQ Example
Q * 980
Cycle inventory = = = 490
2 2
D
Number of orders per year = = 12.24
Q*
D æQ *ö
Annual ordering and holding cost = S +ç ÷ hC = 97,980
Q* è 2 ø
Q* 980
Average flow time = = = 0.041 = 0.49 month
2 D 2 *12,000

EOQ Example
• Lot size reduced to Q = 200 units
𝐷 𝑄
Annual inventory related costs = 𝑆 + ℎ𝐶
𝑄 2
= 250,000

Lot Size and Ordering Cost
• If the lot size Q = 200 is optimal, how much should the
ordering cost be reduced?
Desired lot size, Q = 200
Annual demand, D = 1,000 × 12 = 12,000 units
Unit cost per computer, C = $500
Holding cost per year as a fraction of inventory value, h = 0.2
hC (Q) 0.2  500  200

2 2
S= = = 166.7
2D 2 12,000

Production lot sizing
TBO
Q
Demand during
Production interval
Imax Maximum Inventory

Imax = (p-d) X (Q/p)
2 DS p
Q=
H p−d
p-d d
Production
Usage Q/p
& Usage
4/3/2021 Confidential - Prof. Vasanth Kamath
Q/d 27
Production lot sizing
• The entire lot does not arrive at the same time
• Production occurs at a specified rate P
• Inventory builds up at a rate of P – D
2DS
QP =
(1– D / P)hC
Annual setup cost Annual holding cost

æ Dö æQP ö
ç P ÷S (1– D / P) ç ÷ hC
èQ ø è 2 ø
Aggregating Multiple Products
in a Single Order
• Savings in transportation costs
• Reduces fixed cost for each product
• Lot size for each product can be reduced
• Cycle inventory is reduced
• Single delivery from multiple suppliers or single truck delivering
to multiple retailers
• Receiving and loading costs reduced

Lot Sizing with Multiple Products or
Customers
• Ordering, transportation, and receiving costs grow with the
variety of products or pickup points
• Lot sizes and ordering policy that minimize total cost
• Di: Annual demand for product i
• S: Order cost incurred each time an order is placed,
independent of the variety of products in the order
• si: Additional order cost incurred if product i is included in
the order

Lot Sizing with Multiple Products or
Customers
• Three approaches
1. Each product manager orders his or her model
independently
2. The product managers jointly order every product in each
lot
3. Product managers order jointly but not every order
contains every product; that is, each lot contains a
selected subset of the products

Multiple Products Ordered and
Delivered Independently
• Best Buy sells three models of computers, the Litepro, the
Medpro, and the Heavypro.
• Annual demands for the three products are DL = 12,000 for the
Litepro, DM = 1,200 units for the Medpro, and DH = 120 units for
the Heavypro. Each model costs Best Buy $500.
• A fixed transportation cost of $4,000 is incurred each time an
order is delivered.
• For each model ordered and delivered on the same truck, an
additional fixed cost of $1,000 per model is incurred for
receiving and storage.

• Best Buy incurs a holding cost of 20 percent. Evaluate the lot
sizes that the Best Buy manager should order if lots for each
product are ordered and delivered independently. Also
evaluate the annual cost of such a policy.

Demand
DL = 12,000/yr, DM = 1,200/yr, DH = 120/yr
Common order 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

Litepro Medpro Heavypro
Demand per year 12,000 1,200 120
Fixed cost/order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Cycle inventory 548 173 55
Annual holding cost $54,772 $17,321 $5,477
Order frequency 11.0/year 3.5/year 1.1/year
Annual ordering cost $54,772 $17,321 $5,477
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual cost $109,545 $34,641 $10,954
4/3/2021
• Total annual cost = $155,140
Confidential - Prof. Vasanth Kamath 35
Lots Ordered and Delivered Jointly
S* = S + sL + sM + sH Annual order cost = S * n
DL hC L DM hCM DH hC H
Annual holding cost = + +
2n 2n 2n
DL hC L DM hCM DH hC H
Total annual cost = + + +S*n
2n 2n 2n
The optimal order frequency minimizes the total annual cost and
is obtained by taking the first derivative of the total cost wrt. ‘n’
and setting it equal to 0
DL hC L + DM hCM + DH hC H å
k
n* = Di hCi
2S * n* = i=1
4/3/2021 Confidential - Prof. Vasanth Kamath 2S * 36
Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 9.75/year 9.75/year 9.75/year
Optimal order size (D/n∗) 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Annual holding cost $61,512 $6,151 $615
Annual Order Cost = $ 68,279

