SCM - Slidess - Merged

Chapter 1
Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

Understanding the Supply Chain
Supply Chain Management: Strategy, Planning, and Operation, 5/e Authors: Sunil Chopra, Peter Meindl and D. V. Kalra
Learning Objectives
Discuss the goal of a supply chain, and explain the impact of

•
supply chain decisions on the success of a firm.
• Identify the three key supply chain decision phases, and explain
the significance of each one.
• Describe the cycle and push/pull views of a supply chain.
• Classify the supply chain macro processes in a firm.
What is a Supply Chain?
All stages involved, directly or indirectly, in fulfilling a customer

•
request.
• Includes manufacturers, suppliers, transporters, warehouses,

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

involved in fulfilling a customer request (product development,
marketing, operations, distribution, finance, customer service).
Contd…
• Customer is an integral part of the supply chain

• Includes movement of products from suppliers to manufacturers to
distributors, and information, funds, and products in both
directions.
• May be more accurate to use the term “supply network” or “supply

web”.
• Typical supply chain stages: customers, retailers, distributors,

manufacturers, suppliers.
• All stages may not be present in all supply chains (e.g., no retailer
or distributor for Dell).

Figure 1-1
Flows in a Supply Chain

Figure 1-2
The Objective of a Supply Chain
• Maximize overall value created

Supply chain surplus = Customer value – Supply chain cost
• Example: A customer purchases a wireless router from Best Buy

for $60 (revenue).
• Supply chain incurs costs (information, storage, transportation,

components, assembly, etc.).
• Difference between $60 and the sum of all of these costs is the
supply chain profit.
• Supply chain profitability is total profit to be shared across all

stages of the supply chain.
Contd…
Success should be measured by total supply chain profitability, not

•
by profits at an individual stage.
• Customer is the only source of revenue.
• Sources of cost includes flows of information, products, or funds

between stages of the supply chain.
• Effective supply chain management is the management of flows

between and among supply chain stages to maximize total supply
chain surplus.
Importance of Supply Chain Decisions
• Wal-Mart, $1 billion sales in 1980 to $408 billion in 2010

• Seven-Eleven Japan, ¥1 billion sales in 1974 to ¥3 trillion in 2009
• Webvan folded in two years
• Borders, $4 billion in 2004 to $2.8 billion in 2009
• Dell, $56 billion in 2006, adopted new supply chain strategies
Decision Phases of a Supply Chain
• Supply chain strategy or design

How to structure the supply chain over the next several years
• Supply chain planning

Decisions over the next quarter or year
• Supply chain operation

Daily or weekly operational decisions
Supply Chain Strategy or Design
• Decisions about the structure of the supply chain and what

processes each stage will perform.
• Strategic supply chain decisions

Locations and capacities of facilities
Products to be made or stored at various locations
Modes of transportation
Information systems.
• Supply chain design must support strategic objectives.
• Supply chain design decisions are long-term and expensive to

reverse—must take into account market uncertainty.
Supply Chain Planning
• Definition of a set of policies that govern short-term operations.

• Fixed by the supply configuration from previous phase.
• Starts with a forecast of demand in the coming year
Supply Chain Planning
• Planning decisions:

Which markets will be supplied from which locations
Planned buildup of inventories
Subcontracting, backup locations
Inventory policies
Timing and size of market promotions
• Must consider in planning decisions—demand uncertainty,

exchange rates, competition over the time horizon
Supply Chain Operation
• Time horizon is weekly or daily.

• Decisions regarding individual customer orders.
• Supply chain configuration is fixed and operating policies are

determined.
• Goal is to implement the operating policies as effectively as

possible.
• Allocate orders to inventory or production, set order due dates,

generate pick lists at a warehouse, allocate an order to a particular
shipment, set delivery schedules, place replenishment orders.
• Much less uncertainty (short time horizon).

Process View of a Supply Chain
• Cycle view: processes in a supply chain are divided into a series

of cycles, each performed at the interfaces between two successive
supply chain stages.
• Push/Pull view: processes in a supply chain are divided into two

categories depending on whether they are executed in response to
a customer order (pull) or in anticipation of a customer order
(push).
Cycle View of Supply Chain Processes

Figure 1-3
Cycle View of Supply Chain Processes

Figure 1-4
Push/Pull View of Supply Chains

Figure 1-5
Push/Pull View of Supply Chain Processes
• Supply chain processes fall into one of two categories depending

on the timing of their execution relative to customer demand.
• Pull: Here execution is initiated in response to a customer order

(reactive).
• Push: Here execution is initiated in anticipation of customer

orders (speculative).
• Push/pull boundary separates push processes from pull

processes.
Contd…
Push/Pull View of Supply Chain
Processes
• Useful in considering strategic decisions relating to supply chain

design – more global view of how supply chain processes relate
to customer orders.
• Can combine the push/pull and cycle views

L.L. Bean
Dell
• The relative proportion of push and pull processes can have an

impact on supply chain performance.
Push/Pull View—L.L. Bean

Figure 1-6
Push/Pull View—Dell

Figure 1-7
Supply Chain Macro Processes
Supply chain processes discussed in the two views can be

•
classified into:
Customer Relationship Management (CRM)
Internal Supply Chain Management (ISCM)
Supplier Relationship Management (SRM)
• Integration among the above three macro processes is critical for

effective and successful supply chain management.
Supply Chain Macro Processes

Figure 1-8
Examples of Supply Chains
• Gateway and Apple

• Zara
• W.W. Grainger and McMaster-Carr
• Toyota
• Amazon
Gateway and Apple
• Why did Gateway choose not to carry any finished-product

inventory at its retail stores? Why did Apple choose to carry
inventory at its stores?
• Should a firm with an investment in retail stores carry any
finished-goods inventory? What are the characteristics of products
that are most suitable to be carried in finished-goods inventory?
What characterizes products that are best manufactured to order?
• How does product variety affect the level of inventory that a retail
store must carry?
• Is a direct selling supply chain without retail stores always less
expensive than a supply chain with retail stores?
• What factors explain the success of Apple retail and the failure of
Gateway country stores?
Zara
• What advantage does Zara gain against the competition by having

a very responsive supply chain?

• Why has Inditex chosen to have both in-house manufacturing and
outsourced manufacturing? Why has Inditex maintained
manufacturing capacity in Europe even though manufacturing in
Asia is much cheaper?
• Why does Zara source products with uncertain demand from local
manufacturers and products with predictable demand from Asian
manufacturers?
• What advantage does Zara gain from replenishing its stores
multiple times a week compared to a less frequent schedule? How
does the frequency of replenishment affect the design of its
distribution system?
• Do you think Zara’s responsive replenishment infrastructure is
better suited for online sales or retail sales?
W.W. Grainger and McMaster-Carr
• How many DCs should be built and where should they be

located?

• How should product stocking be managed at the DCs? Should all
DCs carry all products?
• What products should be carried in inventory and what products
should be left with the supplier to be shipped directly in response
to a customer order?
• What products should W.W. Grainger carry at a store?
• How should markets be allocated to DCs in terms of order
fulfillment? What should be done if an order cannot be completely
filled from a DC? Should there be specified backup locations? How
should they be selected?
Contd…
W.W. Grainger and McMaster-Carr
• How should replenishment of inventory be managed at the

various stocking locations?
• How should Web orders be handled relative to the existing

business? Is it better to integrate the Web business with the
existing business or to set up separate distribution?
• What transportation modes should be used for order fulfillment

and stock replenishment?
Toyota
• Where should plants be located, what degree of flexibility and what

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

flexibility?
Amazon.com
• Why is Amazon building more warehouses as it grows? How many

warehouses should it have and where should they be located?
• What advantages does selling books via the Internet provide over
a traditional bookstore? Are there any disadvantages to selling via
the Internet?
• Should Amazon stock every product it sells?
• What advantage can bricks-and-mortar players derive from
setting up an online channel? How should they use the two
channels to gain maximum advantage?
• What advantages/disadvantages does the online channel enjoy in
the sale of shoes (diapers) relative to a retail store?
• For what products does the online channel offer the greater
advantage relative to retail stores? What characterizes these
products?
Gopaljee
• How can Gopaljee’s supply and distribution model be extended to

other business lines in the Indian and South Asian context?
• What all socio-economic features of South Asian societies can be

identified as the foundations for building sustainable supply chains?
• How can the existing distribution channels in the South Asian

region be transformed to maximize the value delivered to the
customer?
• How can such indigenously developed SCM models integrate with

and expand into global supply chains?
Summary of Learning Objectives
• Discuss the goal of a supply chain and explain the impact of

supply chain decisions on the success of a firm.
• Identify the three key supply chain decision phases and explain
the significance of each one.
• Describe the cycle and push/pull views of a supply chain.
• Classify the supply chain macro processes in a firm.
Chapter 2

Supply Chain Performance: Achieving
Strategic Fit and Scope
Learning Objectives
• Explain why achieving strategic fit is critical to a company’s overall

success.
• Describe how a company achieves strategic fit between its supply

chain strategy and its competitive strategy.
• Discuss the importance of expanding the scope of strategic fit

across the supply chain.
• Describe the major challenges that must be overcome to manage a

supply chain successfully.
Competitive and Supply
Chain Strategies
• Competitive strategy defines the set of customer needs a firm

seeks to satisfy through its products and services.
• Product development strategy specifies the portfolio of new
products that the company will try to develop.
• Marketing and sales strategy specifies how the market will be
segmented and product will be positioned, priced, and promoted.
• Supply chain strategy determines the nature of material
procurement, transportation of materials, manufacture of product
or creation of service, distribution of product.
• All functional strategies must support one another and the
competitive strategy.
The Value Chain

Figure 2-1
Achieving Strategic Fit
Strategic fit – competitive and supply chain strategies have

•
aligned goals.
• A company may fail because of a lack of strategic fit or because its

processes and resources do not provide the capabilities to execute
the desired strategy.
Achieving Strategic Fit
• The competitive strategy and all functional strategies must fit

together to form a coordinated overall strategy.
• The different functions in a company must appropriately structure

their processes and resources to be able to execute these
strategies successfully.
• The design of the overall supply chain and the role of each stage
must be aligned to support the supply chain strategy.
How is Strategic Fit Achieved?
Understanding the customer and supply chain uncertainty

•
• Understanding the supply chain
• Achieving strategic fit
Step 1: Understanding the Customer and
Supply Chain Uncertainty
• Quantity of product needed in each lot

• Response time customers will tolerate
• Variety of products needed
• Service level required
• Price of the product
• Desired rate of innovation in the product
Step 1: Understanding the Customer and
Supply Chain Uncertainty
Demand uncertainty is uncertainty of customer demand for a

•
product.
• Implied demand uncertainty – resulting uncertainty for the

supply chain given the portion of the demand the supply chain
must handle and attributes the customer desires.
Customer Needs and Implied Demand
Uncertainty
Customer Need Causes Implied Demand Uncertainty to …

Range of quantity required increases Increase because a wider range of the quantity required
implies greater variance in demand
Lead time decreases Increase because there is less time in which to react to
orders
Variety of products required Increase because demand per product becomes more
increases disaggregate
Number of channels through which Increase because the total customer demand is now
product may be acquired increases disaggregated over more channels
Rate of innovation increases Increase because new products tend to have more
uncertain demand
Required service level increases Increase because the firm now has to handle unusual
surges in demand
Table 2-1
Implied Uncertainty and Other Attributes

Low Implied High Implied
Uncertainty Uncertainty
Product margin Low High
Average forecast error 10% 40% to 100%
Average stockout rate 1% to 2% 10% to 40%
Average forced season-end 0% 10% to 25%
markdown
Table 2-2
Implied Uncertainty and Other Attributes
• Products with uncertain demand are often less mature and have

less direct competition. As a result, margins tend to be high.
• Forecasting is more accurate when demand has less uncertainty.
• Increased implied demand uncertainty leads to increased difficulty

in matching supply with demand. For a given product, this dynamic
can lead to either a stockout or an oversupply situation.
• Markdowns are high for products with greater implied demand

uncertainty because oversupply often results.
Impact of Supply Source Capability

Supply Source Capability Causes Supply Uncertainty to...
Frequent breakdowns Increase
Unpredictable and low yields Increase
Poor quality Increase
Limited supply capacity Increase
Inflexible supply capacity Increase
Evolving production process Increase
Table 2-3
Levels of Implied Demand Uncertainty

Figure 2-2
Step 2: Understanding Supply Chain
Capabilities
How does the firm best meet demand?

