Supply Chain Management

BITS Pilani Sudeep Kumar Pradhan, PhD.

Pilani Campus
 Chapter 5

Network Design in the Supply

Chain

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Network Design Decisions

• Facility role
• What role should each facility play?
• What processes are performed at each facility?

• Facility location
• Where should facilities be located?

• Capacity allocation
• How much capacity should be allocated to each facility?

• Market and supply allocation

• What markets should each facility serve?
• Which supply sources should feed each facility?

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Factors Influencing
Network Design Decisions

• Strategic
• Technological
• Macroeconomic
• Political
• Infrastructure
• Competitive
• Logistics and facility costs

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Strategic Factors

• Firms focusing on cost leadership will tend to

find the lowest-cost location for their
manufacturing facilities, even if that means
locating very far from the markets they serve.

• Firms focusing on responsiveness will tend to

locate facilities closer to the market and may
select a high-cost location if this choice allows
the firm to react quickly to changing market
needs.

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 Strategic Factors (Cont.)
According to Kasra Fredows, the strategic role
of various facilities in a global supply chain
network are as follows
1: Offshore facility: Low cost facility for export
production
2: Source Facility: Low cost for global
production
3:Server Facility: Regional production facility
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Strategic Factors (Cont.)

4: Contributor Facility: Regional production

facility with development skills
5:Outpost facility: Regional production
facility built to gain local skills
6:Lead Facility: Facility that leads in
development and process technologies
(It creates new product, processes and
technologies for the entire network)
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TECHNOLOGICAL FACTORS
• If production technology displays significant
economics of scale, few high-capacity locations are
the most effective.
• In contrast, if facilities have a lower fixed cost,
many local facilities are preferred because this
helps lower transportation costs.
• If production technology is very inflexible and
product requirements vary from to another, a firm
has to set up local facilities to serve the market in
each country.
• Flexibility of the production technology affects the
degree of consolidation.
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 MACROECONOMIC FACTORS
• Macroeconomic factors include taxes,
tariffs, exchange rates, and other
economic factors that are not internal to
an individual firm.
• It has significant influence on the
success or failure of supply chain
networks.
• Therefore, firms take these factors into
account when making network design
decisions.
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TARIFFS AND TAX INCENTIVES
• Tariffs refer to any duties that must be paid when
product or equipment are moved across international,
state, or city boundaries.
• If a country has a very high tariff, companies either do
not serve the local market or setup manufacturing
plants within the country to save on duties.
• High tariffs lead to more production locations within a
supply chain network, with each location having a lower
allocated capacity.
• Tax incentives are a reduction in tariffs or taxes that
countries, states, and cities often provide to encourage
firms to locate their facilities in specific areas.
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EXCHANGE RATE AND DEMAND RISK
• Fluctuation in exchange rates has significant
impact on the profits of any supply chain
serving global markets.
• An effective way to do this is to build some
over capacity in the network and make the
capacity flexible so that it can be used to
supply different markets.
• Companies must also take into account
fluctuations in demand caused by
fluctuations in the economics of different
countries.
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POLITICAL FACTORS

• The political stability of the country under

consideration plays a significant role in the
location choice.

• Countries with independent and clear legal

systems is always preferred.

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INFRASTRUCTURE FACTORS
• Key infrastructure elements to be
considered during network design
include:
• Availability of sites,
• Labor availability
• Proximity to transportation terminals
• Rail service, proximity to air ports and sea ports
• High way access
• Congestion
• Local utilities.

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COMPETITIVE FACTORS
• A fundamental decision firm’s
make is to whether their facilities
close to their competitors or far
from them.

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Positive externalities between the
firms

• Positive externalities are the instances

where the collocation of the multiple
firms benefits all of them.

• It also lead to the competitors locating

close to each other.

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 Locating to Split market

• When there are no PEs, firms locate to be able to

capture the largest possible share of the market.
• When firms do not control price but compete on the
distance from customer, they can maximize market
share by locating close to each other and splitting
the market.
• In case the firms compete on price and incur the
transportation cost to the customer, it may be
optimal for the two firms to locate as far as
possible.
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CUSTOMER RESPONSE TIME
AND LOCAL PRESENCE
• A large response time require few
locations and can focus on increasing
the capacity of each location.

• A short response times need to locate

close to them.

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LOGISTICS AND FACILITY COSTS
• Logistics and facility costs incurred
within a supply chain change as the
number of facilities, their location,
and capacity allocation is changed.
• Companies must consider inventory,
transportation and facility costs
when designing their supply chain
networks.
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A Framework for Global Site Location
Competitive STRATEGY GLOBAL COMPETITION
PHASE I
Supply Chain
INTERNAL CONSTRAINTS Strategy TARIFFS AND TAX
Capital, growth strategy, INCENTIVES
existing network

PRODUCTION TECHNOLOGIES REGIONAL DEMAND

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

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

FACTOR COSTS PHASE IV LOGISTICS COSTS

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

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 Gravity Methods for
Location
( x − x n ) + ( y − y n)
2 2
– x,y: Warehouse Coordinates d n
=
– xn, yn : Coordinates of delivery
 Dn * Fn 
n=k
location n ∑ 
n =1  dn 
 * X n
– dn : Distance to delivery location n x=
– Fn : Cost of shipping one unit for n
 Dn * Fn 
unit distance between the facility ∑ 
i =1  dn 

and either market or supply
source ‘n’.  Dn * Fn 
n=k

– Dn: Quantity shipped between ∑

n =1 

dn 
 * Yn
facility and market. y= n
k  Dn * Fn 
Min ∑d
n
n * Fn * Dn ∑ 
i =1  dn 


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Factor-Rating Method
 Popular because a wide variety of factors
can be included in the analysis
 Six steps in the method
1. Develop a list of relevant factors called critical
success factors
2. Assign a weight to each factor
3. Develop a scale for each factor
4. Score each location for each factor
5. Multiply score by weights for each factor for each
location
6. Recommend the location with the highest point
score
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 Factor-Rating Example

Critical Scores
Success (out of 100) Weighted Scores
Factor Weight France Denmark France Denmark
Labor
availability
and attitude .25 70 60 (.25)(70) = 17.5 (.25)(60) = 15.0
People-to-
car ratio .05 50 60 (.05)(50) = 2.5 (.05)(60) = 3.0
Per capita
income .10 85 80 (.10)(85) = 8.5 (.10)(80) = 8.0
Tax structure .39 75 70 (.39)(75) = 29.3 (.39)(70) = 27.3
Education
and health .21 60 70 (.21)(60) = 12.6 (.21)(70) = 14.7
Totals 1.00 70.4 68.0

Table 8.4
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BITS Pilani, Pilani Campus
Locational
Break-Even Analysis

 Method of cost-volume analysis used for

industrial locations
 Three steps in the method
1. Determine fixed and variable costs for each
location
2. Plot the cost for each location
3. Select location with lowest total cost for
expected production volume

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Locational Break-Even Analysis Example

Three locations:

Selling price = $120

Expected volume = 2,000 units

Fixed Variable Total

City Cost Cost Cost
Akron $30,000 $75 $180,000
Bowling Green $60,000 $45 $150,000
Chicago $110,000 $25 $160,000
Total Cost = Fixed Cost + (Variable Cost x Volume)

BITS Pilani, Pilani Campus

 Locational Break-Even Analysis Example

–
$180,000 –
–
$160,000 –
$150,000 –
–
$130,000 –
–
Annual cost

$110,000 –
–
–
$80,000 –
–
$60,000 –
–
–
Akron Chicago
$30,000 – Bowling Green
lowest lowest cost
– lowest cost
cost
$10,000 –
| | | | | | |
–
Figure 8.2 0 500 1,000 1,500 2,000 2,500 3,000
Volume
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 Thank You

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 Supply Chain Management

BITS Pilani Sudeep Kumar Pradhan, PhD.

Pilani Campus
Center-of-Gravity Method

 Finds location of distribution center

that minimizes distribution costs
 Considers
 Location of markets
 Volume of goods shipped to those
markets
 Shipping cost (or distance)

BITS Pilani, Pilani Campus

Center-of-Gravity Method

 Place existing locations on a

coordinate grid
 Grid origin and scale is arbitrary
 Maintain relative distances
 Calculate X and Y coordinates for
‘center of gravity’
 Assumes cost is directly proportional
to distance and volume shipped

BITS Pilani, Pilani Campus

Center-of-Gravity Method

∑dixQi
i
x - coordinate =
∑Qi
i

∑diyQi
i
y - coordinate =
∑Qi
i

where dix = x-coordinate of location i

diy = y-coordinate of location i
Qi = Quantity of goods moved to or
from location i
BITS Pilani, Pilani Campus
Center-of-Gravity Method
North-South
New York (130, 130)
Chicago (30, 120)
120 –
Pittsburgh (90, 110)
90 –

60 –

30 –
Atlanta (60, 40)

–
| | | | | |
East-West
30 60 90 120 150
Arbitrary
origin Figure 8.3

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 Center-of-Gravity Method

Number of Containers
Store Location Shipped per Month
Chicago (30, 120) 2,000
Pittsburgh (90, 110) 1,000
New York (130, 130) 1,000
Atlanta (60, 40) 2,000

(30)(2000) + (90)(1000) + (130)(1000) + (60)(2000)

x-coordinate =
2000 + 1000 + 1000 + 2000
= 66.7
(120)(2000) + (110)(1000) + (130)(1000) + (40)(2000)
y-coordinate =
2000 + 1000 + 1000 + 2000
= 93.3
BITS Pilani, Pilani Campus
Center-of-Gravity Method
North-South
New York (130, 130)
Chicago (30, 120)
120 –
Pittsburgh (90, 110)
90 – + Center of gravity (66.7, 93.3)

60 –

30 –
Atlanta (60, 40)

–
| | | | | |
East-West
30 60 90 120 150
Arbitrary
origin

BITS Pilani, Pilani Campus

Network Optimization Models
• Allocating demand to production
facilities

• Locating facilities and allocating

Key Costs:
capacity
• Fixed facility cost
• Transportation cost
• Production cost
• Inventory cost
• Coordination cost
Which plants to establish? How to configure the network?
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Plant Location with Multiple Sourcing

• yi = 1 if plant is Min∑
n

f y + ∑∑ c x
n m

ij ij
located at site i, 0 i =1
i i
i =1 j =1

otherwise s.t.
n

• xij = Quantity shipped ∑x = D

i =1
ij j

from plant site i to n

customer j ∑x ≤ K y
j =1
ij i i

∑ y ≤ K ; y ∈{0,1}
j =1
i i i

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 Demand Allocation Model

• Which market is served n m

Min ∑ ∑ cij xij
by which plant? i =1 j =1

s.t.
• Which supply sources n
∑ xij = D j
are used by a plant? i =1
m
∑ xij ≤ K i
xij = Quantity shipped from j =1

plant site i to customer j xij ≥ 0

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 Locating Plants and Warehouses
Simultaneously
• Location and Capacity allocation decisions
have to be made for both factories and
warehouses.