Annual Holding Cost = $ 68,279
Annual Total Cost = $136,558

for a Selected Subset (1 of 3)
Step 1: Identify the most frequently ordered product
assuming each product is ordered independently
hCi Di
ni =
2(S + si )
Step 2: For all products i  i  , evaluate the ordering frequency
hCi Di
ni =
2si
Step 3: For all i  i  , evaluate the frequency of product i
relative to the most frequently ordered product i* to be mi
mi = n ni 
Step 4: Recalculate the ordering frequency of the most
frequently ordered product i* to be n

l
hCi mi D
n= i =1
(
2 S +  i =1 si / mi
l
)
Step 5: Evaluate an order frequency of ni = n mi and the
total cost of such an ordering policy
l
 Di l

TC = nS +  ni si +    hC1
i =1 i =1  2ni 
Tailored aggregation – higher-demand products ordered

more frequently, and lower-demand products ordered less
frequently

for a Selected Subset
• Applying Step 1
hCLDL
nL = = 11.0
2(S + sL )
Thus
hCM DM n = 11.0
nM = = 3.5
2(S + sM )
hCH DH
nH = = 1.1
2(S + sH )

• Applying Step 2
hCM DM hCH DH
nM = = 7.7 and nH = = 2.4
2sM 2sH
• Applying Step 3
n  11.0   n  11.0 
mM =  =  = 2 and mH =   =   =5
 nM   7.7   nH   2.4 

• Applying Step 4
n = 11.47
• Applying Step 5
nL = 11.47 / yr
nH = 11.47 / 5 = 2.29 / yr
nM = 11.47 / 2 = 5.74 / yr
Annual order cost
nS + nLsL + nM sM + nH sH = $65,383.50
Annual holding cost
DL /nL DM /nM DH /nH

× hCL + × hCM + × hCH = $65,383
2 2 2
Total annual cost = $130,767

Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 11.47/year 5.74/year 2.29/year
Optimal order size (D/n∗) 1,046 209 52
Cycle inventory 523 104.5 26
Annual holding cost $52,307 $10,461 $2,615
Annual Order Cost = $ 65,383

Annual Holding Cost = $ 65,383
Annual Total Cost = $130,766

Comparison of the 3 cases
Annual Annual Holding Total Annual
Case Ordering Cost Cost Cost
Multiple Products Ordered and Delivered
$77,570 $77,570 $155,140
Independently
Products Ordered and Delivered Jointly $68,279 $68,279 $136,558
Ordered and Delivered Jointly – Frequency $65,383 $65,383 $130,766

Varies by Order

Quantity Discounts
Two basic questions
1. What is the optimal purchasing decision for a buyer
seeking to maximize profits? How does this decision
affect the supply chain in terms of lot sizes, cycle
inventories, and flow times?
2. Under what conditions should a supplier offer quantity
discounts? What are appropriate pricing schedules that
a supplier seeking to maximize profits should offer?

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

Step 1: Evaluate the optimal lot size for each price Ci,0 ≤ i ≤
r as follows
2DS
Qi =
hCi

Step 2: We next select the order quantity Q*i for each
price Ci
1. qi £ Qi < qi+1
2. Qi < qi
3. Qi ³ qi+1
• Case 3 can be ignored as it is considered for Qi+1
• For Case 1 if qi £ Qi <, qi+1 then set Q*i = Qi
• If Qi < q, i then a discount is not possible
• Set Q*I = qi to qualify for the discounted price of Ci
Step 3: Calculate the total annual cost of ordering
Q*i units
æDö æ Q* ö
Total annual cost, TCi = çç * ÷÷ S + çç i ÷÷ hCi + DCi
è Qi ø è 2ø
Step 4: Select Q*i with the lowest total cost TCi