•
• Supply chain responsiveness is the ability to
Respond to wide ranges of quantities demanded
Meet short lead times
Handle a large variety of products
Build highly innovative products
Meet a very high service level
Contd…
Step 2: Understanding Supply Chain
Capabilities

• Responsiveness comes at a cost.
• Supply chain efficiency is the inverse to the cost of making and

delivering the product to the customer.
• The cost-responsiveness efficient frontier curve shows the lowest

possible cost for a given level of responsiveness.
Cost-Responsiveness Efficient Frontier

Figure 2-3
Responsiveness Spectrum

Figure 2-4
Step 3: Achieving Strategic Fit
Ensure that the degree of supply chain responsiveness is

•
consistent with the implied uncertainty.
• Assign roles to different stages of the supply chain that ensure

the appropriate level of responsiveness.
• Ensure that all functions maintain consistent strategies that

support the competitive strategy.
Zone of Strategic Fit

Figure 2-5
Roles and Allocations

Figure 2-6
Efficient and Responsive Supply Chains
Efficient Supply Chains Responsive Supply Chains

Primary goal Supply demand at the lowest cost Respond quickly to demand
Create modularity to allow

Product design Maximize performance at a minimum
postponement of product
strategy product cost
differentiation
Lower margins because price is a Higher margins because price is not a
Pricing strategy
prime customer driver prime customer driver
Manufacturing Maintain capacity flexibility to buffer
Lower costs through high utilization
strategy against demand/supply uncertainty
Maintain buffer inventory to deal with
Inventory strategy Minimize inventory to lower cost
demand/supply uncertainty
Lead-time Reduce, but not at the expense of Reduce aggressively, even if the costs
strategy costs are significant
Select based on speed, flexibility,

Supplier strategy Select based on cost and quality
reliability, and quality
Table 2-4
Tailoring the Supply Chain
• Achieve strategic fit while serving many customer segments with a

variety of products across multiple channels.
• Requires sharing some links in the supply chain with some

products, while having separate operations for other links.
Changes Over Product Life Cycle

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

• Later stages:
Demand has become more certain, and supply is predictable.
Margins are lower as a result of an increase in competitive
pressure.
Price becomes a significant factor in customer choice.
Expanding Strategic Scope
Scope of strategic fit – the functions within the firm and stages

•
across the supply chain that devise an integrated strategy with an
aligned objective.
• Intraoperation scope – minimize local cost view

Each stage of the supply chain devises strategy independently
Contd…

• Intrafunctional view – minimize total functional cost
Firms align all operations within a function
• Interfunctional scope – maximize company profit

Functional strategies are developed to align with one another and
the competitive strategy
Contd…
• Intercompany scope – maximize supply chain surplus

Supplier and customer work together and share information to
reduce total cost and grow supply chain surplus
• Agile intercompany scope – a firm’s ability to achieve strategic

fit when partnering with supply chain stages that change over time
Different Scopes of Strategic Fit Across a
Supply Chain

Figure 2-7
Challenges
Increasing product variety and shrinking life cycles

•
Greater product variety and shorter life cycles increase
uncertainty while reducing the window of opportunity within
which the supply chain can achieve fit.
• Globalization and increasing uncertainty

Significant fluctuations in exchange rates, global demand, and
the price of crude oil.
Contd…
Challenges
Fragmentation of supply chain ownership

•
Firms are less vertically integrated
Take advantage of supplier and customer competencies they
did not have
New ownership structure makes aligning and managing the
supply chain more difficult
Aligning all members of a supply chain has become critical to
achieving supply chain fit
Contd…
Challenges
• Changing technology and business environment

Customer needs and technology change may force a firm to
rethink their supply chain strategy
• The environment and sustainability

Growing in relevance and must be accounted for when
designing supply chain strategy
Opportunities may require coordination across different
members of the supply chain
Trends in Indian Retail Sector
What different models of supply chains do you visualize emerging

•
in the transforming Indian retail sector?
• What trends do you see in in the emerging Indian supply chain

models that suggest conscious attempts at achieving proper
strategic fit between business strategies and supply chain
strategies?
• How do you see the Indian retail supply chains becoming role
models for supply chains in other sectors?
Explain why achieving strategic fit is critical to a company’s

•
overall success
• Describe how a company achieves strategic fit between its supply

chain strategy and its competitive strategy
• Discuss the importance of expanding the scope of strategic fit

across the supply chain
• Describe the major challenges that must be overcome to manage

a supply chain successfully
Chapter 3

Supply Chain Drivers and Metrics
Learning Objectives
• Describe key financial measures of firm performance.

• Identify the major drivers of supply chain performance.
• Discuss the role of each driver in creating strategic fit between

the supply chain strategy and the competitive strategy.
• Define the key metrics that track the performance of the supply
chain in terms of each driver.
Financial Measures Of Performance

• From a shareholder perspective, return on equity (ROE) is the
main summary measure of a firm’s performance
Financial Measures of Performance
Return on assets (ROA) measures the return earned on each

•
dollar invested by the firm in assets
Earnings before interest

ROA 
Average total assets
Net income  Interest expense  (1 – Tax rate)


Average total assets
Financial Data for Amazon

Table 3-1
An important ratio that defines financial leverage is accounts

•
payable turnover (APT)
Cost of goods sold

APT 
Accounts payable
• ROA can be written as the product of two ratios—profit margin

and asset turnover
Earnings before interest

ROA  (Profit margin)
Sales revenue
Sales revenue
 (Asset turnover)
Total assets
• ART= Sales revenue/Accounts Recievable
• PPET= Sales revenue/PP & E

Financial Measures of Performance

• Cash-to-cash (C2C) cycle roughly measures the average amount
time from when cash enters the process as cost to when it
returns as collected revenue
C2C = – days payable (1/APT)

+ days in inventory (1/INVT)
+ days receivable (1/ART)
Drivers of Supply Chain Performance
• Facilities

The physical locations in the supply chain network where
product is stored, assembled, or fabricated
• Inventory
All raw materials, work in process, and finished goods within a
supply chain
• Transportation
Moving inventory from point to point in the supply chain
Drivers of Supply Chain Performance
• Information

Data and analysis concerning facilities, inventory,
transportation, costs, prices, and customers throughout the
supply chain
• Sourcing
Who will perform a particular supply chain activity
• Pricing
How much a firm will charge for the goods and services that it
makes available in the supply chain
A Framework for Structuring Drivers

Figure 3-1
Facilities
• Role in the supply chain

The “where” of the supply chain
Manufacturing or storage (warehouses)
• Role in the competitive strategy

Economies of scale (efficiency priority)
Larger number of smaller facilities (responsiveness priority)
Facilities
• Components of facilities decisions

Role
 Flexible, dedicated, or a combination of the two
 Product focus or a functional focus
Location
 Where a company will locate its facilities
 Centralize/decentralize, macroeconomic factors, quality of
workers, cost of workers and facility, availability of
infrastructure, proximity to customers, location of other
facilities, tax effects
Contd…
Facilities
Components of facilities decisions

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

Facility-related metrics
 Capacity
 Utilization
 Processing/setup/down/idle time
 Production cost per unit
 Quality losses
 Theoretical flow/cycle time of production
 Actual average flow/cycle time
Facilities
• Overall trade-off: Responsiveness versus efficiency

Cost of the number, location, capacity, and type of facilities
(efficiency) and the level of responsiveness
Increasing the number of facilities increases facility and
inventory costs but decreases transportation costs and reduces
response time
Increasing the flexibility or capacity of a facility increases facility
costs but decreases inventory costs and response time
Overall Trade-Off
• Responsiveness versus efficiency

Cost of the number, location, capacity, and type of facilities
(efficiency)
Level of responsiveness
Increasing number of facilities increases facility and inventory
costs, decreases transportation costs and reduces response
time
Increasing the flexibility or capacity of a facility increases
facility costs, decreases inventory costs and response time
Inventory

Mismatch between supply and demand
Satisfy demand
Exploit economies of scale
Impacts assets, costs, responsiveness, material flow time
Material flow time: The time that elapses between the point at
which material enters the supply chain to the point at which it
exits
Throughput, the rate at which sales occur
Little’s law
I = DT
where, I = flow time, T = throughput, D = demand
Inventory
• Role in competitive strategy

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

Average amount of inventory used to satisfy demand between
shipments
Function of lot size decisions
• Safety inventory
Costs of carrying too much inventory versus cost of losing sales
Inventory held in case demand exceeds expectations
• Seasonal inventory

Inventory built up to counter predictable variability in demand
Cost of carrying additional inventory versus cost of flexible
production
• Level of product availability

The fraction of demand that is served on time from product
held in inventory
Trade off between customer service and cost
• Inventory-related metrics

Cash-to-cash cycle time
Average inventory
Inventory turns
Products with more than a specified number of days of inventory
Average replenishment batch size
Average safety inventory
Seasonal inventory
Fill rate
Fraction of time out of stock
Obsolete inventory
Inventory
Overall trade-off: Responsiveness versus efficiency

•
Increasing inventory generally makes the supply chain more
responsive
A higher level of inventory facilitates a reduction in production
and transportation costs because of improved economies of
scale
Inventory holding costs increase
Transportation

Moves the product between stages in the supply chain
Impact on responsiveness and efficiency
Faster transportation allows greater responsiveness but lower
efficiency
Also affects inventory and facilities
Transportation
• Role in the competitive strategy

