UNIT 3: FACILITY LOCATION AND NETWORK DESIGN

MODELS FOR FACILITY LOCATION AND CAPACITY ALLOCATION:

A manager's goal when locating facilities and allocating capacity should be to maximize the
overall profitability of the resulting supply chain network while providing customers with the
appropriate responsiveness. Revenues come from the sale of product, whereas costs arise from
facilities, labor, transportation, material, and inventories. The profits of the firm are also affected
by taxes and tariffs. Ideally, profits after tariffs and taxes should be maximized when designing a
supply chain network.

Managers use network designmodels in two different situations. First, these models are used to
decide on locations where facilities will be established and the capacity to be assigned to each
facility. Managers must make this decision considering a time horizon over which locations and
capacities will not be altered (typically in years). Second, these models are used to assign current
demand to the available facilities and identify lanes along which product will be transported.
Managers must consider this decision at least on an annual basis as demand, prices, exchange
rates, and tariffs change. In both cases, the goal is to maximize the profit while satisfying
customer needs. The following information ideally is available in making the design decision:
• Location of supply sources and markets
• Location of potential facility sites
• Demand forecast by market
• Facility, labor, and material costs by site
• Transportation costs between each pair of sites
• Inventory costs by site and as a function of quantity
• Sale price of product in different regions
• Taxes and tariffs
• Desired response time and other service factors

PHASE II: NETWORK OPTIMIZATION MODELS

During Phase II of the network design framework (see Figure 5-2), a manager considers regional
demand, tariffs, economies of scale, and aggregate factor costs to decide the regions in which
facilities are to be located. As an example, consider SunOil, a manufacturer of petrochemical
products with worldwide sales. The Vice President of Supply Chain can consider several
different options to meet demand. One possibility is to set up a facility in each region. The
advantage of such an approach is that it lowers transportation cost and also helps avoids duties
that may be imposed if product is imported from other regions. The disadvantage of this
approach is that plants are sized to meet local demand and may not fully exploit economies of
scale. An alternative approach is to consolidate plants in just a few regions. This improves
economies of scale but increases transportation. Network optimization models are useful for
managers considering regional configuration during Phase II. The first step is to collect the data
in a form that can be used for a quantitative model. For SunOil, the Vice President of Supply
Chain decides to view the worldwide demand in terms of five regions-North America, South
America, Europe, Africa, and Asia.

The Capacitated Plant Location Model

The capacitated plant location network optimization model requires the following inputs:
n = number of potential plant locations/capacity (each level of capacity will
count as a separate location)
m = number of markets or demand points
Dj = annual demand from market j
Ki = potential capacity of plant i
fi = annualized fixed cost of keeping factory i open
cij = cost of producing and shipping one unit from factory ito market j (cost
includes production, inventory, transportation, and tariffs)
The supply chain team's goal is to decide on a network design that maximizes profits
after taxes. For the sake of simplicity, however, we assume that all demand must be
met and taxes on earnings are ignored. The model thus focuses on minimizing the cost
of meeting global demand. It can, however, be modified to include profits and taxes.
Define the following decision variables:
Yi = 1 if plant i is open, 0 otherwise
xij = quantity shipped from plant ito market j
The problem is then formulated as the following integer program:
Subject to

The objective function minimizes the total cost (fixed+ variable) of setting up and operating the
network. The constraint in Equation 5.1 requires that the demand at each regional market be
satisfied. The constraint in Equation 5.2 states that no plant can supply more than its capacity.
(Clearly, the capacity is 0 if the plant is closed and Ki if it is open. The product of terms, KJii,
captures this effect.) The constraint in Equation 5.3 enforces that each plant is either open (yi =
1) or closed (Yi = 0). The solution identifies the plants that are to be kept open, their capacity,
and the allocation of regional demand to these plants.

PHASE Ill: GRAVITY LOCATION MODELS

During Phase III (see Figure 5-2), a manager identifies potential locations in each region where
the company has decided to locate a plant. As a preliminary step, the manager needs to identify
the geographic location where potential sites may be considered. Gravity location models can be
useful when identifying suitable geographic locations within a region. Gravity models are used to
find locations that minimize the cost of transporting raw materials from suppliers and finished
goods to the markets served. Next, we discuss a typical scenario in which gravity models can be
used.

Gravity models assume that both the markets and the supply sources can located as grid points
on a plane. All distances are calculated as the geometric distance between two points on the
plane. These models also assume that the transportation cost grows linearly with the quantity
shipped. We discuss a gravity model for locating a single facility that receives raw material from
supply sources and ships finished product to markets. The basic inputs to the model are as
follows:
Xn Yn: coordinate location of either a market or supply source n
Fn: cost of shipping one unit for one mile between the facility and either market or supply source
n
Dn: quantity to be shipped between facility and market or supply source n

If (x, y) is the location selected for the facility, the distance dn between the facility
at location (x, y) and the supply source or market n is given by

the total transportation cost (TC) is given by

The optimal location is one that minimizes the total TC in Equation 5.5. The optimal solution for
SA is obtained using the Solver tool in Excel as shown in Figure 5-8. The first step is to enter the
problem data as shown in cells B5:G12. Next, we set the decision variables (x, y) corresponding
to the location of the new facility in cells B16 and B17, respectively. In cells G5:Gl2, we then
calculate the distance dn from the facility location (x,y) to each source or market using Equation
5.4. The total TC is then calculated in cell B19 using Equation 5.5.