All-Unit Quantity Discount: Example
• Drugs Online (DO) is an online retailer of prescription drugs and health
supplements.
• Vitamins represent a significant percentage of its sales.
• Demand for vitamins is 10,000 bottles per month.
• DO incurs a fixed order placement, transportation, and receiving cost of
$100 each time an order for vitamins is placed with the manufacturer.
DO incurs a holding cost of 20 percent.
• The manufacturer uses the all-unit discount pricing schedule as provided
in next slide.
• Evaluate the number of bottles that the DO manager should order in
each lot.

Order Quantity Unit Price
0–4,999 $3.00
5,000–9,999 $2.96
10,000 or more $2.92
q0 = 0, q1 = 5,000, q2 = 10,000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120,000/year, S = $100/lot, h = 0.2

Step 1
2DS 2DS 2DS

Q0 = = 6,324; Q1 = = 6,367; Q2 = = 6,410
hC0 hC1 hC2
Step 2
Ignore i = 0 because Q0 = 6,324 > q1 = 5,000

For i = 1, 2
Q1* = Q1 = 6,367; Q2* = q2 = 10,000
Step 3
æDö æ Q* ö
TC1 = çç * ÷÷ S + çç 1 ÷÷ hC1 + DC1 = $358,969; TC2 = $354,520
è Q1 ø è 2ø
Lowest total cost is for i = 2

Order Q2* = 10,000 bottles per lot at $2.92 per bottle


Why Quantity Discounts?
• Quantity discounts can increase the supply chain surplus for
the following two main reasons
1. Improved coordination to increase total supply chain
profits
2. Extraction of surplus through price discrimination

Next Session:
Inventory management in a Supply Chain

Session 16-17: Safety Inventory
The Role of Safety Inventory

Safety Inventory in SC: The role
• 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 of stock.
• Safety inventory: Inventory carried for the purpose of
satisfying demand that exceeds the amount forecasted in each
period

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
Two Questions 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?

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

Measuring 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

• Demand has a systematic component and a random
component
• The estimate of the random component is the measure of
demand uncertainty
• Random component is usually estimated by the standard
deviation of demand
• Notation:
D = Average demand per period
sD = standard deviation of demand per period
L = lead time = time between when an order is placed and
when it is received
• Uncertainty of demand during lead time is what is important

• 𝐷𝐿 = demand during L periods = D X L
• 𝜎𝐿 = std dev of demand during L periods = 𝜎𝐷 𝐿
• Coefficient of variation = cv = s/m

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

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)

Continuous Review Policy: Safety
Inventory and Cycle Service Level
L : Lead time for replenishment
D : Average demand per unit time
sD : Standard deviation of demand per period
DL : Mean demand during lead time
sL : Standard deviation of demand during lead time
CSL : Cycle service level
ss : Safety inventory
ROP : Reorder point

𝐷𝐿 = D X L
𝜎𝐿 = 𝜎𝐷 𝐿
𝑆𝑎𝑓𝑒𝑡𝑦 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑠𝑠 = 𝑅𝑂𝑃 − 𝐷 𝑋 𝐿
𝑄
Cycle inventory = Τ2
Average inventory = Cycle inventory + Safety stock

Inventory
Order quantity, Q
Q
Reorder point
Demand during 1st lead

time
Safety stock, Lead time, LT

SS
Time
Order 1 Order 2 Order 3
placed placed placed
Shipment 1 Shipment 2
received received
Evaluating Safety Inventory Given
a reorder point
• Assume that weekly demand for phones at B&M Office
Supplies is normally distributed, with a mean of 2,500 and a
standard deviation of 500.
• The manufacturer takes 2 weeks to fill an order placed by the
B&M manager. The store manager currently orders 10,000
phones when the inventory on hand drops to 6,000.
• Evaluate the safety inventory and the average inventory
carried by B&M. Also evaluate the average time a phone
spends at B&M.