Allows a firm to adjust the location of its facilities and inventory
to find the right balance between responsiveness and efficiency
• Components of transportation decisions

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

•
Air, truck, rail, sea, and pipeline
Information goods via the Internet
Different speed, size of shipments, cost of shipping, and
flexibility
Transportation
• Transportation-related metrics

Average inbound transportation cost
Average income shipment size
Average inbound transportation cost per shipment
Average outbound transportation cost
Average outbound shipment size
Average outbound transportation cost per shipment
Fraction transported by mode
Transportation
• Overall trade-off: Responsiveness versus efficiency

The cost of transporting a given product (efficiency) and the
speed with which that product is transported (responsiveness)
Using fast modes of transport raises responsiveness and
transportation cost but lowers the inventory holding cost
Information
Role in the supply chain

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

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

Different information requirements and uses
• Coordination and information sharing

Supply chain coordination, all stages of a supply chain work
toward the objective of maximizing total supply chain
profitability based on shared information
• Sales and operations planning (S&OP)

The process of creating an overall supply plan (production and
inventories) to meet the anticipated level of demand (sales)
• Enabling technologies

Electronic data interchange (EDI)
The Internet
Enterprise resource planning (ERP) systems
Supply chain management (SCM) software
Radio frequency identification (RFID)
• Information-related metrics

Forecast horizon
Frequency update
Forecast error
Seasonal factors
Variance from plan
Ratio of demand variability to order variability
Information
Overall trade-off: Complexity versus value

•
Good information helps a firm improve both efficiency and
responsiveness
More information is not always better
More information increases complexity and cost of both
infrastructure and analysis exponentially while marginal value
diminishes
Evaluate the minimum information required to accomplish the
desired objectives
Sourcing
Role in the supply Chain

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

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

Perform a task in-house or outsource it to a third party
• Supplier selection
Number of suppliers, evaluation and selection criteria, direct
negotiations or auction
• Procurement
The supplier sends product in response to customer orders
Components of Sourcing Decisions
• Sourcing-related metrics

Days payable outstanding
Average purchase price
Range of purchase price
Average purchase quantity
Supply quality
Supply lead time
Fraction of on-time deliveries
Supplier reliability
Sourcing
• Overall trade-off: Increase the supply chain surplus

Increase the size of the total surplus to be shared across the
supply chain
Impact of sourcing on sales, service, production costs, inventory
costs, transportation costs, and information cost
Outsource if it raises the supply chain surplus more than the firm
can on its own
Keep function in-house if the third party cannot increase the
supply chain surplus or if the outsourcing risk is significant
Pricing

Pricing determines the amount to charge customers for goods
and services
Affects the supply chain level of responsiveness required and the
demand profile the supply chain attempts to serve
Pricing strategies can be used to match demand and supply
Pricing

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

• Pricing and economies of scale
The provider of the activity must decide how to price it
appropriately to reflect these economies of scale
• Everyday low pricing versus high-low pricing

Different pricing strategies lead to different demand profiles that
the supply chain must serve
Fixed price versus menu pricing

•
If marginal supply chain costs or the value to the customer vary
significantly along some attribute, it is often effective to have a
pricing menu
Can lead to customer behavior that has a negative impact on
profits
Pricing-related metrics

•
Profit margin
Days sales outstanding
Incremental fixed cost per order
Incremental variable cost per unit
Average sale price
Average order size
Range of sale price
Range of periodic sales
Pricing
• Overall trade-off: Increase firm profits

Understand of the cost structure of performing a supply chain
activity and the value this activity brings to the supply chain
Strategy may support efficiency in the supply chain, lower
supply chain costs, defend market share, or steal market share
Differential pricing may be used to attract customers with
varying needs
Strategy should help either increase revenues or shrink costs or
preferably both
• Describe key financial measures of firm performance

• Identify the major drivers of supply chain performance
• Discuss the role of each driver in creating strategic fit between

the supply chain strategy and the competitive strategy
• Define the key metrics that track the performance of the supply
chain in terms of each driver
Chapter 4

Designing Distribution Networks
and Applications to Online Sales
Learning Objectives
• Identify the key factors to be considered when designing a

distribution network
• Discuss the strengths and weaknesses of various distribution

options
• Understand how online sales have affected the design of

distribution networks in different industries
The Role of Distribution in the Supply
Chain
• Distribution: The steps taken to move and store a product from

the supplier stage to the customer stage in a supply chain
• Drives profitability by directly affecting supply chain cost and the

customer experience
• Choice of distribution network can achieve supply chain

objectives from low cost to high responsiveness
Factors Influencing
Distribution Network Design

• Distribution network performance is evaluated along two
dimensions
Customer needs that are met
Cost of meeting customer needs
• Evaluate the impact on customer service and cost for different

distribution network options
• Profitability of the delivery network determined by revenue from

met customer needs and network costs
Factors Influencing
Elements of customer service influenced by network structure:

•
Response time
Product variety
Product availability
Customer experience
Order visibility
Returnability
Factors Influencing

• Supply chain costs affected by network structure:
Inventories
Transportation
Facilities and handling
Information
Desired Response Time and Number of
Facilities

Figure 4-1
Inventory Costs and Number of Facilities

Figure 4-2
Transportation Costs and
Number of Facilities

Figure 4-3
Facility Costs and Number of Facilities

Figure 4-4
Logistics Cost, Response Time, and
Number of Facilities

Figure 4-5
Design Options for a
Distribution Network
Distribution network choices from the manufacturer to the end

•
consumer
• Two key decisions

Will product be delivered to the customer location or picked up
from a prearranged site?
Will product flow through an intermediary (or intermediate
location)?
Design Options for a
Distribution Network
One of six designs may be used

•
Manufacturer storage with direct shipping
Manufacturer storage with direct shipping and in-transit merge
Distributor storage with carrier delivery
Distributor storage with last-mile delivery
Manufacturer/distributor storage with customer pickup
Retail storage with customer pickup
Manufacturer Storage with
Direct Shipping

Figure 4-6
Manufacturer Storage with Direct Shipping
Network
Cost Factor Performance

Inventory Lower costs because of aggregation. Benefits of
aggregation are highest for low-demand, high-
value items. Benefits are large if product
customization can be postponed at the
manufacturer.
Transportation Higher transportation costs because of increased
distance and disaggregate shipping.
Facilities and Lower facility costs because of aggregation.
handling Some saving on handling costs if manufacturer
can manage small shipments or ship from
production line.
Information Significant investment in information
infrastructure to integrate manufacturer and
retailer.
Table 4-1
Manufacturer Storage with Direct Shipping
Network
Service Factor Performance

Response time Long response time of one to two weeks because

of increased distance and two stages for order
processing. Response time may vary by product,
thus complicating receiving.
Product variety Easy to provide a high level of variety.
Product availability Easy to provide a high level of product availability
because of aggregation at manufacturer.
Customer Good in terms of home delivery but can suffer if order
experience from several manufacturers is sent as partial shipments.
Time to market Fast, with the product available as soon as the first unit is
produced.
Order visibility More difficult but also more important from a customer
service perspective.
Returnability Expensive and difficult to implement. Table 4-1
In-Transit Merge Network

Figure 4-7
In-Transit Merge

Inventory Similar to drop-shipping.
Transportation Somewhat lower transportation costs than
drop-shipping.
Facilities and Handling costs higher than drop-shipping at
handling carrier; receiving costs lower at customer.
Information Investment is somewhat higher than for
drop-shipping.
Table 4-2
In-Transit Merge

Response time Similar to drop-shipping; may be marginally
higher.
Product variety Similar to drop-shipping.
Product availability Similar to drop-shipping.
Customer Better than drop-shipping because only a single
experience delivery has to be received.
Time to market Similar to drop-shipping.
Order visibility Similar to drop-shipping.
Returnability Similar to drop-shipping.
Table 4-2
Distributor Storage with
Carrier Delivery

Figure 4-8
Carrier Delivery

Inventory Higher than manufacturer storage. Difference
is not large for faster moving items but can be
large for very slow-moving items.
Transportation Lower than manufacturer storage. Reduction
is highest for faster moving items.
Facilities and Somewhat higher than manufacturer storage.
handling The difference can be large for very slow-
moving items.
Information Simpler infrastructure compared to
manufacturer storage.
Table 4-3
Carrier Delivery

Response time Faster than manufacturer storage.
Product variety Lower than manufacturer storage.
Product availability Higher cost to provide the same level of
availability as manufacturer storage.
Customer Better than manufacturer storage with drop-
experience shipping.
Time to market Higher than manufacturer storage.
Order visibility Easier than manufacturer storage.
Returnability Easier than manufacturer storage.
Table 4-3
Last Mile Delivery

Figure 4-9
Last Mile Delivery

Inventory Higher than distributor storage with
package carrier delivery.
Transportation Very high cost given minimal scale
economies. Higher than any other
distribution option.
Facilities and Facility costs higher than manufacturer
handling storage or distributor storage with package
carrier delivery, but lower than a chain of
retail stores.
Information Similar to distributor storage with package
carrier delivery.
Table 4-4
Last Mile Delivery

Response time Very quick. Same day to next-day delivery.

Product variety Somewhat less than distributor storage with package
carrier delivery but larger than retail stores.
Product availability More expensive to provide availability than any other

option except retail stores.
Customer Very good, particularly for bulky items. Slightly higher
experience than distributor storage with package carrier delivery.
Time to market Less of an issue and easier to implement than

manufacturer storage or distributor storage with
package carrier delivery.
Order visibility Easier to implement than other previous options.
Returnability Harder and more expensive than a retail network.
Table 4-4
Manufacturer or Distributor Storage with
Customer Pickup

Figure 4-10
Customer Pickup

Inventory Can match any other option, depending on
the location of inventory.
Transportation Lower than the use of package carriers,
especially if using an existing delivery
network.
Facilities and Facility costs can be high if new facilities have
handling to be built. Costs are lower if existing facilities
are used. The increase in handling cost at the
pickup site can be significant.
Information Significant investment in infrastructure
required.
Table 4-5
Customer Pickup

Response time Similar to package carrier delivery with manufacturer or
distributor storage. Same-day delivery possible for items stored
locally at pickup site.
Product variety Similar to other manufacturer or distributor storage options.
Product Similar to other manufacturer or distributor storage options.
availability
Customer Lower than other options because of the lack of home delivery.
experience Experience is sensitive to capability of pickup location.
Time to market Similar to manufacturer storage options.
Order visibility Difficult but essential.
Returnability Somewhat easier given that pickup location can handle returns.
Table 4-5
Retail Storage with Customer Pickup

Inventory Higher than all other options.
Transportation Lower than all other options.
Facilities and Higher than other options. The increase in
handling handling cost at the pickup site can be
significant for online and phone orders.
Information Some investment in infrastructure required
for online and phone orders.
Table 4-6
Retail Storage with Customer Pickup