PHASE IV: NETWORK OPTIMIZATION MODELS

During Phase IV (see Figure 5-2), a manager decides on the location and capacity allocation for
each facility. Besides locating the facilities, a manager also decides how markets are allocated to
facilities. This allocation must account for customer service constraints in terms of response
time. The demand allocation decision can be altered on a regular basis as costs change and
markets evolve. When designing the network, both location and allocation decisions are made
jointly. We illustrate the relevant network optimization models using the example of two
manufacturers of fiber-optic telecommunication equipment. Both TelecomOne and HighOptic
are manufacturers of the latest generation of telecommunication equipment. TelecomOne has
focused on the eastern half of the United States. It has manufacturing plants located in Baltimore,
Memphis, and Wichita, and serves markets in Atlanta, Boston, and Chicago. HighOptic has
targeted the western half of the United States and serves markets in Denver, Omaha, and
Portland.HighOptic has plants located in Cheyenne and Salt Lake City.
Plant capacities, market demand, variable production and transportation cost per thousand units
shipped, and fixed costs per month at each plant are shown in Table 5-2. Allocating Demand to
Production Facilities From Table 5-2 we calculate that Telecom One has a total production
capacity of 71,000 units per month and a total demand of 30,000 units per month, whereas
HighOptic has a production capacity of 51,000 units per month and a demand of 24,000 units per
month. Each year, managers in both companies must decide how to allocate the demand to their
production facilities as demand and costs change.

The demand allocation problem can be solved using a demand allocation model.
The model requires the following inputs:
n = number of factory locations
m = number ofmarkets or demand points
Dj = annual demand from market j
Ki = capacity of factory i
Cij = cost of producing and shipping one unit from factory i to market j
(cost includes production, inventory, and transportation)

The goal is to allocate the demand from different markets to the various plants to minimize the
total cost of facilities, transportation, and inventory. Define the decision variables:
xij = quantity shipped from factory ito market j

The problem is formulated as the following linear program:

Subject to

The constraints in Equation 5.6 ensure that all market demand is satisfied and the constraints in
Equation 5.7 ensure that no factory produces more than its capacity.

Locating Plants and Warehouses Simultaneously

A much more general form of the plant location model needs to be considered if the entire
supply chain network from the supplier to the customer is to be designed. We consider a supply
chain in which suppliers send material to factories tha(supply warehouses that supply markets as
shown in Figure 5-13. 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 used to replenish warehouses. It is also assumed that units have been
appropriately adjusted such that one unit of input from a supply source produces one unit of the
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 warehouse locations
Dj =annual demand from customer j
Ki = potentiaf capacity of factory at site i
Sh = supply capacity at supplier h
We = potential warehouse capacity at site e
Pi = fixed cost of locating a plant at site i
fe = fixed cost of locating a warehouse at site e
chi = cost of shipping one unit from supply source h to factory i
'i.:ie = cost of producing and shipping one unit from factory ito warehouse e
Cej = cost of shipping one unit from warehouse e to customer j

The goal is to identify plant and warehouse locations as well as quantities shipped between
various points that minimize the total fixed and variable costs. Define the following 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 at site ito warehouse e
xhi = quantity shipped from supplier h to factory at site i
The problem is formulated as the following intege~ program:

THE IMPACT OF UNCERTAINTY ON NETWORK DESIGN:

Supply chain design decisions such as the number and size of plants to build, the size and scope
of a distribution system, and whether to buy or lease one's facilities involve significant
investment. These decisions, once made, cannot be altered in the short term. They remain in
place for several years and define the constraints within which the supply chain must compete.
Thus, it is important that these decisions be evaluated as accurately as possible. Uncertainty of
demand and price drives the value of building flexible production capacity at a plant. If price and
demand do vary over time in a global network, flexible production capacity can be reconfigured
to maximize,profits in the new environment. In the late 1990s, Toyota made its global assembly
plants more flexible so that each plant could supply multiple markets

DISCOUNTED CASH FLOW ANALYSIS

Supply chain design decisions should be evaluated as a sequence of cash flows over the duration
of time that they will be in place. The present value of a stream of cash flows is what that stream
is worth in today's dollars. Discounted cash flow (DCF) analysis evaluates the present value of
any stream of future cash flows and allows management to compare two streams of cash flows in
terms of their financial value. DCF analysis is based on the fundamental premise that "a dollar
today is worth more than a dollar tomorrow" because a dollar today may be invested and earn a
return in addition to the dollar invested. This premise provides the basic tool for comparing the
relative value of future cash flows that will arrive during different time periods.
The present value of future cash flow is found by using a discount factor. If a dollar today can be
invested and earn a rate of return k over the next period, an investment of $1 today will result in
1 + k dollars in the next period. An investor will therefore be · indifferent between obtaining $1
in the next period or $1(1 + k) in the current period. Thus, $1 in the next period is discounted by
the
to obtain its present value. The rate of return k is also referred to as the discount rate, hurdle rate,
or opportunity cost of capital. Given a stream of cash flows Co, C1, ... , CT over the next T
periods, and a rate of return k, the net present value (NPV) of this cash flow stream is
given by