a reorder point
D = 2,500/week; sD = 500
L = 2 weeks; Q = 10,000; ROP = 6,000
DL = DL = (2500)(2) = 5000
ss = ROP - DL = 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

a replenishment policy
• Weekly demand for phones at B&M is normally distributed,
with a mean of 2,500 and a standard deviation of 500.
• The replenishment lead time is two weeks. Assume that the
demand is independent from one week to the next.
• Evaluate the CSL resulting from a policy of ordering 10,000
phones when there are 6,000 phones in inventory

Fill rate
• Proportion of customer demand satisfied from stock
• Stockout occurs when the demand during lead time exceeds
the reorder point
• ESC is the expected shortage per cycle (average demand in
excess of reorder point in each replenishment cycle)
• ss is the safety inventory, Q is the order quantity
𝑄 − 𝐸𝑆𝐶
𝑓𝑟 =
𝑄
𝑠𝑠 𝑠𝑠
𝐸𝑆𝐶 = −𝑠𝑠 1 − 𝐹𝑠 + 𝜎𝐿 𝑓𝑠
𝜎𝐿 𝜎𝐿
ESC = -ss{1-NORMDIST(ss/sL, 0, 1, 1)} + sL NORMDIST(ss/ sL, 0, 1, 0)
Evaluating Fill rate
• Weekly demand for phones at B&M is normally distributed,
with a mean of 2,500 and a standard deviation of 500. The
replenishment lead time is two weeks.
• Assume that the demand is independent from one week to the
next.
• Evaluate the fill rate resulting from the policy of ordering
10,000 phones when there are 6,000 phones in inventory.

Evaluating Fill rate
• ss = 1,000, Q = 10,000, sL = 707
• ESC = -ss{1-NORMDIST(ss/sL, 0, 1, 1)} +

sL NORMDIST(ss/sL, 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

D = 2,500/week; sD = 500
L = 2 weeks; Q = 10,000; ROP = 6,000
s =s L D
L = (500) 2 = 707
Cycle service level, CSL = F(DL + ss, DL, sL) =

= NORMDIST (DL + ss, DL, sL) = NORMDIST(6000,5000,707,1)
= 0.92 (This value can also be determined from a Normal probability
distribution table)

DL = D X L = 2500*2 = 5000
s L
= s D
L = (500) 2 = 707
DL = 5000 ROP = 6000

σL = 707
Evaluating Safety inventory given
desired Cycle Service Level
• Weekly demand for Legos at a Walmart store is normally
distributed, with a mean of 2,500 boxes and a standard
deviation of 500. The replenishment lead time is two weeks.
• Assuming a continuous- review replenishment policy, evaluate
the safety inventory that the store should carry to achieve a
CSL of 90 percent.

desired Cycle Service Level
D = 2,500/week; sD = 500
L = 2 weeks; Q = 10,000; CSL = 0.90
DL = 5000, sL = 707 (from earlier example)
ss = FS-1(CSL)sL = [NORMSINV(0.90)](707) = 906

(this value can also be determined from a Normal probability
distribution table)
ROP = DL + ss = 5000 + 906 = 5906

desired Fill rate
• Weekly demand for Legos at a Carrefour store is normally
distributed, with a mean of 2,500 boxes and a standard
deviation of 500. The replenishment lead time is two weeks.
• The store manager currently orders replenishment lots of
10,000 boxes from Lego. Assuming a continuous-review
replenishment policy, evaluate the safety inventory the store
should carry to achieve a fill rate of 97.5 percent.

desired Fill rate
• Desired fill rate fr = 0.975
• Lot size Q = 10,000 boxes
• Standard deviation of demand during lead time
s =s L D
L = (500) 2 = 707
𝐸𝑆𝐶 = 1 − 𝑓𝑟 𝑄 = 1 − 0.975 10,000 = 250 Expected shortage per cycle
  ss   ss 
ESC = 250 = − ss 1 − F S   + σ L f S  
  σ L   σL 
𝐸𝑆𝐶 = −𝑠𝑠 1 − 𝑁𝑂𝑅𝑀𝐷𝐼𝑆𝑇 𝑆𝑆ൗ𝜎𝐿 , 0,1,1 + 𝜎𝐿 𝑁𝑂𝑅𝑀𝐷𝐼𝑆𝑇(𝑠𝑠Τ𝜎𝐿 , 0,1,0)
desired Fill rate
• The equation may be solved in Excel by trying different values
of ss until the equation is satisfied.
• A more elegant approach for solving the equation is to use
the excel tool GOALSEEK