Response time Same-day (immediate) pickup possible for items
stored locally at pickup site.
Product variety Lower than all other options.
Product availability More expensive to provide than all other options.
Customer Related to whether shopping is viewed as a
experience positive or negative experience by customer.
Time to market Highest among distribution options.
Order visibility Trivial for in-store orders. Difficult, but essential,
for online and phone orders.
Returnability Easier than other options because retail store can
provide a substitute.
Table 4-6
Comparative Performance of Delivery Network
Designs

Table 4-7
Delivery Networks for Different Product/
Customer Characteristics

Table 4-8
Impact of Online Sales on Customer
Service
Response time to customers

•
Physical products take longer to fulfill than retail store
No delay for information goods
• Product variety
Easier to offer larger selection
• Product availability
Aggregating inventory and better information on customer
preferences improves product availability
Service
Customer experience

•
Improved access, customization, and convenience
• Faster time to market
• Order visibility
• Returnability
Harder with online orders
Proportion of returns likely to be much higher
Service

• Direct sales to customers
Social networking channels allow firms to directly pitch products
and promotion
• Flexible pricing, product portfolio, and promotions

Manage revenues from product portfolio more effectively than
traditional channels
Promotion information can be conveyed to customers quickly
and inexpensively
• Efficient funds transfer
Impact of Online Sales on Cost

• Inventory
Lower inventory levels if customers will wait
Postpone variety until after the customer order is received
• Facilities
Costs related to the number and location of facilities in a network
Costs associated with the operations in these facilities
Impact of Online Sales on Cost
Transportation

•
Lower cost of “transporting” information goods in digital form
For non digital, aggregating inventories increases outbound
transportation
• Information
Share demand, planning, and forecasting information throughout
its supply chain
Additional costs to build and maintain the information
infrastructure
Online Sales Scorecard
Area Impact
Response time
Product variety

Product availability
Customer experience
Time to market
Order visibility
Direct sales
Flexible pricing, portfolio, promotions
Efficient funds transfer
Inventory
Facilities
Transportation
Information
Key: +2 = very positive; +1 = positive; 0 = neutral; −1 = negative; −2 =
very negative. Table 4-9
Using Online Sales to Sell Computer
Hardware: Dell

Figure 4-11
Hardware: Dell
Impact of online sales on customer service

•
Delay in fulfilling customer request
• Impact of online sales on cost

Reduced inventory costs
Lower facility costs
Higher total transportation costs
Incremental increase in information costs
Impact of Online Sales on Performance
Impact for Impact for

Customized Standard Low-
Area Hardware Cost Hardware
Response time –1 –2

Product variety +2 0
Product availability +1 +1
Customer experience +2 +1
Time to market +2 +1
Order visibility +1 0
Direct sales +2 +1
Flexible pricing, portfolio, promotions +2 +1
Efficient funds transfer +2 +2
Inventory +2 +1
Facilities +2 +1
Transportation –1 –2
Information 0 0
Table 4-10
Hardware: Dell
• A tailored supply chain network

A hybrid model can be very effective
More significant as hardware becomes more of a commodity
Take advantage of the strengths of both online sales and
traditional retail and distribution channels
Using Online Sales to Sell Books: Amazon
• Impact of online sales on customer service

Internet has not shortened supply chains
Increased selection, convenience

Higher total transportation costs
Increase in information costs
Area Physical Books E-books

Response time –1 +1

Product variety +2 +2
Time to market +1 +2
Order visibility 0 0
Direct sales 0 +1
Efficient funds transfer 0 0
Inventory +1 +2
Facilities +1 +1
Transportation –2 +1
Information –1 –1
Table 4-11
Using Online Sales to Sell Books: Amazon

• A supply chain network for books
Traditional bookstores pressured from both ends
Amazon more efficient
Using the Internet to Sell Groceries:
Peapod

Sell convenience and the time savings
Offers less variety
Creating a personalized shopping experience and customized
advertising and promotions
Using the Internet to Sell Groceries:
Peapod

Higher facility costs due to picking operation
Significantly higher total transportation costs
Area Impact

Response time –1
Product variety 0
Product availability 0
Customer experience +1
Time to market 0
Order visibility –1
Direct sales 0
Flexible pricing, portfolio, promotions +1
Efficient funds transfer 0
Inventory 0
Facilities –1
Transportation –2
Information –1 Table 4-12
Using Internet to Sell Groceries: Peapod

• Value of online sales to a traditional grocery chain
Complement the strengths of their existing network
Offer an entire array of services at differing prices based on the
amount of work the customer does
Using the Internet to Rent Movies: Netflix

Staggering selection and an excellent recommendation engine
Video streaming through a variety of devices
Customers received their DVDs within 24 hours of being shipped
Using the Internet to Rent Movies: Netflix

Considerably higher total transportation costs, increased
streaming will reduce transportation costs
Impact for Impact for

Area DVDs Digital Content
Response time –1 +2
Product variety +2 +2

Time to market –1 –1
Order visibility 0 0
Direct sales 0 0
Efficient funds transfer 0 0

Inventory +2 +2
Facilities +1 +1
Transportation –2 0
Information –1 –1 Table 4-12
Distribution Networks in Practice
The ownership structure of the distribution network can have as

•
big as an impact as the type of distribution network
• It is important to have adaptable distribution networks
• Product price, commoditization, and criticality affect the type of

distribution system preferred by customers
• Integrate the Internet with the existing physical network
Traditional Indian Distribution Channels
• What characteristics of the traditional Indian agricultural produce

distribution channels militate against delivering simultaneous

benefits to the farmer and the consumer?
• What supply chain best practices do you see as being relevant to

the Indian agricultural produce distribution system?
• Organized retailing underway in India is likely to impact the

traditional distribution channels and transform the same radically.
What major changes do you visualize taking place in the
agricultural produce distribution system in India and how do you
see the existing channels responding to the same?
Distribution Networks in Practice

• Consider whether an exclusive distribution strategy is
advantageous
• Product, price, commoditization, and criticality have an impact on

the type of distribution system preferred by customers
• Identify the key factors to be considered when designing a

distribution network
• Discuss the strengths and weaknesses of various distribution

options
• Understand how online sales have affected the design of

distribution networks in different industries
Chapter 5

Network Design in the Supply Chain
Learning Objectives
• Understand the role of network design in a supply chain.

• Identify factors influencing supply chain network design
decisions.
• Develop a framework for making network design decisions.
• Use optimization for facility location and capacity allocation

decisions.
Network Design Decisions
Facility role

•
What role, what processes?
• Facility location
Where should facilities be located?
• Capacity allocation
How much capacity at each facility?
• Market and supply allocation

What markets? Which supply sources?
Factors Influencing
Strategic factors

•
• Technological factors
• Macroeconomic factors
Tariffs and tax incentives
Exchange-rate and demand risk
Freight and fuel costs
• Political
Contd…
Factors Influencing
Infrastructure factors

•
• Competitive factors
Positive externalities between firms
Locating to split the market
• Customer response time and local presence
• Logistics and facility costs
Framework for Network Design Decisions

• Phase I: Define a supply chain strategy/design
Clear definition of the firm’s competitive strategy
Forecast the likely evolution of global competition
Identify constraints on available capital
Determine growth strategy
Socio Economic Factors in Choice of
Facility Location
• What role do socio-economic factors play in the selection of the

facility location?
• How do state policies aimed at promoting balanced regional

development, shape the supply chain network designs?

Figure 5-2
• Phase II: Define the regional facility configuration

Forecast of the demand by country or region
Economies of scale or scope
Identify demand risk, exchange-rate risk, political risk, tariffs,
requirements for local production, tax incentives, and export or
import restrictions
Identify competitors
Phase III: Select a set of desirable potential sites

•
Hard infrastructure requirements
Soft infrastructure requirements
• Phase IV: Location choices
Models for Facility Location and Capacity
Allocation
Maximize the overall profitability of the supply chain network while

•
providing customers with the appropriate responsiveness
• Many trade-offs during network design
• Network design models used to decide on locations and capacities

and to assign current demand to facilities
Models for Facility Location and Capacity
Allocation
Important information

•
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

Figure 5-3
Capacitated Plant Location Model
n = number of potential plant locations/capacity

m = number of markets or demand points yi = 1 if plant i is open, 0 otherwise
D j = annual demand from market j xij = quantity shipped from plant

i to market j
K i = potential capacity of plant i
f i = annualized fixed cost of keeping plant i open
cij = cost of producing and shipping one unit from plant i to market j (cost
includes production, inventory, transportation, and tariffs)
n n m
Minå f i yi + å åc x ij ij
i=1 i=1 j=1
n
subject to
åx ij
= D j for j = 1,...,m
i=1
m
åx ij
= K i yi for i = 1,...,n
j=1
yi Î {0,1} for i = 1,...,n, x ij ³ 0


Figure 5-4

Figure 5-5

Figure 5-5
Phase III: Gravity Location Models

Figure 5-6
Gravity Location Model
xn, yn: Coordinate location of either a market or supply source n

Fn: Cost of shipping one unit for one mile between the facility
and either market or supply source n
Dn: Quantity to be shipped between facility and market or

supply source n
(x, y) is the location selected for the facility, the distance dn

between the facility at location (x, y) and the supply source or
market n is given by
(x – x ) + ( y – y )
2 2
dn = n n

Figure 5-7
Transportation Coordinates
Cost Quantity in
Sources/Markets $/Ton Mile (Fn) Tons (Dn) xn yn

Supply sources
Buffalo 0.90 500 700 1,200
Memphis 0.95 300 250 600
St. Louis 0.85 700 225 825
Markets
Atlanta 1.50 225 600 500
Boston 1.50 150 1,050 1,200
Jacksonville 1.50 250 800 300
Philadelphia 1.50 175 925 975
New York 1.50 300 1,000 1,080
k
Total transportation cost TC   d n Dn Fn Table 5-1
n 1

Figure 5-8

Figure 5-8
• For each supply source or market n, evaluate dn

• Obtain a new location (x’, y’) for the facility, where
k k
Dn Fn xn Dn Fn yn
å d å d
x¢ = n=1
k
n
and y¢ = n=1
k
n
Dn Fn Dn Fn
å d å d
n=1 n n=1 n
• If the new location (x’, y’) is almost the same as

(x, y) stop. Otherwise, set (x, y) = (x’, y’) and go to step 1
Phase IV: Network Optimization Models
Demand City

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

n = Number of factory locations
m = Number of markets or demand points xij = Quantity shipped from factory i to
D j = Annual demand from market j market j
K i = Capacity of factory i
cij = Cost of producing and shipping one unit from factory i to market j
n m
Min  cij xij
i 1 j 1 subject to
n
x
i 1
ij  D j for j  1,...,m
m
x
j 1
ij  K i for i  1,...,n
Network Optimization Models
Optimal demand allocation

•
Atlanta Boston Chicago Denver Omaha Portland
TelecomOne Baltimore 0 8 2
Memphis 10 0 12
Wichita 0 0 0
HighOptic Salt Lake 0 0 11
Cheyenne 6 7 0
Table 5-3
• Merge the companies