• Multiple warehouses may be used to satisfy

demand at a market and multiple factories
may be considered or used to replenish
warehouses

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 Assumption

• The units have been appropriately adjusted such that one unit of input
from a supply source produces one unit of finished product.
The model requires the following inputs:
• m = Number of markets or demand points
• n = Number of Potential factory locations
• l = Number of suppliers
• t = Number of Potential warehouses
• Dj = Annual demand from customer j
• Ki = Potential annual capacity of factory at site i
• SL = Annual Supply capacity at supplier L
• We = Potential annual warehouse capacity at site e
• Fi = Fixed annual cost of locating plant at site i
• Fe = Fixed annual cost of locating warehouse at site e
• Chi = Cost of shipping one unit from supply source h to factory i
• Cie = Cost of producing and shipping one unit from factory i to warehouse e
• Cej = Cost of shipping one unit from warehouse e to customer j
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 Decision variables

• yi = 1, if factory is located at site i, 0 otherwise

• ye = 1, if warehouse is located at site e, 0
otherwise
• xej = Quantity shipped from warehouse e to
market j
• xie = Quantity shipped from factory i to
warehouse e
• xhj = Quantity shipped from supplier h to
factory at site i per year.
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Objective Function

• Min ∑fi yi + ∑fe ye + ∑ ∑Chi xhi + ∑ ∑Cie xie +

∑ ∑Cej xej

• Min (Fixed cost of plant + Fixed cost of

warehouse + Cost of shipping from supplier
to plant + Cost of shipping from plant to
warehouse + Cost of shipping from
warehouse to customer)

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Constraints

• ∑ xhi <= Sh, for h = 1, 2, ….l

• ∑ xhi - ∑ xie >= 0, for i = 1, 2, ….n
• ∑ xie <= kiyi, for i = 1, 2, ….n
• ∑ xie - ∑ xej >= 0, for e = 1, 2, ….t
• ∑ xei <= weye, for e = 1, 2, ….’t’
• ∑ xej <= Dj, for j = 1, 2, ….’m’
• yi, ye ε {0, 1}

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

Network Design in an
Uncertain Environment

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Outline
• The Impact of Uncertainty on Network Design Decisions.
• Discounted Cash Flow Analysis.
• Representations of Uncertainty.
• Evaluating Network Design Decisions Using Decision
Trees.

• Making Supply Chain Decisions Under Uncertainty in

Practice.
• Summary of Learning Objectives.

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The Impact of Uncertainty on Network Design

• Supply chain design decisions include investments in

number and size of plants, number of trucks, number of
warehouses.
• These decisions cannot be easily changed in the short-
term.
• There will be a good deal of uncertainty in demand, prices,
exchange rates, and the competitive market over the
lifetime of a supply chain network.
• Therefore, building flexibility into supply chain operations
allows the supply chain to deal with uncertainty in a
manner that will maximize profits.
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 Discounted Cash Flow Analysis
• Supply chain decisions are in place for a long
time, so they should be evaluated as a sequence of
cash flows over that period.
• Discounted cash flow (DCF) analysis evaluates
the present value of any stream of future cash
flows and allows managers to compare different
cash flow streams in terms of their financial
value.
• Based on the time value of money – a dollar today
is worth more than a dollar tomorrow.
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Discounted Cash Flow Analysis
1
Discount factor =
1+ k
t
T
 1 
NPV = C0 + ∑   Ct
t =1  1 + k 

where
C0 , C1 ,..., CT is a stream of cash flows over T periods
NPV = the net present value of this stream of cash flows
k = rate of return

• Compare NPV of different supply chain design options.

• The option with the highest NPV will provide the greatest
financial return.
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NPV Example: Trips Logistics

• How much space to lease in the next three years.

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

For leasing warehouse space on the spot market:

Expected annual profit = 100,000 x $1.22 –
100,000 x $1.20 = $2,000
Cash flow = $2,000 in each of the next three years
C1 C2
NPV (no lease) = C0 + +
1 + k (1 + k )2
2000 2000
= 2000 + + 2
= $5,471
1.1 1.1

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 NPV Example: Trips Logistics

For leasing warehouse space with a three-year lease:

Expected annual profit = 100,000 x $1.22 – 100,000 x $1.00 = $22,000
Cash flow = $22,000 in each of the next three years

C1 C2
NPV (no lease) = C0 + +
1 + k (1 + k )2
22000 22000
= 22000 + + = $60,182
1.1 1.12

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

• Binomial Representation of Uncertainty

• Other Representations of Uncertainty

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 Binomial Representations of Uncertainty

• When moving from one period to the next, the value of the
underlying factor (e.g., demand or price) has only two possible
outcomes – up or down.
• The underlying factor moves up by a factor or u > 1 with
probability p, or down by a factor d < 1 with probability 1-p.
• Assuming a price P in period 0, for the multiplicative binomial,
the possible outcomes for the next four periods:
– Period 1: Pu, Pd
– Period 2: Pu2, Pud, Pd2
– Period 3: Pu3, Pu2d, Pud2, Pd3
– Period 4: Pu4, Pu3d, Pu2d2, Pud3, Pd4
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Binomial Representations of Uncertainty

• In general, for multiplicative binomial, period

T has all possible outcomes Putd(T-t), for t =
0,1,…,T.
• From state Puad(T-a) in period t, the price may
move in period t+1 to either
– Pua+1d(T-a) with probability p, or
– Puad(T-a)+1 with probability (1-p)
• Represented as the binomial tree.
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Binomial Representations of Uncertainty

• For the additive binomial, the states in the

following periods are:
– Period 1: P+u, P-d
– Period 2: P+2u, P+u-d, P-2d
– Period 3: P+3u, P+2u-d, P+u-2d, P-3d
– Period 4: P+4u, P+3u-d, P+2u-2d, P+u-3d, P-4d

• In general, for the additive binomial, period T has

all possible outcomes P+tu-(T-t)d, for t=0, 1, …, T

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

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 Decision Tree Methodology
1. Identify the duration of each period (month, quarter, etc.) and
the number of periods T over the which the decision is to be
evaluated.
2. Identify factors such as demand, price, and exchange rate,
whose fluctuation will be considered over the next T periods.
3. Identify representations of uncertainty for each factor; that is,
determine what distribution to use to model the uncertainty.
4. Identify the periodic discount rate k for each period.
5. Represent the decision tree with defined states in each
period, as well as the transition probabilities between states
in successive periods.
6. Starting at period T, work back to period 0, identifying the
optimal decision and the expected cash flows at each step.
Expected cash flows at each state in a given period should be
discounted back when included in the previous period.
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Decision Tree Methodology: Trips
Logistics
• Decide whether to lease warehouse space for the
coming three years and the quantity to lease.
• Long-term lease is currently cheaper than the spot
market rate.
• The manager anticipates uncertainty in demand and
spot prices over the next three years.
• Long-term lease is cheaper but could go unused if
demand is lower than forecast; future spot market rates
could also decrease.
• Spot market rates are currently high, and the spot
market would cost a lot if future demand is higher than
expected.
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Trips Logistics: Three Options
• Get all warehousing space from the spot market
as needed.
• Sign a three-year lease for a fixed amount of
warehouse space and get additional
requirements from the spot market.
• Sign a flexible lease with a minimum change that
allows variable usage of warehouse space up to a
limit with additional requirement from the spot
market.
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 Trips Logistics

• 1000 sq. ft. of warehouse space needed for 1000 units of

demand.
• Current demand = 100,000 units per year.
• Binomial uncertainty: Demand can go up by 20% with
p = 0.5 or down by 20% with 1-p = 0.5.
• Lease price = $1.00 per sq. ft. per year.
• Spot market price = $1.20 per sq. ft. per year.
• Spot prices can go up by 10% with p = 0.5 or down by 10%
with 1-p = 0.5.
• Revenue = $1.22 per unit of demand.
• k = 0.1.
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 Trips Logistics Decision Tree
Period 2
Period 1 D=144
Period 0 p=$1.45
0.25
D=144
0.25
p=$1.19
D=120
0.25
p=$1.32 D=96
0.25
p=$1.45
0.25
D=144
0.25 D=120 p=$0.97
p=$1. 08
D=100 D=96
p=$1.20 0.25 p=$1.19

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

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

D=64
p=$0.97
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 Thank You

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 Supply Chain Management

BITS Pilani Sudeep Kumar Pradhan, PhD.

Pilani Campus
 Trips Logistics

• 1000 sq. ft. of warehouse space needed for 1000 units of

demand.
• Current demand = 100,000 units per year.
• Binomial uncertainty: Demand can go up by 20% with
p = 0.5 or down by 20% with 1-p = 0.5.
• Lease price = $1.00 per sq. ft. per year.
• Spot market price = $1.20 per sq. ft. per year.
• Spot prices can go up by 10% with p = 0.5 or down by 10%
with 1-p = 0.5.
• Revenue = $1.22 per unit of demand.
• k = 0.1.
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 Trips Logistics Decision Tree
Period 2
Period 1 D=144
Period 0 p=$1.45
0.25
D=144
0.25
p=$1.19
D=120
0.25
p=$1.32 D=96
0.25
p=$1.45
0.25
D=144
0.25 D=120 p=$0.97
p=$1. 08
D=100 D=96
p=$1.20 0.25 p=$1.19

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

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

D=64
p=$0.97
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 Trips Logistics Example

• Analyze the option of not signing a lease and

obtaining all warehouse space from the spot market.
• Start with Period 2 and calculate the profit at each
node.
• For D=144, p=$1.45, in Period 2:
C(D=144, p=1.45,2) = 144,000x1.45 = $208,800
P(D=144, p =1.45,2) = 144,000x1.22 –
C(D=144,p=1.45,2) = 175,680-208,800 = -$33,120
• Profit at other nodes can be calculated in same way.

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BITS Pilani, Pilani Campus
Trips Logistics Example

• Expected profit at each node in Period 1 is the

profit during Period 1 plus the present value of
the expected profit in Period 2.
• Expected profit EP(D=, p=,1) at a node is the
expected profit over all four nodes in Period 2
that may result from this node.
• PVEP(D=,p=,1) is the present value of this
expected profit and P(D=,p=,1), and the total
expected profit, is the sum of the profit in Period
1 and the present value of the expected profit in
Period 2.

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BITS Pilani, Pilani Campus
 Trips Logistics Example

• From node D=120, p=$1.32 in Period 1, there are four

possible states in Period 2.
• Evaluate the expected profit in Period 2 over all four
states possible from node D=120, p=$1.32 in Period 1
to be
EP(D=120,p=1.32,1) = 0.25xP(D=144,p=1.45,2) +
0.25xP(D=144,p=1.19,2) +
0.25xP(D=96,p=1.45,2) +
0.25xP(D=96,p=1.19,2)
= 0.25x(-33,120)+0.25x4,320+0.25x(-
22,080)+0.25x2,880
= -$12,000

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BITS Pilani, Pilani Campus
 Trips Logistics Example
• The present value of this expected value in Period 1 is
PVEP(D=12, p=1.32,1) = EP(D=120,p=1.32,1) / (1+k)
= -$12,000 / (1+0.1)
= -$10,909
• The total expected profit P(D=120,p=1.32,1) at node
D=120,p=1.32 in Period 1 is the sum of the profit in Period 1
at this node, plus the present value of future expected profits
possible from this node
P(D=120,p=1.32,1) = [(120,000x1.22)-(120,000x1.32)] +
PVEP(D=120,p=1.32,1)
= -$12,000 + (-$10,909) = -$22,909
• The total expected profit for the other nodes in Period 1 will
be calculated..
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BITS Pilani, Pilani Campus
 Trips Logistics Example
• For Period 0, the total profit P(D=100,p=120,0) is the sum of
the profit in Period 0 and the present value of the expected
profit over the four nodes in Period 1
EP(D=100,p=1.20,0) = 0.25xP(D=120,p=1.32,1) +
0.25xP(D=120,p=1.08,1) +
0.25xP(D=96,p=1.32,1) +
0.25xP(D=96,p=1.08,1)
= 0.25x(-22,909)+0.25x32,073+0.25x(15,273)+0.25x
21,382 = $3,818
PVEP(D=100,p=1.20,0) = EP(D=100,p=1.20,0) / (1+k)
= $3,818 / (1 + 0.1) = $3,471

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BITS Pilani, Pilani Campus
Trips Logistics Example

P(D=100,p=1.20,0)=100,000x1.22-
100,000x1.20 +PVEP(D=100,p=1.20,0)
= $2,000 + $3,471 = $5,471
• Therefore, the expected NPV of not signing the
lease and obtaining all warehouse space from
the spot market is given by NPV(Spot Market)
= $5,471

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BITS Pilani, Pilani Campus
Trips Logistics Example

• Using the same approach for the lease option,

NPV(Lease) = $38,364.
• Recall that when uncertainty was ignored, the NPV
for the lease option was $60,182.
• However, the manager would probably still prefer
to sign the three-year lease for 100,000 sq. ft.
because this option has the higher expected profit.