desired Fill rate
Fill Rate Safety Inventory
97.5% 67
98.0% 183
98.5% 321
99.0% 499
99.5% 767
The store manager at Carrefour store should target a safety

inventory of 67 boxes to achieve the desired fill rate of 97.5
percent
Impact of Desired Product Availability,
Lead time, and Demand Uncertainty
on Safety Inventory
• Desired product availability (cycle service level or fill rate)
increases, required safety inventory increases
• Demand uncertainty (sD) 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, sD (better forecasts, better
information collection and use)
Impact of Supply Uncertainty on
Safety inventory
D: Average demand per period
sD: Standard deviation of demand per period
L: Average lead time
sL: Standard deviation of lead time
𝐷𝐿 = 𝐷 𝑋 𝐿
𝜎𝐿 = 𝐿𝜎𝐷2 + 𝐷2 𝑆𝐿2

Impact of Lead time Uncertainty on
Safety inventory
• Daily demand for tablets at Amazon is normally distributed,
with a mean of 2,500 and a standard deviation of 500.
• The tablet supplier takes an average of L = 7 days to replenish
inventory at Amazon.
• Amazon is targeting a CSL of 90 percent (providing a fill rate
close to 100 percent) for its tablet inventory. Evaluate the
safety inventory of tablets that Amazon must carry if the
standard deviation of the lead time is seven days.
• Amazon is working with the supplier to reduce the standard
deviation to zero. Evaluate the reduction in safety inventory
that Amazon can expect as a result of this initiative.
Safety inventory
D = 2,500/day; sD = 500
L = 7 days; Q = 10,000; CSL = 0.90; sL = 7 days
Mean demand during lead time DL = DL = (2500)(7) = 17500

Standard deviation during lead time is given by
s L
= L s 2D + D 2 s 2L
= (7) 5002 + (2500)2 (7)2 = 17550

Safety stock calculations
ss = F-1s(CSL)sL = NORMSINV(0.90) x 17550 = 22,491
Safety inventory
• If the standard deviation is 7 days, Amazon must carry a
safety inventory of 22,491 units. This is equivalent to about
nine days of demand.
• If Amazon works with the suppliers and reduces the standard
deviation of lead time (SL) from six to zero, it can reduce the
safety inventory to a significant amount.
• As the standard deviation of lead time declines from 7 days
to 0, the amount of safety inventory declines from 9 days to
less than a day demand.

Safety inventory
Safety inventory when sL = 6 is 19,298

Impact of Aggregation on Safety
inventory
• Models of aggregation
• Information centralization
• Specialization
• Product substitution
• Component commonality
• Postponement

Impact of Aggregation
• Aggregation is one of the most important mechanisms through
which supply chain can reduce safety inventory required.
• Consider n regions: (All parameters are considered for central
location C)
n
D = D
C
i
i =1
n
sD= s 𝜎𝐷𝐶 =
C 2
i 𝑛𝜎𝐷
i =1
s = Ls D
C C
L
ss = F s (CSL) s L
−1 C