The NPV of different options should be compared when making supply chain decisions. A
negative NPV for an option indicates that the option will lose money for the supply chain. The
decision with the highest NPV provides a supply chain with the
highest financial return.

REPRESENTATIONS OF UNCERTAINTY
The manager at Trips Logistics considers both future demand and spot market prices to be
predictable. In reality, demand and prices are highly uncertain and are likely to fluctuate during
the life of any supply chain decision. For a global supply chain, exchange rates and inflation are
also likely to vary over time in differen_t locations. Supply chain managers must incorporate
these uncertainties when making network design decisions. Next we discuss some models that
can be used to represent uncertainty in factors such as demand, price, and exchange rate.

BINOMIAL REPRESENTATION OF UNCERTAINTY

The binomial representation of uncertainty is based on the assumption that when moving from
one period to the next, the value of the underlying factor (such as demand or
EVALUATING NETWORK DESIGN DECISIONS USING DECISION TREES
A manager makes several different decisions when designing a supply chain network.
For instance:
• Should the firm sign a long-term contract for warehousing space or get space from the spot
market as needed?
• What should the firm's mix of long-term and spot market be in the portfolio of transportation
capacity?
• How much capacity should various facilities have? What fraction of this capacity should be
flexible?

If uncertainty is ignored, a manager will always sign long-term contracts (because they are
typically cheaper) and avoid all flexible capacity (because it is more expensive). Such decisions,
however, can hurt the firm if future demand or prices are not as forecast at the time of the
decision.

A decision tree is a graphic device used to evaluate decisions under uncertainty. Decision trees
with DCFs can be used to evaluate supply chain design decisions given uncertainty in prices,
demand, exchange rates, and inflation. The first step in setting up a decision tree is to identify the
number of time periods into the future that will be considered when making the decision. The
decision maker should also identify the duration of a period-which could be a day, a month,
a quarter, or any other time period. The duration of a period should be the minimum period of
time over which factors affecting supply chain decisions may change by a significant amount.
"Significant" is hard to define, but in most cases it is appropriate to use the duration over which
an aggregate plan holds as a period. If planning is done monthly, we set the duration of a period
at a month. In the following discussion, Twill represent the number of time periods over which
the supply chain decision is to be evaluated.

The next step is to identify factors that will affect the value of the decision and are likely to
fluctuate over the next T periods. These factors include demand, price,exchange rate, and
inflation, among others. Having identified the key factors, the next step is to identify probability
distributions that define the fluctuation of each factor from one period to the next. If, for
instance, demand and price are identified as the two key factors that affect the decision, the
probability of moving from a given value of demand and price in one period to any other value
of demand and price in the next period must be defined.

The next step is to identify a periodic discount rate k to be applied to future cash flows. It is not
essential that the same discount rate apply to each period or even at every node in a period. The
discount rate should take into account the inherent risk associated with the investment. In
general, a higher discount rate should apply to investments with higher risk. The decision is now
evaluated using a decision tree, which contains the present and T future periods. Within each
period a node must be defined for every possible combination of factor values (say, demand and
price) that can be achieved. Arrows are drawn from origin nodes in Period ito end nodes in
Period i + 1. The probability on an arrow is referred to as the transition probability and is the
probability of transitioning from the origin node in Period i to the end node in Period i + 1. The
decision tree is evaluated starting from nodes in Period T and working back to Period 0. For each
node, the decision is optimized taking into account current and future values of various factors.
The analysis is based on Bellman's principle, which states that for any choice of strategy in a
given state, the optimal strategy in the next period is the one that is selected if the entire analysis
is assumed to begin in the next period. This principle allows the optimal strategy to be solved' in
a backward fashion starting at the last period. Expected future cash flows are discounted back
and included in the decision currently under consideration.

The decision tree analysis methodology is summarized as follows:

1. Identify the duration of each period (month, quarter, etc.) and the number of periods T over
which the decision is to be evaluated.
2. Identify factors such as demand, price, and exchange rate whose fluctuation will be
considered over the next T periods.
3. Identify representations of uncertainty for each factor; that is, determine what distribution to
use to model the uncertainty.
4. Identify the periodic discount rate k for each period.
5. Represent the decision tree with defined states in each period as well as the transition
probabilities between states in successive periods.
6. Starting at period T, work back to Period 0 identifying the optimal decision and the expected
cash flows at each step. Expected cash flows at each state in a given period should be discounted
back when included in the previous period