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

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Making Supply Chain Design Decisions
Under Uncertainty in Practice
• Combine strategic planning and financial
planning during network design.

• Use multiple metrics to evaluate supply chain

networks.

• Use financial analysis as an input to decision

making, not as the decision-making process.
• Use estimates along with sensitivity analysis.

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 Summary of Learning
Objectives
• What are the uncertainties that influence supply
chain performance and network design?

• What are the methodologies that are used to

evaluate supply chain decisions under
uncertainty?

• How can supply chain network design decisions in

an uncertain environment be analyzed?

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BITS Pilani, Pilani Campus
 Question

What are some major non-financial

uncertainties that a company
should consider when making
decisions on where to source
product?

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Solution
• Supply chain risks include the chance of
disruptions and delays due to natural
disaster, war, terrorism, labor disputes, and
poor supplier performance.

• The chance of forecasting errors and

information systems breakdown are also
threats to the supply chain.

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Solution

• Risks associated with inventory include the

rate of obsolescence, shrinkage, and
demand uncertainty as well as the number
and financial strength of customers.

• There is always the chance that your

intellectual property may be compromised
by supply chain partners.

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Forecasting

BITS Pilani, Pilani Campus

 Outline
 Forecasting Approaches
 Overview of Qualitative Methods
 Overview of Quantitative Methods

BITS Pilani, Pilani Campus

Outline – Continued
 Time-Series Forecasting
 Decomposition of a Time Series
 Naive Approach
 Moving Averages
 Exponential Smoothing
 Exponential Smoothing with Trend
Adjustment
 Trend Projections
 Seasonal Variations in Data
 Cyclical Variations in Data

BITS Pilani, Pilani Campus

Outline – Continued
 Associative Forecasting Methods:
Regression and Correlation Analysis
 Using Regression Analysis for Forecasting
 Standard Error of the Estimate
 Correlation Coefficients for Regression
Lines
 Multiple-Regression Analysis

BITS Pilani, Pilani Campus

 What is Forecasting?
 Process of
predicting a future
event
 Underlying basis of
??
all business
decisions
 Production
 Inventory
 Personnel
 Facilities
BITS Pilani, Pilani Campus
 Forecasting Time Horizons
 Short-range forecast
 Up to 1 year, generally less than 3 months
 Purchasing, job scheduling, workforce levels, job
assignments, production levels
 Medium-range forecast
 3 months to 3 years
 Sales and production planning, budgeting
 Long-range forecast
 3+ years
 New product planning, facility location, research
and development

BITS Pilani, Pilani Campus

 Seven Steps in Forecasting
 Determine the use of the forecast
 Select the items to be forecasted
 Determine the time horizon of the
forecast
 Select the forecasting model(s)
 Gather the data
 Make the forecast
 Validate and implement results
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 The Realities!

 Forecasts are seldom perfect

 Most techniques assume an
underlying stability in the system
 Product family and aggregated
forecasts are more accurate than
individual product forecasts

BITS Pilani, Pilani Campus

Forecasting Approaches
Quantitative Methods
 Used when situation is ‘stable’ and
historical data exist
 Existing products
 Current technology
 Involves mathematical techniques
 e.g., forecasting sales of color
televisions

BITS Pilani, Pilani Campus

Overview of Qualitative Methods

 Jury of executive opinion

 Pool opinions of high-level experts,
sometimes augment by statistical models
 Delphi method
 Panel of experts, queried iteratively

BITS Pilani, Pilani Campus

Overview of Qualitative Methods

 Sales force composite

 Estimates from individual salespersons
are reviewed for reasonableness, then
aggregated
 Consumer Market Survey
 Ask the customer

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Jury of Executive Opinion
 Involves small group of high-level experts
and managers
 Group estimates demand by working
together
 Combines managerial experience with
statistical models
 Relatively quick
 ‘Group-think’
disadvantage

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Sales Force Composite
 Each salesperson projects his or
her sales
 Combined at district and national
levels
 Sales reps know customers’ wants
 Tends to be overly optimistic

BITS Pilani, Pilani Campus

 Delphi Method
 Iterative group Decision Makers
(Evaluate
process, continues responses and
until consensus is make decisions)
reached
 3 types of Staff
participants (Administering
survey)
 Decision makers
 Staff
 Respondents
Respondents
(People who can
make valuable
judgments)
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Consumer Market Survey
 Ask customers about purchasing
plans
 What consumers say, and what
they actually do are often different
 Sometimes difficult to answer

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 Overview of Quantitative
Approaches

1. Naive approach
2. Moving averages
Time-Series
3. Exponential Models
smoothing
4. Trend projection
5. Linear regression Associative
Model

BITS Pilani, Pilani Campus

Time Series Forecasting

 Set of evenly spaced numerical data

 Obtained by observing response variable
at regular time periods
 Forecast based only on past values, no
other variables important
 Assumes that factors influencing past and
present will continue influence in future

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Time Series Components

Trend Cyclical

Seasonal Random

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 Components of Demand
Trend
component
Demand for product or service

Seasonal peaks

Actual
demand

Average
demand over
Random four years
variation
| | | |
1 2 3 4
Year Figure 4.1

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 Trend Component
 Persistent, overall upward or
downward pattern
 Changes due to population,
technology, age, culture, etc.
 Typically several years duration

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Seasonal Component
 Regular pattern of up and down
fluctuations
 Due to weather, customs, etc.
 Occurs within a single year
Number of
Period Length Seasons
Week Day 7
Month Week 4-4.5
Month Day 28-31
Year Quarter 4
Year Month 12
Year Week 52
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 Cyclical Component
 Repeating up and down movements
 Affected by business cycle, political, and
economic factors
 Multiple years duration
 Often causal or
associative
relationships

0 5 10 15 20
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 Thank You

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BITS Pilani, Pilani Campus
 Supply Chain Management

BITS Pilani Sudeep Kumar Pradhan, PhD.

Pilani Campus
Supply Chain Management

Managing Economies of Scale

in the Supply Chain: Cycle
Inventory

BITS Pilani, Pilani Campus

 Outline

• Role of Cycle Inventory in a Supply Chain.

• Economies of Scale to Exploit Fixed Costs.
• Economies of Scale to Exploit Quantity
Discounts.
• Short-Term Discounting: Trade Promotions.
• Managing Multi-Echelon Cycle Inventory.
• Estimating Cycle Inventory-Related Costs in
Practice.

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BITS Pilani, Pilani Campus
Role of Inventory in the Supply Chain
Improve Matching of Supply
and Demand
Improved Forecasting

Reduce Material Flow Time

Reduce Waiting Time

Reduce Buffer Inventory

Supply / Demand Seasonal

Economies of Scale Variability Variability

Cycle Inventory Safety Inventory Seasonal Inventory

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BITS Pilani, Pilani Campus
 Role of Cycle Inventory
in a Supply Chain
• Lot, or batch size: quantity that a supply chain stage either
produces or orders at a given time.
• Cycle inventory: average inventory that builds up in the
supply chain because a supply chain stage either produces
or purchases in lots that are larger than those demanded
by the customer
– Q = lot or batch size of an order
– d = demand per unit time
• Inventory profile: plot of the inventory level over time.
Cycle inventory = Q/2 (depends directly on lot size)
• Average flow time = Avg inventory / Avg flow rate
• Average flow time from cycle inventory = Q/(2d)
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BITS Pilani, Pilani Campus
 Role of Cycle Inventory
in a Supply Chain
Q = 1000 units
d = 100 units/day
Cycle inventory = Q/2 = 1000/2 = 500 = Avg
inventory level from cycle inventory.
Avg flow time = Q/2d = 1000/(2)(100) = 5 days.
• Cycle inventory adds 5 days to the time a unit
spends in the supply chain.
• Lower cycle inventory is better because:
– Average flow time is lower
– Working capital requirements are lower
– Lower inventory holding costs
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BITS Pilani, Pilani Campus
 Role of Cycle Inventory
in a Supply Chain
• Cycle inventory is held primarily to take advantage of
economies of scale in the supply chain.
• Supply chain costs influenced by lot size:
– Material cost = C
– Fixed ordering cost = S
– Holding cost = H = hC (h = cost of holding $1 in inventory for one year)

• Primary role of cycle inventory is to allow different stages to

purchase product in lot sizes that minimize the sum of material,
ordering, and holding costs.
• Ideally, cycle inventory decisions should consider costs across
the entire supply chain, but in practice, each stage generally
makes its own supply chain decisions – increases total cycle
inventory and total costs in the supply chain.
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 Economies of Scale
to Exploit Fixed Costs

• Lot sizing for a single product (EOQ)

• Aggregating multiple products in a single order
• Lot sizing with multiple products or customers
– Lots are ordered and delivered independently for
each product
– Lots are ordered and delivered jointly for all
products
– Lots are ordered and delivered jointly for a subset of
products

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BITS Pilani, Pilani Campus
 Economies of Scale
to Exploit Fixed Costs

Annual demand = D
Number of orders per year = D/Q
Annual material cost = CD
Annual order cost = (D/Q)S
Annual holding cost = (Q/2)H = (Q/2)hC
Total annual cost = TC = CD + (D/Q)S + (Q/2)hC
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BITS Pilani, Pilani Campus
 Fixed Costs: Optimal Lot Size
and Reorder Interval (EOQ)
D: Annual demand
S: Setup or Order Cost H = hC
C: Cost per unit
h: Holding cost per year as a fraction of
2 DS
product cost
Q* =
H: Holding cost per unit per year
Q: Lot Size
H
2S
T: Reorder interval

n* =
Material cost is constant and therefore
is not considered in this model DH

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BITS Pilani, Pilani Campus
 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.

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BITS Pilani, Pilani Campus
 Example
Demand, D = 12,000 computers per year
d = 1000 computers/month
Unit cost, C = $500
Holding cost fraction, h = 0.2
Fixed cost, S = $4,000/order
Q* = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980
computers
Cycle inventory = Q/2 = 490
Flow time = Q/2d = 980/(2)(1000) = 0.49 month
Reorder interval, T = 0.98 month
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BITS Pilani, Pilani Campus
 Example (continued)
Annual ordering and holding cost =
= (12000/980)(4000) + (980/2)(0.2)(500) = $97,980

Suppose lot size is reduced to Q=200, which would reduce flow

time:
Annual ordering and holding cost =
= (12000/200)(4000) + (200/2)(0.2)(500) = $250,000

To make it economically feasible to reduce lot size, the fixed

cost associated with each lot would have to be reduced
*Discussion
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BITS Pilani, Pilani Campus
 Example

The store manager at Best Buy would like to

reduce the optimal lot size from 980 to 200.
For this lot size reduction to be optimal, the
store manager wants to evaluate how much
the order cost per lot should be reduced.

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 Example
If desired lot size = Q* = 200 units, what would S
have
to be?
D = 12000 units
C = $500
h = 0.2
Use EOQ equation and solve for S:
S = [hC(Q*)2]/2D =
[(0.2)(500)(200)2]/(2)(12000) = $166.67
To reduce optimal lot size by a factor of k, the fixed
order cost must be reduced by a factor of k2
15
BITS Pilani, Pilani Campus
 Key Points from EOQ Model

• In deciding the optimal lot size, the tradeoff is

between setup (order) cost and holding cost.