• Solve using location-specific costs
yi = 1 if factory i is open, 0 otherwise

xij = quantity shipped from factory i to market j
n n m
Minå f i yi + å åc x ij ij
i=1 i=1 j=1

Figure 5-9

Figure 5-10

Figure 5-10

Figure 5-11
Capacitated Model with Single Sourcing
• Market supplied by only one factory

• Modify decision variables
yi = 1 if factory i is open, 0 otherwise
xij = 1 if market j is supplied by factory i, 0 otherwise
n n m
Minå f i yi + å å D j cij xij
subject to i=1 i=1 j=1
n
åx ij
= 1 for j = 1,...,m
i=1
m
åD x i ij
£ K i yi for i = 1,...,n
j=1
xij , yi Î {0,1}

Figure 5-12
• Optimal network configuration with single sourcing

Open/
Closed Atlanta Boston Chicago Denver Omaha Portland
Baltimore Closed 0 0 0 0 0 0
Cheyenne Closed 0 0 0 0 0 0
Salt Lake Open 0 0 0 6 0 11
Memphis Open 10 8 0 0 0 0
Wichita Open 0 0 14 0 7 0
Table 5-4
Locating Plants and Warehouses
Simultaneously

Figure 5-13
Simultaneously
• Model 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 = Potential capacity of factory at site i
Sh = Supply capacity at supplier h
We = Potential warehouse capacity at site e
Fi = 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
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
Simultaneously
• Goal is to identify plant and warehouse locations and quantities

shipped that minimize the total fixed and variable costs
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 i to warehouse e
xhi = Quantity shipped from supplier h to factory at site i
n t l n t m
Minå Fi yi + å f e ye + å å chi xie + å å cej xej
i=1 e=1 h=1 i=1 e=1 j=1
Simultaneously
subject to

n m
åx hi
£ Sh for h = 1,...,l åx ej
£ We ye for e = 1,...,t
i=1 j=1
l t t
åx hi
– å xie ³ 0 for i = 1,...,n åx ej
= D j for j = 1,...,m
h=1 e=1 e=1
t
åx ie
£ Ki yi for i = 1,...,n yi , ye Î {0,1}, xej , xie , xhi ³ 0
e=1
n m
åx ie
– å xej ³ 0 for e = 1,...,t
i=1 j=1
Accounting for Taxes, Tariffs, and
Customer Requirements
• A supply chain network should maximize profits after tariffs and

taxes while meeting customer service requirements
• Modified objective and constraint

m n n n m
Maxå rj å xij – å Fi yi – å å cij xij
j=1 i=1 i=1 i=1 j=1
åx ij
£ D j for j = 1,...,m
i=1
Making Network Design Decisions in
Practice
• Do not underestimate the life span of facilities

• Do not gloss over the cultural implications
• Do not ignore quality-of-life issues
• Focus on tariffs and tax incentives when locating facilities
• Understand the role of network design in a supply chain

• Identify factors influencing supply chain network design decisions
• Develop a framework for making network design decisions
• Use optimization for facility location and capacity allocation

decisions
Chapter 6

Designing Global Supply Chain
Networks
Learning Objectives
• Identify factors that need to be included in total cost when making

global sourcing decisions.
• Define uncertainties that are particularly relevant when designing

global supply chains.
• Explain different strategies that may be used to mitigate risk in

global supply chains.
• Understand decision tree methodologies used to evaluate supply

chain design decisions under uncertainty.
Impact of Globalization on Supply Chain
Networks
Opportunities to simultaneously grow revenues and decrease costs

•
• Accompanied by significant additional risk
• Difference between success and failure often ability to incorporate

suitable risk mitigation into supply chain design
• Uncertainty of demand and price drives the value of building

flexible production capacity
Impact of Globalization on Supply Chain
Networks
Risk Factors Percentage of Supply Chains Impacted

Natural disasters 35

Shortage of skilled resources 24
Geopolitical uncertainty 20
Terrorist infiltration of cargo 13
Volatility of fuel prices 37
Currency fluctuation 29
Port operations/custom delays 23
Customer/consumer preference shifts 23
Performance of supply chain partners 38
Logistics capacity/complexity 33
Forecasting/planning accuracy 30
Supplier planning/communication issues 27
Inflexible supply chain technology 21
Table 6-1
The Offshoring Decision: Total Cost
Comparative advantage in global supply chains

•
• Quantify the benefits of offshore production along with the reasons
• Two reasons for offshoring failure

Focusing exclusively on unit cost rather than total cost
Ignoring critical risk factors
Performance Activity Impacting Impact of Offshoring

Dimension Performance
Order communication Order placement More difficult communication

Supply chain visibility Scheduling and expediting Poorer visibility
Raw material costs Sourcing of raw material Could go either way

depending on raw material
sourcing
Unit cost Production, quality (production Labor/fixed costs decrease;
and transportation) quality may suffer
Freight costs Transportation modes and Higher freight costs
quantity
Taxes and tariffs Border crossing Could go either way
Supply lead time Order communication, supplier Lead time increase results in
production scheduling, poorer forecasts and higher
production time, customs, inventories
transportation, receiving
Table 6-2
Performance Activity Impacting Impact of Offshoring

Dimension Performance
On-time delivery/lead Production, quality, customs, Poorer on-time delivery and

time uncertainty transportation, receiving increased uncertainty
resulting in higher inventory
and lower product availability
Minimum order quantity Production, transportation Larger minimum quantities
increase inventory
Product returns Quality Increased returns likely
Inventories Lead times, inventory in transit Increase

and production
Working capital Inventories and financial Increase
reconciliation
Hidden costs Order communication, invoicing Higher hidden costs
errors, managing exchange rate
risk
Stock-outs Ordering, production, Increase
transportation with poorer
visibility Table 6-2
A global supply chain with offshoring increases the length and

•
duration of information, product, and cash flows
• The complexity and cost of managing the supply chain can be

significantly higher than anticipated
• Quantify factors and track them over time
• Big challenges with off shoring is increased risk and its potential
impact on cost
• Key elements of total cost

Supplier price
Terms
Delivery costs
Inventory and warehousing
Cost of quality
Customer duties, value added-taxes, local tax incentives
Cost of risk, procurement staff, broker fees, infrastructure, and
tooling and mold costs
Exchange rate trends and their impact on cost
Risk Management in Global Supply Chains
• Risks include supply disruption, supply delays, demand

fluctuations, price fluctuations, and exchange-rate fluctuations
• Critical for global supply chains to be aware of the relevant risk

factors and build in suitable mitigation strategies
Category Risk Drivers

Disruptions Natural disaster, war, terrorism
Labor disputes
Supplier bankruptcy
Delays High capacity utilization at supply source
Inflexibility of supply source
Poor quality or yield at supply source
Systems risk Information infrastructure breakdown
System integration or extent of systems
being networked
Forecast risk Inaccurate forecasts due to long lead
times, seasonality, product variety, short
life cycles, small customer base
Information distortion
Table 6-3
Category Risk Drivers

Intellectual property risk Vertical integration of supply chain
Global outsourcing and markets
Procurement risk Exchange-rate risk
Price of inputs
Fraction purchased from a single source
Industry-wide capacity utilization
Receivables risk Number of customers
Financial strength of customers
Inventory risk Rate of product obsolescence
Inventory holding cost
Product value
Demand and supply uncertainty
Capacity risk Cost of capacity
Capacity flexibility
Table 6-3
Good network design can play a significant role in mitigating

•
supply chain risk
• Every mitigation strategy comes at a price and may increase

other risks
• Global supply chains should generally use a combination of

rigorously evaluated mitigation strategies along with financial
strategies to hedge uncovered risks
Risk Mitigation Tailored Strategies

Strategy

Increase capacity Focus on low-cost, decentralized capacity
for predictable demand. Build centralized
capacity for unpredictable demand.
Increase decentralization as cost of
capacity drops.
Get redundant suppliers More redundant supply for high-volume
products, less redundancy for low-volume
products. Centralize redundancy for low-
volume products in a few flexible
suppliers.
Increase responsiveness Favor cost over responsiveness for
commodity products. Favor responsiveness
over cost for short–life cycle products.
Table 6-4
Risk Mitigation Tailored Strategies

Strategy
Increase inventory Decentralize inventory of predictable, lower value
products. Centralize inventory of less predictable,
higher value products.
Increase flexibility Favor cost over flexibility for predictable, high-
volume products. Favor flexibility for unpredictable,
low-volume products. Centralize flexibility in a few
locations if it is expensive.
Pool or aggregate demand Increase aggregation as unpredictability grows.
Increase source capability Prefer capability over cost for high-value, high-risk
products. Favor cost over capability for low-value
commodity products. Centralize high capability in
flexible source if possible.
Table 6-4
Flexibility, Chaining, and Containment
• Three broad categories of flexibility

New product flexibility
 Ability to introduce new products into the market at a rapid
rate
Mix flexibility
 Ability to produce a variety of products within a short period of
time
Volume flexibility
 Ability to operate profitably at different levels of output

Figure 6-1

• As flexibility is increased, the marginal benefit derived from the
increased flexibility decreases
With demand uncertainty, longer chains pool available capacity
Long chains may have higher fixed cost than multiple smaller
chains
Coordination more difficult across with a single long chain
• Flexibility and chaining are effective when dealing with demand

fluctuation but less effective when dealing with supply disruption
Discounted Cash Flow Analysis
Supply chain decisions should be evaluated as a sequence of cash

•
flows over time
• Discounted cash flow (DCF) analysis evaluates the present value

of any stream of future cash flows and allows managers to
compare different cash flow streams in terms of their financial
value
• Based on the time value of money – a dollar today is worth more

than a dollar tomorrow
Discounted Cash Flow Analysis
1
Discount factor 
1 k

t
 1  T
NPV  C 0     Ct
t 1  1  k 
where
C0, C1,…,CT is stream of cash flows over T periods
NPV = net present value of this stream
k = rate of return
• Compare NPV of different supply chain design options
• The option with the highest NPV will provide the greatest
financial return
Trips Logistics Example
Demand = 100,000 units

•
• 1,000 sq. ft. of space for every 1,000 units of demand
• Revenue = $1.22 per unit of demand
• Sign a three-year lease or obtain warehousing space on the spot
market?
• Three-year lease cost = $1 per sq. ft.
• Spot market cost = $1.20 per sq. ft.
• k = 0.1
Expected annual profit if warehouse = 100,000 x $1.22

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

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

than spot market
Using Decision Trees

• Many different decisions
Should the firm sign a long-term contract for warehousing space
or get space from the spot market as needed?
What should the firm’s mix of long-term and spot market be in
the portfolio of transportation capacity?
How much capacity should various facilities have? What fraction
of this capacity should be flexible?
Using Decision Trees
During network design, managers need a methodology that allows