• A BMW dealership has k = 4 retail outlets serving the entire
Chicago area (disaggregate option). Weekly demand at each
outlet is normally distributed, with a mean of D = 25 cars and a
standard deviation of σD = 5.
• The lead time for replenishment from the manufacturer is L = 2
weeks. Each outlet covers a separate geographic area, and the
correlation of demand across any pair of areas is r.
• The dealership is considering the possibility of replacing the
four outlets with a single large outlet (aggregate option).
Assume that the demand in the central outlet is the sum of the
demand across all four areas. The dealership is targeting a CSL
of 0.90.
Standard deviation of weekly demand, sD = 5;
Replenishment, L = 2 weeks; Decentralized CSL = 0.9
Total required
safety inventory, ss = k ´ Fs–1(CSL) ´ L ´ s D
= 4 ´ Fs–1(0.9) ´ 2 ´ 5
= 4 ´ NORMSINV (0.9) ´ 2 ´ 5 = 36.25 cars
Standard deviation of
weekly demand at central outlet, s DC = 4 ´ 5 = 10
ss = Fs–1(0.9) ´ L ´ s DC = NORMSINV (0.9) ´ 2 ´10 = 18.12
• If number of independent stocking locations decreases by n, the
expected level of safety inventory will be reduced by square
root of n (square root law)
• Many e-commerce retailers attempt to take advantage of
aggregation (Amazon) compared to bricks and mortar retailers
(Borders)
• Aggregation has two major disadvantages:
• Increase in response time to customer order
• Increase in transportation cost to customer
• Some e-commerce firms (such as Amazon) have reduced
aggregation to mitigate these disadvantages

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

Specialization
• Stock all items in each location or stock different items at
different locations?
• Different products may have different demands in different
locations (e.g., snow shovels)
• There can be benefits from aggregation
• Benefits of aggregation can be affected by:
• coefficient of variation of demand (higher cv yields greater
reduction in safety inventory from centralization)
• value of item (high value items provide more benefits from
centralization)

Product Substitution
• Substitution: use of one product to satisfy the demand for
another product
• Manufacturer-driven substitution
• Customer-driven substitution

Component Commonality
• Using common components in a variety of different products
• Can be an effective approach to exploit aggregation and reduce
component inventories
Value of Component Commonality
450000
400000
350000
300000
250000
SS
200000
150000
100000
50000
0
1 2 3 4 5 6 7 8 9
Postponement
• The ability of a supply chain to delay product differentiation or
customization until closer to the time the product is sold
• Goal is to have common components in the supply chain for
most of the push phase and move product differentiation as
close to the pull phase as possible
• Examples: Dell, Benetton

https://forio.com/about/blog/bullwhips-and-beer/

Next Session:
Coordination in a Supply Chain

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Supply chain management

• Understanding the drivers of supply chain performance.

• Understanding the challenges of logistics/ transportation/ network

• Developing capabilities for analytical analysis of supply chains.

2/2/2021 Confidential - Prof. Vasanth Kamath 2

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• Includes manufacturers, suppliers, transporters, warehouses,

• Within each organization, the supply chain includes all functions

• Includes movement of products from suppliers to manufacturers to

2/2/2021 Confidential - Prof. Vasanth Kamath 6

2/2/2021 Confidential - Prof. Vasanth Kamath 7

2/2/2021 Confidential - Prof. Vasanth Kamath 8

The Supply-Chain Management Effect (mit.edu)

2/2/2021 Confidential - Prof. Vasanth Kamath 9

The Supply-Chain Management Effect (mit.edu)

2/2/2021 Confidential - Prof. Vasanth Kamath 10

The Supply-Chain Management Effect (mit.edu)

2/2/2021 Confidential - Prof. Vasanth Kamath 11

2/2/2021 Confidential - Prof. Vasanth Kamath 12

• Supply chain profitability is the difference between the revenue

2/2/2021 Confidential - Prof. Vasanth Kamath 14

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2/2/2021 Confidential - Prof. Vasanth Kamath 16

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Cycle View: The processes in a

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• Example: Walmart – High availability at low prices.

• Competitive strategy is defined based on how the customer

2/9/2021 Confidential - Prof. Vasanth Kamath 2

• To execute a company’s competitive strategy, all the

2/9/2021 Confidential - Prof. Vasanth Kamath 4

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Understanding the customer and

Understanding the supply chain

Achieving strategic fit

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Customers go for low price. He/ She is

2/9/2021 Confidential - Prof. Vasanth Kamath 11

Demand uncertainty – uncertainty of customer

Implied demand uncertainty – demand uncertainty

2/9/2021 Confidential - Prof. Vasanth Kamath 13

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Supply Source Capability Causes Supply Uncertainty to...

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