• If demand increases by a factor of 4, it is optimal

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

• If lot size is to be reduced, one has to reduce

fixed order cost. To reduce lot size by a factor of
2, order cost has to be reduced by a factor of 4.
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BITS Pilani, Pilani Campus
 Aggregating Multiple Products
in a Single Order
• Transportation is a significant contributor to the fixed cost per
order.
• Can possibly combine shipments of different products from the
same supplier
– same overall fixed cost
– shared over more than one product
– effective fixed cost is reduced for each product
– lot size for each product can be reduced
• Can also have a single delivery coming from multiple suppliers or
a single truck delivering to multiple retailers.
• Aggregating across products, retailers, or suppliers in a single
order allows for a reduction in lot size for individual products
because fixed ordering and transportation costs are now spread
across multiple products, retailers, or suppliers.
17
BITS Pilani, Pilani Campus
Example: Aggregating Multiple Products
in a Single Order
• Suppose there are 4 computer products in the previous
example: Deskpro, Litepro, Medpro, and Heavpro.
• Assume demand for each is 1000 units per month.
• If each product is ordered separately:
– Q* = 980 units for each product
– Total cycle inventory = 4(Q/2) = (4)(980)/2 = 1960 units.

• Aggregate orders of all four products:

– Combined Q* = 1960 units
– For each product: Q* = 1960/4 = 490
– Cycle inventory for each product is reduced to 490/2 = 245
– Total cycle inventory = 1960/2 = 980 units
– Average flow time, inventory holding costs will be reduced
18
BITS Pilani, Pilani Campus
 Lot Sizing with Multiple
Products or Customers
• In practice, the fixed ordering cost is dependent at least in part on
the variety associated with an order of multiple models
– A portion of the cost is related to transportation
(independent of variety)
– A portion of the cost is related to loading and
receiving (not independent of variety)
• Three scenarios:
– Lots are ordered and delivered independently for
each product
– Lots are ordered and delivered jointly for all three
models
– Lots are ordered and delivered jointly for a selected
subset of models
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BITS Pilani, Pilani Campus
 Example
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 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.
20
BITS Pilani, Pilani Campus
Lot Sizing with Multiple Products

• Demand per year

– DL = 12,000; DM = 1,200; DH = 120
• Common transportation cost, S = $4,000
• Product specific order cost
– sL = $1,000; sM = $1,000; sH = $1,000
• Holding cost, h = 0.2
• Unit cost
– CL = $500; CM = $500; CH = $500

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BITS Pilani, Pilani Campus
 Delivery Options

• No Aggregation: Each product ordered

separately.

• Complete Aggregation: All products

delivered on each truck.

• Tailored Aggregation: Selected subsets of

products on each truck.

22
BITS Pilani, Pilani Campus
 No Aggregation: Order Each Product
Independently
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

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

Total cost = $155,140

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BITS Pilani, Pilani Campus
 Aggregation: Order All
Products Jointly
Here all three models are included in each time an order is placed.

S * = S + s L + sM + s H
Annualordering cos t = S * * n
D * h * C L DM * h * CM DH * h * C H
Annualhoding cos t = L + +
2n 2n 2n
DL * h * C L DM * h * CM DH * h * C H
TotalCost = + + + S *n
2n 2n 2n
DL * h * C L + DM * h * CM + DH * h * C H
n* =
2* S*
k

*
∑ D * h *C
i i
n = i =1
2* S*
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BITS Pilani, Pilani Campus
 Complete Aggregation:
Order All Products Jointly
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Order 9.75/year 9.75/year 9.75/year
frequency
Optimal 1,230 123 12.3
order size
Annual $61,512 $6,151 $615
holding cost
Annual order cost = 9.75 × $7,000 = $68,250
Annual total cost = $136,528
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BITS Pilani, Pilani Campus
Tailored Aggregation

26
BITS Pilani, Pilani Campus
 Frequency of most frequently
ordered products=11

The frequency nL = 11
with which it is included with
the
most frequently ordered product
nm = 3.5
nH = 1.1
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BITS Pilani, Pilani Campus
Step 2 for example problem

nM = 7.7; nH = 2.4
11
mM = = 1.4
7. 7
11
mH = = 4.5
2.4
mM = 1.4 = 2
mH = 4.5 = 5
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BITS Pilani, Pilani Campus
 Applying step 3, the ordering frequency of most
frequently ordered model is recalculated as=11.47
29
BITS Pilani, Pilani Campus
 n L = 11.47 / year
11.47
nm = = 5.74 / year
Applying 2
step 4 nH =
11.47
= 2.29 / year
5

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BITS Pilani, Pilani Campus
 Tailored Aggregation: Using Heuristic

Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Order 10.47/year 5.74/year 2.29/year
frequency
Optimal 1,046 209 52
order size
Annual $52,307 $10,461 $2,615
holding cost
Annual order cost = $65,383.5
Annual total cost = $130,767
31
BITS Pilani, Pilani Campus
 Comparison for all three options

Options Total Cost

No Aggregation $155,140

Complete Aggregation $136,528

Tailored Aggregation $130,767

32
BITS Pilani, Pilani Campus
 Lessons from Aggregation

• Aggregation allows firm to lower lot size

without increasing cost.
• Complete aggregation is effective if
product specific fixed cost is a small
fraction of joint fixed cost.
• Tailored aggregation is effective if
product specific fixed cost is a large
fraction of joint fixed cost.

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BITS Pilani, Pilani Campus
 Quantity Discounts

• Lot size based

– All units
– Marginal unit
• Volume based

• How should buyer react?

• What are appropriate discounting
schemes?

34
BITS Pilani, Pilani Campus
All-Unit Quantity Discounts: Example

Cost/Unit Total Material Cost

$3
$2.96
$2.92

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

Order Quantity Order Quantity

35
BITS Pilani, Pilani Campus
 All-Unit Quantity Discounts

• Pricing schedule has specified quantity break

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

Step 1: Calculate the EOQ for the lowest price. If it is feasible

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

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BITS Pilani, Pilani Campus
 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 price charged by the manufacturer follows the all
unit discount pricing schedule is shown following.
Evaluate the number of bottles that the DO manager
should orderln each lot.

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BITS Pilani, Pilani Campus
 All-Unit Quantity Discount: Example

Order quantity Unit Price

0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92
q0 = 0, q1 = 5000, q2 = 10000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120000 units/year, S = $100/lot, h = 0.2

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BITS Pilani, Pilani Campus
Step 1: Calculate Q2* = Sqrt[(2DS)/hC2]
= Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410
Not feasible (6410 < 10001)
Calculate TC2 using C2 = $2.92 and q2 = 10001
TC2=(120000/10001)(100)+(10001/2)(0.2)(2.92)+
(120000)(2.92)= $354,520
Step 2: Calculate Q1* = Sqrt[(2DS)/hC1]
=Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367
Feasible (5000<6367<10000)  Stop
TC1=(120000/6367)(100)+(6367/2)(0.2)(2.96)+(120000)(2.
96) = $358,969
TC2 < TC1  The optimal order quantity Q* is q2 = 10001
40
BITS Pilani, Pilani Campus
 Marginal Unit Quantity Discount

• It is referred as multi-block tariffs.

• The marginal cost per unit varies with the

quantity purchased.

• If an order of size q is placed, the first q1-q0

units are priced at C0, the next q2-q1 are
priced at Ci and so on.

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BITS Pilani, Pilani Campus
 MUQD______
Vi be the cost of ordering qi units. Define V0=0 and Vi for 0 ≤ i ≤ r

Vi = Co (q1 − qo ) + C1 (q2 − q1 ) + ............ + Ci −1 (qi − qi −1 )

For each value of i, o ≤ i ≤ r − 1 ,consider

MCO = Vi + (Q − qi )Ci an order size Q in the range qi to qi+1 units.

D
ACO = 
Q
S
  The material cost of each order of size Q
(qi ≤ Q ≤ qi +1 ) is given by

h
AHC = [Vi ( )
+ Q − qi Ci ]
2

D
AMC = [Vi + (Q − qi )Ci ]
Q 42
BITS Pilani, Pilani Campus
 MUQD______

TAC = ACO + AHC + AMC

D h D
=   S + [Vi + (Q − qi )Ci ] + [Vi + (Q − qi )Ci ]
Q 2 Q

2 D(S + Vi − qi Ci )
Qi =
hCi

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BITS Pilani, Pilani Campus
 Example
• Assume that manufacturer uses the following
MUQD
pricing schedule.
Order quantity Unit Price
0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92

Evaluate the number of bottles that Drugs Online

should order in each lot.

44
BITS Pilani, Pilani Campus
 Solution

q0 = 0; q1 = 5,000; q2 = 10,000
C0 = $3.00; C1 = $2.96; C2 = $2.92
q0 = 0; q1 = 5,000; q2 = 10,000
C0 = $3.00; C1 = $2.96; C2 = $2.92

Vo = 0;V1 = 3(5000 −) 0 ) = 15,000

Vo = 0;V1 = 3(5000 − 0 ) = 15,000
(
V2 = 3 5000 − 0 + 2.96(10,000 − 5,000)
= $29,800

V2 = 3(5000 − 0 ) + 2.96(10,000 − 5,000)

D = 120,000; S = $100 / lot ; h = 0.2

= $29,800
D = 120,000; S = $100 / lot ; h = 0.2

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BITS Pilani, Pilani Campus
 Solution
• For i=0, evaluate Q0=6,324 (it is not feasible).
• Optimum order size is 5,000 and corresponding
total cost is $363,900 in this price range.
• For i=1, evaluate Q1=11,028 (it is not feasible)
• Optimum order size is 10,000 and
corresponding total cost is $361,780 in this
price range.
• For i=1, evaluate Q2=16,961 (it is feasible).
• Optimum order size is 16,961 and
corresponding total cost is $360,365 in this
price range.
• Optimum order size is 16,961.
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BITS Pilani, Pilani Campus
 Why Quantity Discounts?

• Coordination in the supply chain

– Commodity products
– Products with demand curve
• 2-part tariffs
• Volume discounts

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BITS Pilani, Pilani Campus
 Coordination for
Commodity Products

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

Retailer’s optimal lot size = 6,324 bottles

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

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BITS Pilani, Pilani Campus
 Coordination for
Commodity Products
• What can the supplier do to decrease supply
chain costs?
– Coordinated lot size: 9,165; Retailer cost =
$4,059; Supplier cost = $5,106; Supply chain
cost = $9,165
• Effective pricing schemes
– All-unit quantity discount
• $3 for lots below 9,165
• $2.9978 for lots of 9,165 or more
– Pass some fixed cost to retailer (enough that he
raises order size from 6,324 to 9,165)

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BITS Pilani, Pilani Campus
 Two-Part Tariffs and
Volume Discounts
• Design a two-part tariff that achieves the coordinated
solution.
– In this case the manufacture charges its entire profit as an up-
front franchise fee and then sells to the retailer at cost.
– In this particular situation, up-front fee is $180,000 and CR=$2.
• Design a volume discount scheme that achieves the
coordinated solution.
– The manufacture offers a price of CR=$4 per bottle if the
quantity DO purchases per year is less than 120,000,
otherwise CR=$3.50 per bottle.

• Impact of inventory costs.

– Pass on some fixed costs with above pricing

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BITS Pilani, Pilani Campus
 Lessons from Discounting Schemes
• Lot size based discounts increase lot size and
cycle inventory in the supply chain.
• Lot size based discounts are justified to achieve
coordination for commodity products.
• Volume based discounts with some fixed cost
passed on to retailer are more effective in
general.
– Volume based discounts are better over rolling
horizon

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BITS Pilani, Pilani Campus
 Short-Term Discounting:
Trade Promotions
• Trade promotions are price discounts for a limited period of time
(also may require specific actions from retailers, such as displays,
advertising, etc.).
• Key goals for promotions from a manufacturer’s perspective:
– Induce retailers to use price discounts, displays, advertising to increase sales
– Shift inventory from the manufacturer to the retailer and customer
– Defend a brand against competition
– Goals are not always achieved by a trade promotion
• What is the impact on the behavior of the retailer and on the
performance of the supply chain?
• Retailer has two primary options in response to a promotion:
– Pass through some or all of the promotion to customers to spur sales
– Purchase in greater quantity during promotion period to take advantage of
temporary price reduction, but pass through very little of savings to
customers.