•
them to estimate the uncertainty in demand and price forecast
and incorporate this in the decision-making process
• Most important for network design decisions because they are

hard to change in the short term
Basics of Decision Tree Analysis
• A decision tree is a graphic device used to evaluate decisions under

uncertainty
Identify the number and duration of time periods that will be
considered
Identify factors that will affect the value of the decision and are
likely to fluctuate over the time periods
Evaluate decision using a decision tree
Decision Tree Methodology
• Identify the duration of each period (month, quarter, etc.) and

the number of periods T over which the decision is to be
evaluated
• Identify factors whose fluctuation will be considered
• Identify representations of uncertainty for each factor
• Identify the periodic discount rate k for each period
• Represent the decision tree with defined states in each period as
well as the transition probabilities between states in successive
periods
• Starting at period T, work back to Period 0, identifying the
optimal decision and the expected cash flows at each step
Decision Tree – Trips Logistics
• Three warehouse lease options

Get all warehousing space from the spot market as needed
Sign a three-year lease for a fixed amount of warehouse space
and get additional requirements from the spot market
Sign a flexible lease with a minimum charge that allows variable
usage of warehouse space up to a limit with additional
requirement from the spot market

• 1000 sq. ft. of warehouse space needed for 1000 units of demand
• Current demand = 100,000 units per year
• Binomial uncertainty: Demand can go up by 20% with
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
Decision Tree

Figure 6-2
• Analyze the option of not signing a lease and using 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) = 144,000 x 1.45
= $208,800
P(D = 144, p = 1.45,2) = 144,000 x 1.22
– C(D = 144, p = 1.45, 2)
= 175,680 – 208,800
= –$33,120
Cost Profit
Revenue C(D =, p =, 2) P(D =, p =, 2)

D = 144, p = 144,000 × 1.22 144,000 × 1.45 –$33,120
1.45
D = 144, p = 144,000 × 1.22 144,000 × 1.19 $4,320
1.19
D = 144, p = 144,000 × 1.22 144,000 × 0.97 $36,000
0.97
D = 96, p = 1.45 96,000 × 1.22 96,000 × 1.45 –$22,080
D = 96, p = 1.19 96,000 × 1.22 96,000 × 1.19 $2,880
D = 96, p = 0.97 96,000 × 1.22 96,000 × 0.97 $24,000
D = 64, p = 1.45 64,000 × 1.22 64,000 × 1.45 –$14,720
D = 64, p = 1.19 64,000 × 1.22 64,000 × 1.19 $1,920
D = 64, p = 0.97 64,000 × 1.22 64,000 × 0.97 $16,000 Table 6-5
• 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
• 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) = 0.2 x [P(D = 144, p = 1.45,2) +
P(D = 144, p = 1.19,2) + P(D = 96, p = 1.45,2) +
P(D = 96, p = 1.19,2)
= 0.25 x [–33,120 + 4,320 – 22,080 + 2,880]
= –$12,000
• The present value of this expected value in Period 1 is

PVEP(D = 120, p = 1.32,1)
= EP(D = 120, p = 1.32,1) / (1 + k)
= –$12,000 / (1.1)
= –$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) = 120,000 x 1.22 – 120,000 x 1.32 +
PVEP(D = 120, p = 1.32,1)
= –$12,000 – $10,909 = –$22,909

• 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) = 0.25 x [P(D = 120, p = 1.32,1) +
P(D = 120, p = 1.08,1) + P(D = 96, p = 1.32,1) +
P(D = 96, p = 1.08,1)]
= 0.25 x [–22,909 + 32,073 – 15,273) + 21,382]
= $3,818
PVEP(D = 100, p = 1.20,1) = EP(D = 100, p = 1.20,0) / (1 + k)

= $3,818 / (1.1) = $3,471
P(D = 100, p = 1.20,0) = 100,000 x 1.22 – 100,000 x 1.20 +

PVEP(D = 100, p = 1.20,0)
= $2,000 + $3,471 = $5,471
• 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
• Fixed Lease Option

P(D =, p =, 1)
= D x 1.22 – D x p +
Node EP(D =, p =, 1) EP(D =, p =, 1) / (1 + k)
D = 120, p = 1.32 100,000 sq. ft. –$22,909
D = 120, p = 1.08 100,000 sq. ft. $32,073
D = 80, p = 1.32 100,000 sq. ft. –$15,273
D = 80, p = 1.08 100,000 sq. ft. $21,382
Table 6-6

Profit P(D =, p =, 2)
Warehouse Space = D x 1.22 – (100,000
Node Leased Space at Spot Price (S) x 1 + S x p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880
D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320
D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000
D = 96, p = 1.45 100,000 sq. ft. 0 sq. ft. $17,120
D = 96, p = 1.19 100,000 sq. ft. 0 sq. ft. $17,120
D = 96, p = 0.97 100,000 sq. ft. 0 sq. ft. $17,120
D = 64, p = 1.45 100,000 sq. ft. 0 sq. ft. –$21,920
D = 64, p = 1.19 100,000 sq. ft. 0 sq. ft. –$21,920
D = 64, p = 0.97 100,000 sq. ft. 0 sq. ft. –$21,920 Table 6-7
P(D =, p =, 1)
Warehouse = D x 1.22 –

Space (100,000 x 1 + S x
at Spot p) + EP(D =, p =
Node EP(D =, p =, 1) Price (S) ,1)(1 + k)
D = 120, p = 1.32 0.25 x [P(D = 144, p = 20,000 $35,782
1.45,2) + P(D = 144, p =
1.19,2) + P(D = 96, p =
1.45,2) + P(D = 96, p =
1.19,2)] = 0.25 x (11,880 +
23,320 + 17,120 + 17,120) =
$17,360
D = 120, p = 1.08 0.25 x (23,320 + 33,000 + 20,000 $45,382
17,120 + 17,120) = $22,640
D = 80, p = 1.32 0.25 x (17,120 + 17,120 – 0 –$4,582
21,920 – 21,920) = –$2,400
D = 80, p = 1.08 0.25 x (17,120 + 17,120 – 0 –$4,582
21,920 – 21,920) = –$2,400 Table 6-8
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
• Flexible Lease Option

Profit P(D =, p =, 2)
Warehouse Warehouse Space = D x 1.22 – (W x 1 + S
Node Space at $1 (W) at Spot Price (S) x p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880
D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320
D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000
D = 96, p = 1.45 96,000 sq. ft. 0 sq. ft. $21,120
D = 96, p = 1.19 96,000 sq. ft. 0 sq. ft. $21,120
D = 96, p = 0.97 96,000 sq. ft. 0 sq. ft. $21,120
D = 64, p = 1.45 64,000 sq. ft. 0 sq. ft. $14,080
D = 64, p = 1.19 64,000 sq. ft. 0 sq. ft. $14,080
D = 64, p = 0.97 64,000 sq. ft. 0 sq. ft. $14,080 Table 6-9
P(D =, p =, 1)

Warehouse = D x 1.22 – (W
Warehouse Space x 1 + S x p) +
Space at $1 at Spot EP(D =, p = ,1)(1
Node EP(D =, p =, 1) (W) Price (S) + k)
D = 120, 0.25 x (11,880 + 100,000 20,000 $37,600
p = 1.32 23,320 + 21,120 +
21,120) = $19,360
D = 120, 0.25 x (23,320 + 100,000 20,000 $47,200
p = 1.08 33,000 + 21,120 +
21,120) = $24,640
D = 80, 0.25 x (21,120 + 80,000 0 $33,600
p = 1.32 21,120 + 14,080 +
14,080) = $17,600
D = 80, 0.25 x (21,920 + 80,000 0 $33,600
p = 1.08 21,920 + 14,080 +
14,080) = $17,600 Table 6-10

Option Value
All warehouse space from the spot market $5,471
Lease 100,000 sq. ft. for three years $38,364
Flexible lease to use between 60,000 and 100,000 sq. $46,545
ft.
Table 6-11
Onshore or Offshore

• D-Solar demand in Europe = 100,000 panels per year
• Each panel sells for €70
• Annual demand may increase by 20 percent with probability 0.8

or decrease by 20 percent with probability 0.2
• Build a plant in Europe or China with a rated capacity of 120,000

panels
D-Solar Decision

European Plant Chinese Plant
Fixed Cost Variable Cost Fixed Cost Variable Cost
(euro) (euro) (yuan) (yuan)
1 million/year 40/panel 8 million/year 340/panel
Table 6-12
Period 1 Period 2
Demand Exchange Rate Demand Exchange Rate
112,000 8.64 yuan/euro 125,440 8.2944
yuan/euro
Table 6-13
D-Solar Decision
• European plant has greater volume flexibility

• Increase or decrease production between 60,000 to 150,000
panels
• Chinese plant has limited volume flexibility
• Can produce between 100,000 and 130,000 panels
• Chinese plant will have a variable cost for 100,000 panels and
will lose sales if demand increases above 130,000 panels
• Yuan, currently 9 yuan/euro, expected to rise 10%, probability
of 0.7 or drop 10%, probability of 0.3
• Sourcing decision over the next three years
• Discount rate k = 0.1
D-Solar Decision
Period 0 profits = 100,000 x 70 – 1,000,000 – 100,000 x 40 = €2,000,000

Expected profit from onshoring = 2,000,000 + 2,360,000/1.1 + 2,763,200/1.21

= €6,429,091
Period 0 profits = 100,000 x 70 – 8,000,000/9 – 100,000 x 340/9

= €2,333,333
Period 1 profits = 112,000 x 70 – 8,000,000/8.64 – 112,000 x 340/8.64

= €2,506,667
Period 2 profits = 125,440 x 70 – 8,000,000/7.9524 – 125,440 x 340/7.9524 = €2,674,319
Expected profit from off-shoring = 2,333,333 + 2,506,667/1.1 + 2,674,319/1.21

= €6,822,302
Decision Tree

Figure 6-3
D-Solar Decision

• Period 2 evaluation – onshore
Revenue from the manufacture

and sale of 144,000 panels = 144,000 x 70
= €10,080,000
Fixed + variable cost

of onshore plant = 1,000,000 + 144,000 x 40
= €6,760,000
P(D = 144, E = 10.89,2) = 10,080,000 – 6,760,000

= €3,320,000
D-Solar Decision
D E Sales Production Revenue Cost (euro) Profit

Cost (euro) (euro)

Quantity
144 10.89 144,000 144,000 10,080,000 6,760,000 3,320,000
144 8.91 144,000 144,000 10,080,000 6,760,000 3,320,000
96 10.89 96,000 96,000 6,720,000 4,840,000 1,880,000
96 8.91 96,000 96,000 6,720,000 4,840,000 1,880,000
144 7.29 144,000 144,000 10,080,000 6,760,000 3,320,000
96 7.29 96,000 96,000 6,720,000 4,840,000 1,880,000
64 10.89 64,000 64,000 4,480,000 3,560,000 920,000
64 8.91 64,000 64,000 4,480,000 3,560,000 920,000
64 7.29 64,000 64,000 4,480,000 3,560,000 920,000
Table 6-14
D-Solar Decision