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BITS Pilani, Pilani Campus
 Short Term Discounting

Q*: Normal order quantity

Assumptions:
C: Normal unit cost
d: Short term discount 1. Discount will only be offered once.
D: Annual demand 2. The order quantity Qd is multiple
of Q*
h: Cost of holding $1 per year 3. Retailer take no action to influence
Qd: Short term order quantity the customer demand. The customer
demand remains unchanged

CQ
*
dD
Q
d
Forward buy = Qd - Q* = +
(C - d )h C - d
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BITS Pilani, Pilani Campus
DO is a retailer that sells vitaherb, a popular
vitamin diet supplement. Demand for vitaherb is
120,000 bottles per year. The manufacturer
currently charges $3 for each bottle and DO
incurs a holding cost of 20 percent. DO currently
orders in lots of Q* = 6,324 bottles. The
manufacturer has offered a discount of $0.15 for
all bottles purchased by retailers over the coming
month. How many bottles of vitaherb should DO
order given the promotion?
54
BITS Pilani, Pilani Campus
 Short Term Discounts:
Forward Buying
Normal order size, Q* = 6,324 bottles
Normal cost, C = $3 per bottle
Discount per tube, d = $0.15
Annual demand, D = 120,000
Holding cost, h = 0.2
0.15 * 120,000 0.15*6324
Q
d
= +
(3 − 0.15)0.2 (3 − 0.15)
Qd = 38,236
Forward buy = 38,236-6324=31,912
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BITS Pilani, Pilani Campus
Promotion Pass Through
to Consumers
Demand curve at retailer: 300,000 - 60,000p
Normal supplier price, CR = $3.00
– Optimal retail price = $4.00
– Customer demand = 60,000
Promotion discount = $0.15
– Optimal retail price = $3.925
– Customer demand = 64,500
Retailer only passes through half the promotion
discount and demand increases by only 7.5%

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BITS Pilani, Pilani Campus
 Trade Promotions

• When a manufacturer offers a promotion,

the goal for the manufacturer is to take
actions (countermeasures) to discourage
forward buying in the supply chain.

• Counter measures
– EDLP
– Customer coupons

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BITS Pilani, Pilani Campus
 Summary of Learning Objectives

• How are the appropriate costs balanced to

choose the optimal amount of cycle inventory
in the supply chain?
• What are the effects of quantity discounts on
lot size and cycle inventory?
• What are appropriate discounting schemes for
the supply chain, taking into account cycle
inventory?
• What are the effects of trade promotions on lot
size and cycle inventory?
• What are managerial levers that can reduce lot
size and cycle inventory without increasing
costs?
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BITS Pilani, Pilani Campus
 Thank You

11/13/2021 59
BITS Pilani, Pilani Campus
 Supply Chain Management

BITS Pilani Sudeep Kumar Pradhan, PhD.

Pilani Campus
Supply Chain Management

Managing Uncertainty in the

Supply Chain: Safety Inventory

BITS Pilani, Pilani Campus

Outline

• The role of safety inventory in a supply chain

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

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BITS Pilani, Pilani Campus
The Role of Safety Inventory
in a Supply Chain
• Forecasts are rarely completely accurate.
• If average demand is 1000 units per week, then
half the time actual demand will be greater than
1000, and half the time actual demand will be
less than 1000; what happens when actual
demand is greater than 1000? - Gucci
• If you kept only enough inventory in stock to
satisfy average demand, half the time you would
run out.
• Safety inventory: Inventory carried for the
purpose of satisfying demand that exceeds the
amount forecasted in a given period.
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BITS Pilani, Pilani Campus
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

5
BITS Pilani, Pilani Campus
Two Questions to Answer in
Planning Safety Inventory

• What is the appropriate level of

safety inventory to carry?

• What actions can be taken to

improve product availability while
reducing safety inventory?

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BITS Pilani, Pilani Campus
Determining the Appropriate
Level of Demand Uncertainty

• Appropriate level of safety inventory

determined by:
– supply or demand uncertainty
– desired level of product availability
• Higher levels of uncertainty require higher
levels of safety inventory given a particular
desired level of product availability.
• Higher levels of desired product availability
require higher levels of safety inventory given
a particular level of uncertainty

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BITS Pilani, Pilani Campus
 Measuring Demand Uncertainty

• Demand has a systematic component and a random

component
• The estimate of the random component is the measure of
demand uncertainty.
• Random component is usually estimated by the standard
deviation of demand.
• Notation:
D = Average demand per period
σD = 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.
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BITS Pilani, Pilani Campus
Measuring Demand Uncertainty

• P = demand during k periods = kD

• Ω = std dev of demand during k periods =

σRSqrt(k) (Demand between two periods is
independent)

• Coefficient of variation = cv = σ/µ =(std dev)

/mean= size of uncertainty relative to demand

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BITS Pilani, Pilani Campus
 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
(RC) that end with all customer demand met. RC is
the interval between two successive replenishment
deliveries.
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BITS Pilani, Pilani Campus
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).

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BITS Pilani, Pilani Campus
 Continuous Review Policy: Safety Inventory
and Cycle Service Level

D
L: Lead time for replenishment
D: Average demand per unit L
= DL
time
σD:Standard deviation of demand
per period
DL: Mean demand during lead
σ L
= L σD
ss = F S (CSL) ×σ L
−1
time
σL: Standard deviation of

ROP = D L + ss
demand during lead time
CSL: Cycle service level
ss: Safety inventory
ROP: Reorder point CSL = F ( ROP, D L ,σ L )
Average Inventory = Q/2 + ss
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BITS Pilani, Pilani Campus
Estimating Safety Inventory (Continuous
Review Policy)
Assume that weekly demand for Palms at B&M Computer World is
normally distributed, with a mean of 2,500 and a standard
deviation of 500. The manufacturer takes two weeks to fill an
order placed by the B&M manager. The store manager currently
orders 10,000 Palms when the inventory on hand drops to 6,000.
Evaluate the safety inventory carried by B&M and the average
inventory carried by B&M. Also evaluate the average time spent
by a Palm at B&M.
D = 2,500/week; σD = 500
L = 2 weeks; Q = 10,000; ROP = 6,000

SS and Avv. Time spend ?

13
BITS Pilani, Pilani Campus
Estimating Safety Inventory (Continuous
Review Policy)
D = 2,500/week; σD = 500
L = 2 weeks; Q = 10,000; ROP = 6,000

DL = DL = (2500)(2) = 5000
ss = ROP - RL = 6000 - 5000 = 1000
Cycle inventory = Q/2 = 10000/2 = 5000
Average Inventory = cycle inventory + ss =
5000 + 1000 = 6000
Average Flow Time = Avg inventory /
throughput = 6000/2500 = 2.4 weeks
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BITS Pilani, Pilani Campus
Estimating Cycle Service Level (Continuous
Review Policy)

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

σ =σ
L R
L = (500) 2 = 707
Cycle Service Level, CSL = Prob. (z less than equal to
1.414)= 0.92.

(This value is determined from a Normal

probability distribution table).

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BITS Pilani, Pilani Campus
 Fill Rate
• Proportion of customer demand
satisfied from stock ESC
fr = 1 −
• Stockout occurs when the Q
demand during lead time
exceeds the reorder point  ss 
• ESC is the expected shortage ESC = − ss{1 − F S  }
per cycle (average demand in σ L 
excess of reorder point in each
replenishment cycle)  ss 
+ σ L f S  
• ss is the safety inventory σ L 
• Q is the order quantity

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

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BITS Pilani, Pilani Campus
Factors Affecting Fill Rate

• Safety inventory: Fill rate increases if

safety inventory is increased. This also
increases the cycle service level.
• Lot size: Fill rate increases on increasing
the lot size.

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BITS Pilani, Pilani Campus
Evaluating
Safety Inventory Given CSL

D = 2,500/week; σD = 500
L = 2 weeks; Q = 10,000; CSL = 0.90

ROP ?

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BITS Pilani, Pilani Campus
Evaluating
Safety Inventory Given CSL

D = 2,500/week; σD = 500
L = 2 weeks; Q = 10,000; CSL = 0.90
DL = 5000, σL = 707 1.28

ss = FS-1(CSL)σL = FS-1(0.90)(707) = 906

ROP = DL + ss = 5000 + 906 = 5906

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BITS Pilani, Pilani Campus
Evaluating Safety Inventory
Given Desired Fill Rate

D = 2500, σD = 500, Q = 10000

If desired fill rate is fr = 0.975, how much
safety inventory should be held?
ESC = (1 - fr)Q = 250  ss   ss 
ESC = 250 = − ss 1 − F S   + σ L f S  
Solve   σ L   σL 
  ss  ∞
1
250 = ESC = − ss 1 − FS   + σ L ∫ e − w dw
 σ L  w=
ss 2 2π
2σ L 2

SS=67 20
BITS Pilani, Pilani Campus
Evaluating Safety Inventory Given Fill Rate
(try different values of ss)

Fill Rate Safety Inventory

97.5% 67
98.0% 183
98.5% 321
99.0% 499
99.5% 767

The required safety inventory grows rapidly with an increase in

the desired product availability.

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

22
BITS Pilani, Pilani Campus
Impact of Supply Uncertainty

• D: Average demand per period

• σD: Standard deviation of demand per
period
• L: Average lead time
• sL: Standard deviation of lead time
DL = DL

σ σ D s
2 2 2
L
= L D
+ L
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BITS Pilani, Pilani Campus
Example

Daily demand for PCs at Dell is normally distributed, with a

mean of 2,500 and a standard deviation of 500. A key
component in PC assembly is the hard drive. The hard drive
supplier takes an average of L = 7 days to replenish inventory
at Dell. Dell is targeting a CSL of 90 percent (providing a fill
rate close to 1 00 percent) for its hard drive inventory.
Evaluate the safety inventory of hard drives that Dell must
carry if the standard deviation of the lead time is seven days.
Dell is working with the supplier to reduce the standard
deviation to zero. Evaluate the reduction in safety inventory
that Dell can expect as a result of this initiative.

24
BITS Pilani, Pilani Campus
Impact of Supply Uncertainty

Demand information at Dell for PC is given as

D = 2,500/day; σD = 500. Target CSL = 0.90 and
Hard Drive supplier information as follows L = 7 days; sL = 7 days
Evaluate the safety inventory of hard drive, Dell has to carry.
DL = DL = (2500)(7) = 17500

σ L
= L σ + D sL
2
D
2 2

2 2
= (7) 500 + (2500) (7) = 17500
2

ss = F-1s(CSL)σL = NORMSINV(0.90) x 17550= 22,491

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BITS Pilani, Pilani Campus
Required safety inventory as a function of lead time
sL Std. dev. during SS(units) SS(days)
lead time
7 17,550 22,491 9
6 15,058 19,298 7.72
5 12,570 16,109 6.44
4 10,087 12,927 5.17
3 7,616 9,760 3.90
2 5,172 6,628 2.65
1 2,828 3,625 1.45
0 1,323 1,695 0.68

A reduction in supply chain uncertainty can help dramatically reduce

safety inventory required without hurting product availability.
BITS Pilani, Pilani Campus
Techniques for reduction of
Safety Inventory
• Models of aggregation

• Information centralization

• Specialization
• Product substitution
• Component commonality
• Postponement
27
BITS Pilani, Pilani Campus
Impact of Aggregation

D = ∑D
C
i
i =1
n

σ ∑σ
C 2
D
= i
i =1

σ = Lσ D
C C
L

ss = F s (CSL) ×σ L
−1 C

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BITS Pilani, Pilani Campus
Impact of Aggregation

Car Dealer : 4 dealership locations (disaggregated)

D = 25 cars; σD = 5 cars; L = 2 weeks; desired CSL=0.90
What would the effect be on safety stock if the 4 outlets are
consolidated into 1 large outlet (aggregated)?

At each disaggregated outlet:

For L = 2 weeks, σL = 7.07 cars
ss = Fs-1(CSL) x σL = Fs-1(0.9) x 7.07 = 9.06
Each outlet must carry 9 cars as safety stock inventory, so safety
inventory for the 4 outlets in total is (4)(9) = 36 cars

29
BITS Pilani, Pilani Campus
Impact of Aggregation

One outlet (aggregated option):

DC = D1 + D2 + D3 + D4 = 25+25+25+25 = 100 cars/wk
σDC = Sqrt(52 + 52 + 52 + 52) = 10
σLC = σDC Sqrt(L) = (10)Sqrt(2) = (10)(1.414) = 14.14
ss = Fs-1(CSL) x σLC = Fs-1(0.9) x 14.14 =18.12
or about 18 cars
If ρ does not equal 0 (demand is not completely
independent), the impact of aggregation is not as great.

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BITS Pilani, Pilani Campus
Safety Inventory in the Disaggregate and
Aggregate options
ρ Disaggregate Safety Inventory Aggregate Safety
Inventory
0 36.24 18.12
0.2 36.24 22.92
0.4 36.24 26.88
0.6 36.24 30.32
0.8 36.24 33.41
1.0 36.24 36.24

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BITS Pilani, Pilani Campus
Impact of Supply Uncertainty

Demand information at Dell for PC is given as

D = 2,500/day; σD = 500. Target CSL = 0.90 and
Hard Drive supplier information as follows L = 7 days; sL = 7 days
Evaluate the safety inventory of hard drive, Dell has to carry.
DL = DL = (2500)(7) = 17500

σ L
= L σ + D sL
2
D
2 2

2 2
= (7) 500 + (2500) (7) = 17500
2

ss = F-1s(CSL)σL = NORMSINV(0.90) x 17550= 22,491

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BITS Pilani, Pilani Campus
Required safety inventory as a function of lead time
sL Std. dev. during SS(units) SS(days)
lead time
7 17,550 22,491 9
6 15,058 19,298 7.72
5 12,570 16,109 6.44
4 10,087 12,927 5.17
3 7,616 9,760 3.90
2 5,172 6,628 2.65
1 2,828 3,625 1.45
0 1,323 1,695 0.68

A reduction in supply chain uncertainty can help dramatically reduce

safety inventory required without hurting product availability.
BITS Pilani, Pilani Campus
Techniques for reduction of
Safety Inventory
• Models of aggregation

• Information centralization

• Specialization
• Product substitution
• Component commonality
• Postponement
34
BITS Pilani, Pilani Campus
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 stock-out, another warehouse can fill the order.

• Better responsiveness, lower transportation cost, higher

product availability, but reduced safety inventory.

• Examples: McMaster-Carr, Gap, Wal-Mart.

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BITS Pilani, Pilani Campus
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).

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BITS Pilani, Pilani Campus
Product Substitution

• Substitution: use of one product to satisfy

the demand for another product.
• Manufacturer-driven one-way substitution
– It is influenced by the cost differential between
high and low value item.
– The value substitution increases as demand
uncertainty increases.
– It is also influenced by the correlation between
products.

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BITS Pilani, Pilani Campus
Product Substitution

• Customer-driven two-way substitution.

Recognition of customer-driven two-way substitution

and joint management across substitutable products
allows a SC to reduce the required safety inventory
While ensuring a high level of product availability.

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BITS Pilani, Pilani Campus
Component Commonality

• Using common components in a variety

of different products.

• Can be an effective approach to exploit

aggregation and reduce component
inventories.

39
BITS Pilani, Pilani Campus
Component Commonality

• Using common components in a variety

of different products.

• Can be an effective approach to exploit

aggregation and reduce component
inventories.

40
BITS Pilani, Pilani Campus
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

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BITS Pilani, Pilani Campus
Supply Chain Management

Sourcing Decisions in a Supply

Chain

BITS Pilani, Pilani Campus

Outline

• The Role of Sourcing in a Supply Chain

• Supplier Scoring and Assessment
• Supplier Selection and Contracts
• Design Collaboration
• The Procurement Process
• Sourcing Planning and Analysis
• Making Sourcing Decisions in Practice
• Summary of Learning Objectives
43
BITS Pilani, Pilani Campus
The Role of Sourcing
in a Supply Chain

• Sourcing is the set of business processes

required to purchase goods and services.

• Sourcing processes include:

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

44
BITS Pilani, Pilani Campus
Benefits of Effective
Sourcing Decisions
• Better economies of scale can be achieved if orders are
aggregated.
• More efficient procurement transactions can
significantly reduce the overall cost of purchasing.
• Design collaboration can result in products that are
easier to manufacture and distribute, resulting in lower
overall costs.
• Good procurement processes can facilitate coordination
with suppliers.
• Appropriate supplier contracts can allow for the sharing
of risk.
• Firms can achieve a lower purchase price by increasing
competition through the use of auctions
45
BITS Pilani, Pilani Campus
Supplier Scoring and
Assessment

• Supplier performance should be compared

on the basis of the supplier’s impact on total
cost.

• There are several other factors besides

purchase price that influence total cost.

46
BITS Pilani, Pilani Campus
 Supplier Assessment Factors

• Replenishment Lead Time • Pricing Terms

• On-Time Performance • Information
• Supply Flexibility Coordination Capability
• Delivery Frequency / • Design Collaboration
Minimum Lot Size Capability
• Supply Quality • Exchange Rates, Taxes,
• Inbound Transportation Duties
Cost • Supplier Viability

47
BITS Pilani, Pilani Campus
 Example Problem

• Daily demand for lawn mowers at Green Thumb is

normally distributed with a mean of 1,000 and a
standard deviation of 300.
• Green thumb, a manufacture of lawn mowers has
historically purchased a thousand bearings per
week from a local supplier who charges $1.00 per
bearing.
• The purchasing manager has identified another
potential source willing to supply the bearing at
$0.97 per bearing.
• Before making decision, the purchasing manager
evaluates the performance of the two suppliers.

48
BITS Pilani, Pilani Campus
Example Problem

• The supplier has average lead time of two

weeks and has agreed to deliver the bearings in
batches of 2,000.
• Based on past on-time performance, the
purchasing manager estimates that the lead
time has a standard deviation of one week.
• The new source has an average lead time of six
weeks with a standard deviation of four weeks.
• The new source requires a minimum batch size
of 8,000 bearings.

49
BITS Pilani, Pilani Campus
Example Problem

• Which supplier should purchasing manager

go with? Green thumb has a holding cost of
25 percent.

• They currently use a continuous review

policy for managing inventory and aims for
a cycle service level of 95 percent?

50
BITS Pilani, Pilani Campus
The cost of using current
supplier
• Annual material cost: 1,000*52*1=$52,000
• Average cycle inventory: 2,000/2 =1,000
• Annual cost of holding cycle inventory:
1,000*1*0.25=$250
• SD of demand during lead time:
(2*3002+ 10002*12)0.5= 1086.28
• SS= NORMSINV(0.95)*1086.28=3,787
• Annual cost of holding SS= 3,787*0.25*1=
$946.75
• Annual cost of using current supplier: $52,000+
$250+$946.75= $53,196.75
51
BITS Pilani, Pilani Campus
The cost of using new supplier

• Annual material cost: 1,000*52*0.97=$50,440

• Average cycle inventory: 8,000/2 =4,000
• Annual cost of holding cycle inventory:
4,000*0.97*0.25=$970
• SD of demand during lead time:
(6*3002+ 10002*42)0.5= 4066.94
• SS= NORMSINV(0.95)*4066.94=12,690
• Annual cost of holding SS= 12,690*0.25*0.97= $3,077.21
• Annual cost of using current supplier: $50,440+
$970+$3,077.21= $54,487.21

52
BITS Pilani, Pilani Campus
Supplier Selection- Auctions and
Negotiations

• Supplier selection can be performed

through competitive bids, reverse
auctions, and direct negotiations.
• Supplier evaluation is based on total cost
of using a supplier.

53
BITS Pilani, Pilani Campus
Contracts and Supply Chain
Performance

• Contracts for Product Availability and

Supply Chain Profits
– Buyback Contracts
– Revenue-Sharing Contracts
– Quantity Flexibility Contracts

54
BITS Pilani, Pilani Campus
Contracts for Product Availability
and Supply Chain Profits
• Many shortcomings in supply chain performance occur
because the buyer and supplier are separate
organizations and each tries to optimize its own profit.
• Total supply chain profits might therefore be lower than
if the supply chain coordinated actions to have a common
objective of maximizing total supply chain profits.
• Double marginalization results in suboptimal order
quantity.
• An approach to dealing with this problem is to design a
contract that encourages a buyer to purchase more and
increase the level of product availability.
• The supplier must share in some of the buyer’s demand
uncertainty.

55
BITS Pilani, Pilani Campus
Contracts to Coordinate
Supply Chain Costs
• Differences in costs at the buyer and supplier
can lead to decisions that increase total supply
chain costs.
• Example: Replenishment order size placed by
the buyer. The buyer’s EOQ does not take into
account the supplier’s costs.
• A quantity discount contract may encourage the
buyer to purchase a larger quantity (which
would be lower costs for the supplier), which
would result in lower total supply chain costs.
• Quantity discounts lead to information
distortion because of order batching.
56
BITS Pilani, Pilani Campus
Contracts to Increase Agent
Effort

• There are many instances in a supply chain where an

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

57
BITS Pilani, Pilani Campus
Contracts to Induce
Performance Improvement
• A buyer may want performance
improvement from a supplier who otherwise
would have little incentive to do so.
• A shared savings contract provides the
supplier with a fraction of the savings that
result from the performance improvement.
• Particularly effective where the benefit from
improvement occurs primarily to the buyer,
but where the effort for the improvement
comes primarily from the supplier.
58
BITS Pilani, Pilani Campus
Design Collaboration

• 50-70 percent of spending at a manufacturer

is through procurement.
• 80 percent of the cost of a purchased part is
fixed in the design phase.
• Design collaboration with suppliers can
result in reduced cost, improved quality, and
decreased time to market.
• Important to employ design for logistics,
design for manufacturability.
• Manufacturers must become effective design
coordinators throughout the supply chain.
59
BITS Pilani, Pilani Campus
The Procurement Process

• The process in which the supplier sends product in response

to orders placed by the buyer.
• Goal is to enable orders to be placed and delivered on schedule
at the lowest possible overall cost.
• Two main categories of purchased goods:
– Direct materials: components used to make finished goods
– Indirect materials: goods used to support the operations of a firm
– Differences between direct and indirect materials
– Focus for direct materials should be on improving coordination and
visibility with supplier
– Focus for indirect materials should be on
decreasing the transaction cost for each order.
• Procurement for both should consolidate orders where
possible to take advantage of economies of scale and quantity
discounts

60
BITS Pilani, Pilani Campus
Product Categorization by Value and
Criticality

High
Critical Items Strategic Items
Criticality

General Items Bulk Purchase

Items
Low

Low High
Value/Cost
61
BITS Pilani, Pilani Campus
 Global Supply Chain
Management V2 Simulation
How to Play Guide

Copyright © 2016 President and Fellows of Harvard College.

This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 62

 Challenge
When companies provide extensive product options, it makes
predicting and fulfilling customer demand highly complex.

This simulation illustrates how a few key decisions can improve the
ability of a company to accurately predict and fulfill demand.

You have just been hired as the Supply Chain Manager responsible for
production of two new lines of mobile phones. You will be able to make
key decisions and see the impact of your decisions on the performance
of your company over the span of 4 years.
Copyright © 2016 President and Fellows of Harvard College.
This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 63

 Your Objectives
• You are in charge of releasing two models of mobile phones:
• Model A, a base model
• Model B, a high end model

• Decide which features to include and with whom to outsource the work.