EP(D = 120, E = 9.90, 1)= 0.24 x P(D = 144, E = 10.89, 2) +

0.56 x P(D = 144, E = 8.91, 2) +
0.06 x P(D = 96, E = 10.89, 2) +
0.14 x P(D = 96, E = 8.91, 2)
= 0.24 x 3,320,000 + 0.56 x 3,320,000 +
0.06 x 1,880,000 + 0.14 x 1,880,000
= €3,032,000
PVEP(D = 120, E = 9.90,1) = EP(D = 120, E = 9.90,1)/(1 + k)

= 3,032,000/1.1 = €2,756,364
D-Solar Decision

Revenue from manufacture
and sale of 120,000 panels = 120,000 x 70 = €8,400,000
Fixed + variable cost of onshore plant = 1,000,000 + 120,000 x 40

= €5,800,000
P(D = 120, E = 9.90, 1) = 8,400,000 – 5,800,000 +

PVEP(D = 120, E = 9.90, 1)
= 2,600,000 + 2,756,364
= €5,356,364
D-Solar Decision

D E Sales Production Revenue Cost (euro) Profit
Cost (euro) (euro)
Quantity
120 9.90 120,000 120,000 8,400,000 5,800,000 5,356,364
120 8.10 120,000 120,000 8,400,000 5,800,000 5,356,364
80 9.90 80,000 80,000 5,600,000 4,200,000 2,934,545
80 8.10 80,000 80,000 5,600,000 4,200,000 2,934,545
Table 6-15
D-Solar Decision

EP(D = 100, E = 9.00, 1) = 0.24 x P(D = 120, E = 9.90, 1) +
0.56 x P(D = 120, E = 8.10, 1) +
0.06 x P(D = 80, E = 9.90, 1) +
0.14 x P(D = 80, E = 8.10, 1)
= 0.24 x 5,356,364 + 0.56 x 5,5356,364 +
0.06 x 2,934,545 + 0.14 x 2,934,545
= € 4,872,000
PVEP(D = 100, E = 9.00,1) = EP(D = 100, E = 9.00,1)/(1 + k)

= 4,872,000/1.1 = €4,429,091
D-Solar Decision

Revenue from manufacture and sale of 100,000 panels
= 100,000 x 70 = €7,000,000
Fixed + variable cost of onshore plant = 1,000,000 + 100,000 x 40

= €5,000,000
P(D = 100, E = 9.00, 1) = 8,400,000 – 5,800,000 +

PVEP(D = 100, E = 9.00, 1)
= 2,000,000 + 4,429,091
= €6,429,091
D-Solar Decision
• Period 2 evaluation – offshore

Revenue from the manufacture and sale of 130,000 panels
= 130,000 x 70
= €9,100,000
Fixed + variable cost of offshore plant

= 8,000,000 + 130,000 x 340
= 52,200,000 yuan
P(D = 144, E = 10.89,2) = 9,100,000 – 52,200,000/10.89

= €4,306,612
D-Solar Decision
D E Sales Production Revenue Cost (yuan) Profit

Cost (euro) (euro)

Quantity
144 10.89 130,000 130,000 9,100,000 52,200,000 4,306,612
144 8.91 130,000 130,000 9,100,000 52,200,000 3,241,414
96 10.89 96,000 100,000 6,720,000 42,000,000 2,863,251
96 8.91 96,000 100,000 6,720,000 42,000,000 2,006,195
144 7.29 130,000 130,000 9,100,000 52,200,000 1,939,506
96 7.29 96,000 100,000 6,720,000 42,000,000 958,683
64 10.89 64,000 100,000 4,480,000 42,000,000 623,251
64 8.91 64,000 100,000 4,480,000 42,000,000 –233,805
64 7.29 64,000 10,000 4,480,000 3,560,000 –1,281,317
Table 6-16
D-Solar Decision

EP(D = 120, E = 9.90,1) = 0.24 x P(D = 144, E = 10.89, 2) +
0.56 x P(D = 144, E = 8.91, 2) +
0.06 x P(D = 96, E = 10.89, 2) +
0.14 x P(D = 96, E = 8.91, 2)
= 0.24 x 4,306,612 + 0.56 x 3,241,414 +
0.06 x 2,863,251 + 0.14 x 2,006,195
= € 3,301,441
PVEP(D = 120, E = 9.90,1) = EP(D = 120, E = 9.90,1)/(1 + k)

= 3,301,441/1.1 = €3,001,310
D-Solar Decision


= 120,000 x 70 = €8,400,000
Fixed + variable cost of offshore plant

= 8,000,000 + 120,000 x 340
= 48,800,000 yuan
P(D = 120, E = 9.90, 1) = 8,400,000 – 48,800,000/9.90 +

PVEP(D = 120, E = 9.90, 1)
= 3,470,707 + 3,001,310
= €6,472,017
D-Solar Decision

D E Sales Production Revenue Cost (yuan) Expected
Cost (euro) Profit
Quantity (euro)
120 9.90 120,000 120,000 8,400,000 48,800,000 6,472,017
120 8.10 120,000 120,000 8,400,000 48,800,000 4,301,354
80 9.90 80,000 100,000 5,600,000 42,000,000 3,007,859
80 8.10 80,000 100,000 5,600,000 42,000,000 1,164,757
Table 6-17
D-Solar Decision

EP(D = 100, E = 9.00, 1) = 0.24 x P(D = 120, E = 9.90, 1) +
0.56 x P(D = 120, E = 8.10, 1) +
0.06 x P(D = 80, E = 9.90, 1) +
0.14 x P(D = 80, E = 8.10, 1)
= 0.24 x 6,472,017 + 0.56 x 4,301,354
+ 0.06 x 3,007,859 + 0.14 x 1,164,757
= € 4,305,580
PVEP(D = 100, E = 9.00,1) = EP(D = 100, E = 9.00,1)/(1 + k)

= 4,305,580/1.1 = €3,914,164
D-Solar Decision

= 100,000 x 70 = €7,000,000
Fixed + variable cost of onshore plant

= 8,000,000 + 100,000 x 340
= €42,000,000 yuan
P(D = 100, E = 9.00, 1) = 7,000,000 – 42,000,000/9.00 +

PVEP(D = 100, E = 9.00, 1)
= 2,333,333 + 3,914,164
= €6,247,497
Decisions Under Uncertainty

• Combine strategic planning and financial planning during global
network design
• Use multiple metrics to evaluate global supply chain networks
• Use financial analysis as an input to decision making, not as the

decision-making process
• Use estimates along with sensitivity analysis
• Identify factors that need to be included in total cost when making

global sourcing decisions
• Define uncertainties that are particularly relevant when designing

global supply chains
• Explain different strategies that may be used to mitigate risk in

global supply chains
• Understand decision tree methodologies used to evaluate supply

chain design decisions under uncertainty
Chapter 7

Demand Forecasting
in a Supply Chain
Learning Objectives
Understand the role of forecasting for both an enterprise and a

•
supply chain.
• Identify the components of a demand forecast.
• Forecast demand in a supply chain given historical demand data

using time-series methodologies.
• Analyze demand forecasts to estimate forecast error.
Role of Forecasting in a Supply Chain
The basis for all planning decisions in a supply chain

•
• Used for both push and pull processes

Production scheduling, inventory, aggregate planning
Sales force allocation, promotions, new production introduction
Plant/equipment investment, budgetary planning
Workforce planning, hiring, layoffs
• All of these decisions are interrelated
Characteristics of Forecasts
Forecasts are always inaccurate and should thus include both the

•
expected value of the forecast and a measure of forecast error
• Long-term forecasts are usually less accurate than short-term

forecasts
• Aggregate forecasts are usually more accurate than disaggregate

forecasts
• In general, the farther up the supply chain a company is, the

greater is the distortion of information it receives
Components and Methods
• Companies must identify the factors that influence future demand

and then ascertain the relationship between these factors and
future demand
Past demand
Lead time of product replenishment
Planned advertising or marketing efforts
Planned price discounts
State of the economy
Actions that competitors have taken
Components and Methods
• Qualitative

Primarily subjective
Rely on judgment
• Time series
Use historical demand only
Best with stable demand
• Causal
Relationship between demand and some other factor
• Simulation
Imitate consumer choices that give rise to demand
Components of an Observation
Observed demand (O) = systematic component (S)

+ random component (R)
• Systematic component – expected value of demand

Level (current deseasonalized demand)
Trend (growth or decline in demand)
Seasonality (predictable seasonal fluctuation)
• Random component – part of forecast that deviates from

systematic component
• Forecast error – difference between forecast and actual

demand
Basic Approach
• Understand the objective of forecasting.

• Integrate demand planning and forecasting throughout the
supply chain.
• Identify the major factors that influence the demand forecast.
• Forecast at the appropriate level of aggregation.
• Establish performance and error measures for the forecast.
Time-Series Forecasting Methods

• Three ways to calculate the systematic component
Multiplicative
S = level x trend x seasonal factor
Additive
S = level + trend + seasonal factor
Mixed
S = (level + trend) x seasonal factor
Static Methods
Systematic component = (level + trend) ´ seasonal factor

Ft+l = [L + (t + l)T ]St+l
where
L = Estimate of level at t = 0
T = Estimate of trend
St = Estimate of seasonal factor for Period t
Dt = Actual demand observed in Period t
Ft = Forecast of demand for Period t
Tahoe Salt
Year Quarter Period, t Demand, Dt

1 2 1 8,000

1 3 2 13,000
1 4 3 23,000
2 1 4 34,000
2 2 5 10,000
2 3 6 18,000
2 4 7 23,000
3 1 8 38,000
3 2 9 12,000
3 3 10 13,000
3 4 11 32,000
4 1 12 41,000
Table 7-1
Tahoe Salt

Figure 7-1
Estimate Level and Trend
Periodicity p = 4, t = 3
ì é t –1+( p/2) ù

ï ê Dt –( p/2) + Dt+( p/2) + å 2Di ú / (2 p) for p even
ï êë i=t+1–( p/2) úû
Dt = í
ï t+[( p–1)/2]
ï å Di / p for p odd
î i=t –[( p–1)/2]
é t –1+( p/2) ù
Dt = ê Dt –( p/2) + Dt+( p/2) + å 2Di ú / (2 p)
êë i=t+1–( p/2) úû
4
= D1 + D5 + å 2Di / 8
i=2
Tahoe Salt

Figure 7-2
Tahoe Salt

Figure 7-3
A linear relationship exists between the deseasonalized

demand and time based on the change in demand over time
Dt = L + Tt
Estimating Seasonal Factors

Di
St =
Dt
Figure 7-4
Estimating Seasonal Factors
r–1
åS jp+1
Si = j=0

r
S1 = (S1 + S5 + S9 ) / 3 = (0.42 + 0.47 + 0.52) / 3 = 0.47
S2 = (S2 + S6 + S10 ) / 3 = (0.67 + 0.83 + 0.55) / 3 = 0.68
S3 = (S3 + S7 + S11) / 3 = (1.15 +1.04 +1.32) / 3 = 1.17
S4 = (S 4 + S8 + S12 ) / 3 = (1.66 +1.68 +1.66) / 3 = 1.67
F13 = (L +13T )S13 = (18,439 +13 ´ 524)0.47 = 11,868