Important Info:
• Sales season is May through December—there is no demand before May or after December
• Demand is anticipated to be consistent over these months

You will be judged on the following criteria:

Gross Margin
Number of Votes of Confidence by Board Members

Copyright © 2016 President and Fellows of Harvard College.

This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 64

Board Members’ Objectives
Member Objective
Carla Forecasting: choice of options (consensus
vs. mean)
Ankit Forecasting: choice of options (role of risk)

Adele Stocking Levels: Weighing the costs of

over/understocking
Mia Production flexibility: accurate response/
sourcing strategy (focus on flexibility)
Matheo Production flexibility: accurate response/
sourcing strategy (focus on demand
uncertainty)
Copyright © 2016 President and Fellows of Harvard College.
September 1, 2016 65
 Design Room
• Add up to four options to the base model
• *Pay attention to the estimated change in
demand created by each option, its impact on
profit per unit, and other variables

Copyright © 2016 President and Fellows of Harvard College.

This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 66

 Forecasting Room
• Predict the demand of the two phone
models for each year

• *Remember, demand is spread out

evenly across all months from May to
December.

Copyright © 2016 President and Fellows of Harvard College.

This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 67

 Production Room
• After choosing suppliers you will advance
month by month and observe the accuracy of
your forecasts
• You will be able to change your production
schedule, but this will require a significant
payment to your suppliers

Copyright © 2016 President and Fellows of Harvard College.

This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 68

 Board Room
• Review your financial
performance
• See how well your strategic
choices have played out over
the year based on Board
Member feedback.

Copyright © 2016 President and Fellows of Harvard College.

This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 69

 • When the board meeting ends, return to the Design Room
to start the next year
• You will repeat the cycle of design, forecasting, production,
and board evaluation for four years
• Remember that you can track your progress using the
scorecard on the left-hand side of the screen
• You can refer to previous decisions you made by clicking on
the Decision History section.

Good Luck!

Copyright © 2016 President and Fellows of Harvard College.

This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the
permission of Harvard Business Publishing.

Updated: March 31, 2017 70

 Thank You

11/13/2021 71
BITS Pilani, Pilani Campus
 Supply Chain Management

BITS Pilani Sudeep Kumar Pradhan, PhD.

Pilani Campus
 Supply Chain Management

Pricing and Revenue

Management in the Supply Chain
1
BITS Pilani, Pilani Campus
The Role of Revenue
Management in the Supply
Chain
• Revenue management is the use of pricing to
increase the profit generated from a limited
supply of supply chain assets
• Supply assets exist in two forms: capacity and
inventory
• Revenue management may also be defined as
the use of differential pricing based on
customer segment, time of use, and product or
capacity availability to increase supply chain
profits
• Most common example is probably in airline
pricing
3
BITS Pilani, Pilani Campus
• Implicit assumption so far has been that
demand cannot be influenced
• In reality, this is not true
• Demand level changes can be made through:
– Advertising, displays, and promotional tools
– Pricing

BITS Pilani, Pilani Campus

Dell’s Pricing Strategy

• Product price different based on type of

customer
• Product price varies over time
• Prices of options offered also vary over time

BITS Pilani, Pilani Campus

Other Examples

• IBM is investigating software that will allow

it to adjust prices according to demand
• Nikon Coolpix Digital Camera sold for about
$600.
– Manufacturer provides a rebate of $100
independently of where the camera is
purchased
• Boise Cascade Office Products sells many
products on-line
– Prices for the 12,000 items ordered most
frequently on-line might change as often as
daily BITS Pilani, Pilani Campus
Questions Related to Pricing

• What are these companies doing?

• Why does Dell charge a different price for
different consumers? At different times?
• If Dell can do it, can it work for other
companies?
• What is the impact of the mail-in rebate?
• Shouldn’t Nikon and Sharp just reduce the
wholesale price paid by the retailers instead of
asking the consumer to mail in the coupon?
• What is wrong with a traditional fixed-price
policy?

BITS Pilani, Pilani Campus

Revenue Management
Principles

• All companies trying to boost profit by using

what are know as smart pricing or revenue
management techniques
• Techniques first pioneered by the airline, hotel,
and rental car industries.
• Airline industry
– Revenue management has increased revenue
significantly
– American Airlines’ estimates of annual incremental
revenue of $1 billion through revenue management

BITS Pilani, Pilani Campus

Manager’s Issue

• What is the optimal price at which revenue is

maximized?
• Need to characterize the relationship between
pricing and demand for each product
• Utilize this characterization to determine the
optimal price for each product
• May involve many complexities
– Vast quantities of data may need to be analyzed
– Competitors’ behavior may need to be captured
• Many firms do manage to at least approximate
this relationship.
BITS Pilani, Pilani Campus
Example – Single Product

• Management estimates the relationship

between demand, D, and price, p
• D = 1,000 - 0.5p
• When the p=$1,600, D=200
• When the p=$1,200, D=400

BITS Pilani, Pilani Campus

 Price vs Revenue Table

Price Demand Revenue

$250 875 $218,750

$500 750 $375,000

$750 625 $468,750

$1,000 500 $500,000

$1,250 375 $468,750

$1,500 250 $375,000

Maximum Revenue = $500,000 when price = $1,000

BITS Pilani, Pilani Campus

Demand-Price Curve

FIGURE 13-1: Price/Demand curve for Example 13-1

BITS Pilani, Pilani Campus
Markdowns

• Assumption in example: demand is

deterministic based on price
• Realistic picture
– Demand is random
– At the end of a selling season, there may be
remaining inventory
• Firms frequently employ a markdown or sale to dispose
excess inventory
• Think about demand from the customer’s
perspective:
– Each customer has a maximum price that he or
she is willing to pay for the product
• Reservation price
BITS Pilani, Pilani Campus
 Markdown Concept

• When the p=$1,200, D=400

– 400 customers have a reservation price at or above $1200
– When the price is below their reservation price, they will
buy
• The lower the price, the more customers with a
reservation price at or above that price
• Sell product to customers whose reservation prices
were below the original price, but above the sale
price.
• Traditionally, retailers have tried to avoid
markdowns
– Evidence of mistakes in purchasing, pricing, or marketing
– Low reservation price customers seen as:
• less desirable or profitable,
• useful to get rid of the excess inventory

BITS Pilani, Pilani Campus

13.4 Price Differentiation

• Customers who are willing to buy at sales price

were different than the customers who were
willing to buy at original price
• In fashion, some customers are very fashion
conscious
– Eager to buy at the start of the selling season
– Willing to pay more to have fashionable items first
• Other customers are value-conscious
– Willing to wait until the end of the sales season
– Unwilling to pay the same high prices as the
fashionable customers
• Different customers charged different prices
can result in higher revenue
BITS Pilani, Pilani Campus
Price Differentiation Example

• According to the demand–price curve, the

retailer charges many customers who are
willing to pay a higher price only $1000

• About 200 customers willing to pay $1,600

• About 100 willing to pay $1,800

• By charging a single price, management is

leaving a large amount of money on the
table

BITS Pilani, Pilani Campus

Multi-tiered Pricing Strategy

• Money left on the table = (2,000 - 1,000) • 500/2 = 250,000

• Consider a differential or customized pricing strategy
– Tailors pricing to different market segments
• Consider a two-price strategy in which the firm introduces
two prices, $1,600 and $1,000.
– At a p=$1,600, there is demand for 200 items
– At a p= $1,000, there is demand for 500 items
– Total revenue in this case is 1,600 • 200 + 1,000 • (500 - 200) =
620,000
– $120,000 more than in the single-tier strategy
• A three-tier pricing strategy can do even better
– At p=$1,800, D=100; p=$1,600, D=200; p=$1,000, D=500
– Total revenue equals
1,800 • 100 + 1,600 • (200 - 100) + 1,000 • (500 - 200) = 640,000
$20,000 more than in two-tier strategy
BITS Pilani, Pilani Campus
Three-Tier Pricing Strategy

FIGURE 13-3: Three-Tier Pricing Strategy

BITS Pilani, Pilani Campus
Revenue Management

• Selling the right inventory unit to the right type of

customer, at the right time, and for the right price
– Integrates pricing and inventory strategies to influence market
demand,
– Provides controls for companies to improve the bottom line
• Revenue management techniques have been traditionally
applied in the airline, hotel, and rental car industries
• Common characteristics of such industries:
– existence of perishable products
– fluctuating demand
– fixed capacity of the system
– segmentation of the market based on sensitivity to price or
service time
– products sold in advance

BITS Pilani, Pilani Campus

Customer Segments in Airline
Industry
• Leisure travelers
– Highly sensitive to price
– Not generally sensitive to the duration of the
trip
– Willing to book non-refundable tickets far
ahead of time
• Business travelers
– Not particularly price-sensitive
– Highly sensitive to trip duration
– Need high flexibility to adjust their travel plans
as needed
BITS Pilani, Pilani Campus
Customer Differentiation in the
Airline Industry

FIGURE 13-4: Customer differentiation in the airline industry

BITS Pilani, Pilani Campus
Differential Pricing

• “Build fences” to prevent business travelers

from moving from the top-left box to the
bottom-right box
– Require weekend stays and early booking
• The more fare classes, the more fences
required
• Other factors:
– How many of each type of ticket to offer?
– How much to price for each ticket

BITS Pilani, Pilani Campus

Revenue Management Systems

• Market Segmentation
– For a specific time and flight (origin to
destination),
– Different products designed and priced to target
different market segments
– Products feature different restrictions
• Non-refundable
• Available up to 21 days before the flight.
• Booking Control
– Allocates available seats to fare classes
– Setting limits on the number of seats that can be
allocated to lower fare classes
• Requires:
– Sophisticated algorithms
– Basic criterion: Equal marginal revenues in each
class BITS Pilani, Pilani Campus
Optimal Allocation of Flights

• Leisure fare is $100 per ticket

• Business fare is $250 per ticket
• 80 seats on the plane
• Company can sell as many seats as they
make available at the leisure fare
• Business fare is random

BITS Pilani, Pilani Campus

Demand Distribution for Business
Fares

FIGURE : Demand distribution

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Marginal Revenues of the Two
Classes

FIGURE : Marginal revenue of leisure and business

class

BITS Pilani, Pilani Campus

Marginal Revenues

• Determine expected revenue for each number

of allocated seats
• Determine expected marginal revenue of
business class
– revenue associated with allocating one additional
seat can also be calculated
– this decreases as the number of allocated seats
increases
• Marginal revenue associated with leisure class
seats
– unlimited demand for seats implies marginal
revenue is constant
• Marginal revenue of the two is equal at 18
seats
– 18 seats should be allocated to business class
BITS Pilani, Pilani Campus
Complexities of the Real
Systems
• Variety of flight classes
• Different hierarchies of classes
• More complex demand information
• Network management
– A flight can be part of many ultimate origin-
destination pairs
– System needs to account for this by allocating seats
to particular flights
• Prices change over time
– Flight may be expensive on some days and times
– If a plane is not filling up, the airline might increase
the allocation of lower price fares to that flight over
time

BITS Pilani, Pilani Campus

Smart Pricing

• American Airlines’ success prompted other

industries to adopt similar practices
regarding pricing
• Specific techniques and tools of airline
revenue management don’t necessarily
apply to very different industries
• Many of the underlying principles and
concepts of revenue management do

BITS Pilani, Pilani Campus

Fundamental Approaches to Smart
Pricing
• Differential Pricing
– Charging different prices to different customers
• Dynamic pricing
– Charging different prices over time

BITS Pilani, Pilani Campus

Differential Pricing

• Charge different customers different prices

according to their price sensitivity
• Dell does this by distinguishing between
private consumers, small or large
businesses, government agencies, and
health care providers
• Difficult to do in many cases

BITS Pilani, Pilani Campus

 Differential Pricing Strategies

• Group Pricing
– Discounts to specific groups of customers very common in many
industries
– Senior citizen discounts at diners, software discounts to universities,
student discounts at movie theaters, “ladies night” at bars
– Works only when there is a correlation between group members and
price sensitivity
• Channel Pricing
– Charging different prices for the same product sold through different
channels
– Different prices on web sites vs. retail stores
– Works only if customers who use different channels have different price
sensitivities
• Regional Pricing
– Exploiting different price sensitivities at different locations
– Beer is much more expensive in a typical stadium than in a bar
BITS Pilani, Pilani Campus
Differential Pricing Strategies

• Time-based Differentiation
– Similar products differentiated based on time
– Amazon.com charges different rates for different
delivery times
• A technique for segmenting price sensitive customers and
customers who are more delivery time sensitive.
• Dell charges different prices for repair contracts that
complete repairs in different amounts of time (overnight
vs. within a week)
• Product Versioning
– Offer slightly different products in order to
differentiate price sensitivities
– May take the form of branding.
• Store brand vs Generic brand
• Additional features added to products at the higher end of
the line
» High end buyers are inclined to buy the higher end products in
the line
» Pay significantly more than the lower end products
» Cost very little more to manufacture.
BITS Pilani, Pilani Campus
Differential Pricing Strategies
Coupons and Rebates
• Distinguish between customers that place a
high value on time or flexibility
• Those who are willing to spend the time to
get a lower price by using a coupon or
submitting a rebate form
• Mail-in rebates at the point of sale
– Adds a significant hurdle to the buying process
– Customers willing to pay the higher price will
not necessarily send the coupon
– Do not incorporate fences
– Require a more detailed analysis.

BITS Pilani, Pilani Campus

Rebates

• No rebate
– Each retailer decides on the price and the amount
to order from the manufacturer to maximize its
profit.
– Retailer needs to find a price and an order quantity
so as to maximize its expected profit
– Manufacturer would like the retailer to order as
much as possible @ the wholesale price
• Mail-in-rebates
– manufacturer influences customer demand
– provides an upside incentive to the retailer to
increase its order quantity
– Retailer’s profit increases
– Increase in demand forces the retailer to order
more from the manufacturer.
– Optimal order quantity:
• Compensates for the rebate/ Implies an increase in the
manufacturer’s expected profit.
BITS Pilani, Pilani Campus
Dynamic Pricing

• Retailers change price at the end of the

season to get rid of excess inventory
• Manufacturers change price during the
season to distinguish between low and high
reservation price customers
• Use pricing to affect demand

BITS Pilani, Pilani Campus

Dynamic Pricing Better than Fixed-
Price Strategy

• Dynamic Pricing may increase profit by

2-6%
– Significant in industries with low margins
• Retail industry
• Computers industry

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Conditions under which
Dynamic Pricing Is Superior
• Available capacity
– Smaller the production capacity relative to average
demand, the larger the benefit from dynamic
pricing
• Demand variability
– Benefit of dynamic pricing increases as the degree
of demand uncertainty increases
• Seasonality in demand pattern
– Benefit of dynamic pricing increases as the level of
demand seasonality increases
• Length of the planning horizon
– Longer the planning horizon, the smaller the
benefit from dynamic pricing

BITS Pilani, Pilani Campus

Impact of the Internet

• Many approaches of smart pricing made more

practical by internet and e-commerce
• Menu cost
– cost that retailers incur when changing the posted
price
– Much lower on the Internet than in the off-line
world
– Updating of prices possible on a daily basis
• Lower buyer search price
– cost that buyers incur when looking for a product
– forces competition between sellers
– leads to a focus on smart pricing strategies

BITS Pilani, Pilani Campus

Impact of the Internet

• Visibility
– to the back-end of the supply chain
– makes it possible to coordinate pricing, inventory, and production
– information has facilitated growth of smart pricing
• Customer segmentation
– using buyers’ historical data is possible on the Internet
– very difficult in conventional stores
• Testing capability
– Internet can be used to test pricing strategies in real time
– On-line seller may test a higher price on a small group of the site
visitors
– Use those data to determine a pricing strategy

BITS Pilani, Pilani Campus

Caveats

• Must avoid the appearance of unfair treatment of

customers
– Amazon.com’s failed experimented with a pricing strategy in which
customers were paying different amounts for the same DVD based
on demographics or the browser used
– Coke’s development of a soda machine that would measure the
outside temperature, and increase prices as the temperature
increased
• On-line sites Priceline and Hotwire.com provide:
– an outlet for last-minute, unsold seats and hotel rooms
– opaque fares
– “Protects” the published fares promoted by the airlines and
hotels themselves
– When many published fares are about as good as the opaque
fares, it is harder to attract customers to the Priceline and
Hotwire sites BITS Pilani, Pilani Campus
Conditions Under Which Revenue
Management Has the Greatest Effect
• The value of the product varies in different
market segments (Example: airline seats)
• The product is highly perishable or product
waste occurs (Example: fashion and seasonal
apparel)
• Demand has seasonal and other peaks
(Example: products ordered at Amazon.com)
• The product is sold both in bulk and on the
spot market (Example: owner of warehouse
who can decide whether to lease the entire
warehouse through long-term contracts or save
a portion of the warehouse for use in the spot
market)
42
BITS Pilani, Pilani Campus
Revenue Management for
Multiple Customer Segments

• If a supplier serves multiple customer segments

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

43
BITS Pilani, Pilani Campus
Revenue Management
for Perishable Assets

• Any asset that loses value over time is

perishable
• Examples: high-tech products such as
computers and cell phones, high fashion
apparel, underutilized capacity, fruits and
vegetables
• Two basic approaches:
– Vary price over time to maximize expected revenue
– Overbook sales of the asset to account for
cancellations

44
BITS Pilani, Pilani Campus
Revenue Management
for Perishable Assets

• Overbooking or overselling of a supply chain

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

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Revenue Management
for Seasonal Demand

• Seasonal peaks of demand are common in many

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

• Pricing and promotion can be used to influence the level of

demand.
• Traditionally, fashion retailers have used price markdowns
to sell off excess inventory at the end of the season.
• Mid-1980’s: airline executives began to use a set of more
sophisticated approaches to manipulating demand.
• Revenue management has two goals
– Differentiate demand
– Use pricing to adjust aggregate demand
• Variety of techniques
– Differential pricing
– Dynamic pricing
• Made more effective by the Internet and e-business
• Caveat that customer should not be unfairly treated
BITS Pilani, Pilani Campus
References

• Text book
• Lecture slides of Willam swan on RM
• Lecture slides of simchi Levi et al. on RM
• Lecture slides of Yossi Sheffi on RM

BITS Pilani, Pilani Campus

 Supply Chain Management

Coordination in the Supply

Chain

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Lack of SC Coordination
and the Bullwhip Effect

• Supply chain coordination – all stages in the

supply chain take actions together (usually
results in greater total supply chain profits).
• SC coordination requires that each stage take
into account the effects of its actions on the
other stages.
• Lack of coordination results when:
– Objectives of different stages conflict or
– Information moving between stages is distorted
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Bullwhip Effect

• Fluctuations in orders increase as they move

up the supply chain from retailers to
wholesalers to manufacturers to suppliers.
• Distorts demand information within the
supply chain, where different stages have very
different estimates of what demand looks like.
• Results in a loss of supply chain coordination.
• Examples: Proctor & Gamble (Pampers); HP
(Printers) and Barilla (Pasta)

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 The Effect of Lack of
Coordination on Performance
• Manufacturing cost • Level of product
(increases) availability (decreases)

• Inventory cost (increases) • Relationships across the

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

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Obstacles to Coordination
in a Supply Chain

• Incentive Obstacles

• Information Processing Obstacles

• Operational Obstacles

• Pricing Obstacles

• Behavioral Obstacles

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Incentive Obstacles

• When incentives offered to different stages or

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

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Information Processing
Obstacles

• When demand information is distorted as it

moves between different stages of the supply
chain, leading to increased variability in
orders within the supply chain.
• Forecasting based on orders, not customer
demand
– Forecasting demand based on orders magnifies
demand fluctuations moving up the supply chain
from retailer to manufacturer.
• Lack of information sharing.

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Operational Obstacles

• Actions taken in the course of placing and

filling orders that lead to an increase in
variability.
• Ordering in large lots (much larger than
dictated by demand).
• Large replenishment lead times.
• Rationing and shortage gaming (common in
the computer industry because of periodic
cycles of component shortages and surpluses).

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Pricing Obstacles

• When pricing policies for a product lead

to an increase in variability of orders
placed.

• Lot-size based quantity decisions.

• Price fluctuations (resulting in forward

buying).

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

• Aligning Goals and Incentives

• Improving Information Accuracy
• Improving Operational Performance
• Designing Pricing Strategies to Stabilize
Orders
• Building Strategic Partnerships and Trust

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Aligning Goals and Incentives

• Align incentives so that each participant has

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

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Improving Information Accuracy

• Sharing point of sale data

• Collaborative forecasting and planning

• Single stage control of replenishment

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

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Improving Operational Performance
• Reducing replenishment lead time.
– Reduces uncertainty in demand
– EDI is useful

• Reducing lot sizes.

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

• Rationing based on past sales and sharing information to limit

gaming.
– “Turn-and-earn”
– Information sharing

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Designing Pricing Strategies
to Stabilize Orders
• Encouraging retailers to order in smaller lots and reduce
forward buying.

• Moving from lot size-based to volume-based quantity

discounts (consider total purchases over a specified time
period).

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

• Building strategic partnerships and trust – easier to

implement these approaches if there is trust.
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Building Strategic Partnerships
and Trust in a Supply Chain

• Designing a Relationship with Cooperation

and Trust

• Managing Supply Chain Relationships for

Cooperation and Trust

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Building Strategic Partnerships
and Trust in a Supply Chain

• Trust-based relationship
– Dependability
– Leap of faith

• Cooperation and trust work because:

– Alignment of incentives and goals
– Actions to achieve coordination are easier to implement
– Supply chain productivity improves by reducing duplication or
allocation of effort to appropriate stage
– Greater information sharing results

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Trust in the Supply Chain

• Historically, supply chain relationships are

based on power or trust.

• Disadvantages of power-based relationship:

– Results in one stage maximizing profits, often at
the expense of other stages
– Can hurt a company when balance of power
changes
– Less powerful stages have sought ways to resist

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Building Trust into a
Supply Chain Relationship

• Deterrence-based view
– Use formal contracts
– Parties behave in trusting manner out of self-
interest
• Process-based view
– Trust and cooperation are built up over time as a
result of a series of interactions
– Positive interactions strengthen the belief in
cooperation of other party
• Neither view holds exclusively in all situations
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Effects of Interdependence on Supply Chain
Relationships

Partner High Level of

Organization’s Dependence

Relatively Interdependence
High
Powerful Effective Relationship

Organization
Low Level of Relatively
Low Interdependence
Powerful

Low High
Partner’s Dependence
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Creating Effective Contracts

• Create contracts that encourage negotiation

when unplanned contingencies arise.
• It is impossible to define and plan for every
possible occurrence.
• Informal relationships and agreements can
fill in the “gaps” in contracts.
• Informal arrangements may eventually be
formalized in later contracts.
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Designing Effective Conflict
Resolution Mechanisms

• Initial formal specification of rules and

guidelines for procedures and
transactions.

• Regular, frequent meetings to promote

communication.

• Courts or other intermediaries

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Managing Supply Chain Relationships for
Cooperation and Trust
• Effective management of a relationship is
important for its success.
• Top management is often involved in the
design but not management of a
relationship.
• Process of alliance evolution.
• Perceptions of reduced benefits or
opportunistic actions can significantly
impair a supply chain partnership

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Achieving Coordination in Practice

• Quantify the bullwhip effect.

• Get top management commitment for coordination.
• Devote resources to coordination.
• Focus on communication with other stages.

• Try to achieve coordination in the entire supply chain

network.
• Use technology to improve connectivity in the supply chain.

• Share the benefits of coordination equitably

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 Thank You

11/13/2021 73
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