F14 = (L +14T )S14 = (18,439 +14 ´ 524)0.68 = 17,527
F15 = (L +15T )S15 = (18,439 +15 ´ 524)1.17 = 30,770
F16 = (L +16T )S16 = (18,439 +16 ´ 524)1.67 = 44,794
Adaptive Forecasting
The estimates of level, trend, and seasonality are adjusted after

•
each demand observation
• Estimates incorporate all new data that are observed
Adaptive Forecasting
Ft+1 = (Lt + lTt )St+1

where
Lt = estimate of level at the end of Period t
Tt = estimate of trend at the end of Period t
St = estimate of seasonal factor for Period t
Ft = forecast of demand for Period t (made Period t – 1 or

earlier)
Dt = actual demand observed in Period t
Et = Ft – Dt = forecast error in Period t
Steps in Adaptive Forecasting
• Initialize

Compute initial estimates of level (L0), trend (T0), and seasonal
factors (S1,…,Sp)
• Forecast
Forecast demand for period (t + 1)
• Estimate error
Compute error (Et+1) = Ft+1 – Dt+1
• Modify estimates
Modify the estimates of level Lt+1, trend Tt+1, and seasonal
factor St+p+1, given the error Et+1
Moving Average

• Used when demand has no observable trend or seasonality
Systematic component of demand = level
• The level in period t is the average demand over the last N

periods
Lt = (Dt + Dt-1 + … + Dt–N+1) / N
Ft+1 = Lt and Ft+n = Lt
• After observing the demand for period t + 1, revise the estimates

Lt+1 = (Dt+1 + Dt + … + Dt-N+2) / N, Ft+2 = Lt+1
Moving Average Example
A supermarket has experienced weekly demand of milk of D1 =

•
120, D2 = 127, D3 = 114, and D4 = 122 gallons over the past
four weeks
Forecast demand for Period 5 using a four-period moving
average
What is the forecast error if demand in Period 5 turns out to be
125 gallons?
Moving Average Example
L4 = (D4 + D3 + D2 + D1)/4

= (122 + 114 + 127 + 120)/4 = 120.75
• Forecast demand for Period 5

F5 = L4 = 120.75 gallons
• Error if demand in Period 5 = 125 gallons

E5 = F5 – D5 = 125 – 120.75 = 4.25
• Revised demand
L5 = (D5 + D4 + D3 + D2)/4
= (125 + 122 + 114 + 127)/4 = 122
Simple Exponential Smoothing
• Used when demand has no observable trend or seasonality

Systematic component of demand = level
• Initial estimate of level, L0, assumed to be the average of all

historical data
1 n
Given data for Periods 1 to n
L0 = å Di

n i=1
Current forecast Ft+1 = Lt and Ft+n = Lt
Revised forecast using
smoothing constant 0 < Lt+1 = a Dt+1 + (1– a )Lt
a<1
t –1
Thus Lt+1 = åa (1– a ) n Dt+1–n + (1– a )t D1
n=0
• Supermarket data

4
L0 = å Di / 4 = 120.75
i=1
F1 = L0 = 120.75
E1 = F1 – D1 = 120.75 –120 = 0.75
L1 = a D1 + (1– a )L0
 0.1120  0.9 120.75  120.68
Trend-Corrected Exponential Smoothing
(Holt’s Model)

• Appropriate when the demand is assumed to have a level and
trend in the systematic component of demand but no seasonality
Systematic component of demand = level + trend
(Holt’s Model)
• Obtain initial estimate of level and trend by running a linear

regression
Dt = at + b
T0 = a, L0 = b
• In Period t, the forecast for future periods is

Ft+1 = Lt + Tt and Ft+n = Lt + nTt
• Revised estimates for Period t

Lt+1 = aDt+1 + (1 – a)(Lt + Tt)
Tt+1 = b (Lt+1 – Lt) + (1 – b)Tt
(Holt’s Model)
• MP3 player demand

D1 = 8,415, D2 = 8,732, D3 = 9,014,
D4 = 9,808, D5 = 10,413, D6 = 11,961
a = 0.1, b = 0.2
• Using regression analysis

L0 = 7,367 and T0 = 673
• Forecast for Period 1

F1 = L0 + T0 = 7,367 + 673 = 8,040
(Holt’s Model)
• Revised estimate

L1 = aD1 + (1 – a)(L0 + T0)
= 0.1 x 8,415 + 0.9 x 8,040 = 8,078
T1 = b(L1 – L0) + (1 – b)T0
= 0.2 x (8,078 – 7,367) + 0.8 x 673 = 681
• With new L1
F2 = L1 + T1 = 8,078 + 681 = 8,759
• Continuing
F7 = L6 + T6 = 11,399 + 673 = 12,072
Trend- and Seasonality-Corrected
Exponential Smoothing
• Appropriate when the systematic component of demand is

assumed to have a level, trend, and seasonal factor
Systematic component = (Level + Trend) x Seasonal factor
Ft+1 = (Lt + Tt)St+1 and Ft+l = (Lt + lTt)St+l
Exponential Smoothing

• After observing demand for period (t + 1), revise estimates for
level, trend, and seasonal factors
Lt+1 = a (Dt+1/St+1) + (1 – a)(Lt + Tt)
Tt+1 = b(Lt+1 – Lt) + (1 – b)Tt
St+p+1 = g(Dt+1/Lt+1) + (1 – g)St+1
Where,
 a = smoothing constant for level
 b = smoothing constant for trend
 g = smoothing constant for seasonal factor
Winter’s Model
L0 = 18,439, T0 = 524

S1= 0.47, S2 = 0.68, S3 = 1.17, S4 = 1.67
F1 = (L0 + T0)S1 = (18,439 + 524)(0.47) = 8,913
The observed demand for Period 1, D1 = 8,000
Forecast error for Period 1
= E1 = F1 – D1
= 8,913 – 8,000 = 913
Winter’s Model
• Assume a = 0.1, b = 0.2, g = 0.1; revise estimates for level and

trend for period 1 and for seasonal factor for Period 5
L1 = a(D1/S1) + (1 – a)(L0 + T0)
= 0.1 x (8,000/0.47) + 0.9 x (18,439 + 524) = 18,769
T1 = b(L1 – L0) + (1 – b)T0
= 0.2 x (18,769 – 18,439) + 0.8 x 524 = 485
S5 = g(D1/L1) + (1 – g)S1
= 0.1 x (8,000/18,769) + 0.9 x 0.47 = 0.47
F2 = (L1 + T1)S2 = (18,769 + 485)0.68 = 13,093
Time Series Models

Forecasting Method Applicability
Moving average No trend or seasonality
Simple exponential No trend or seasonality
smoothing
Holt’s model Trend but no
seasonality
Winter’s model Trend and seasonality
Measures of Forecast Error
Et = Ft – Dt
n
Et
å
n
MSEn = å Et2
1

100
n t=1 Dt
MAPEn = t=1
n
n
1 n
At = Et MADn = å At biasn = å Et
n t=1
t=1
biast
s = 1.25MAD TSt
MADt
a t –1 1– 
at  
Declining alpha   a t –1 1 –  t
Selecting the Best Smoothing Constant

Figure 7-5
Selecting the Best Smoothing Constant

Figure 7-6
Forecasting Demand at Tahoe Salt
Moving average

•
• Simple exponential smoothing
• Trend-corrected exponential smoothing
• Trend- and seasonality-corrected exponential smoothing

Figure 7-7
Moving average

L12 = 24,500
F13 = F14 = F15 = F16 = L12 = 24,500
s = 1.25 x 9,719 = 12,148

Figure 7-8
Single exponential smoothing

L0 = 22,083
L12 = 23,490
F13 = F14 = F15 = F16 = L12 = 23,490
s = 1.25 x 10,208 = 12,761

Figure 7-9

L0 = 12,015 and T0 = 1,549
L12 = 30,443 and T12 = 1,541
F13 = L12 + T12 = 30,443 + 1,541 = 31,984
F14 = L12 + 2T12 = 30,443 + 2 x 1,541 = 33,525
F15 = L12 + 3T12 = 30,443 + 3 x 1,541 = 35,066
F16 = L12 + 4T12 = 30,443 + 4 x 1,541 = 36,607
s = 1.25 x 8,836 = 11,045

Figure 7-10

L0 = 18,439 T0 =524

S1 = 0.47
L0 S=
2 = 0.68 S3T= 1.17
18,439 S = 1.67
0 =524 4
L12 =
S1 = 0.47 S = 0.68
24,791ST12 = 532
2 3 = 1.17 S4 = 1.67
F13 = (L12 + T12)S13 = (24,791 + 532)0.47 = 11,940
L12 = 24,791 T12 = 532
F = (L + 2T )S = (24,791 + 2 x 532)0.68 = 17,579
F13
14
= (L12
12 + T12)S13 = (24,791 + 532)0.47 = 11,940
12 13
F = (L + 3T )S = (24,791 + 3 x 532)1.17 = 30,930

F14 =15(L12 +
12 12
2T12)S 13
13 = (24,791 + 2 x 532)0.68 = 17,579
F16 = (L12 + 4T12)S13 = (24,791 + 4 x 532)1.67 = 44,928
F15 = (L12 + 3T12)S13 = (24,791 + 3 x 532)1.17 = 30,930
s = 1.25 x 1,469 = 1,836
F16 = (L12 + 4T12)S13 = (24,791 + 4 x 532)1.67 = 44,928
s = 1.25 x 1,469 = 1,836

Forecasting Method MAD MAPE (%) TS Range
Four-period moving 9,719 49 –1.52 to 2.21
average
Simple exponential 10,208 59 –1.38 to 2.15
smoothing
Holt’s model 8,836 52 –2.15 to 2.00
Winter’s model 1,469 8 –2.74 to 4.00
Table 7-2
The Role of IT in Forecasting
• Forecasting module is core supply chain software

• Can be used to best determine forecasting methods for the firm
and by product categories and markets
• Real time updates help firms respond quickly to changes in

marketplace
• Facilitate demand planning
Risk Management
• Errors in forecasting can cause significant misallocation of

resources in inventory, facilities, transportation, sourcing, pricing,
and information management
• Common factors are long lead times, seasonality, short product

life cycles, few customers and lumpy demand, and when orders
placed by intermediaries in a supply chain
• Mitigation strategies – increasing the responsiveness of the

supply chain and utilizing opportunities for pooling of demand
Forecasting in Practice

• Collaborate in building forecasts
• Share only the data that truly provide value
• Be sure to distinguish between demand and sales
Understand the role of forecasting for both an enterprise and a

•
supply chain
• Identify the components of a demand forecast
• Forecast demand in a supply chain given historical demand data

using time-series methodologies
• Analyze demand forecasts to estimate forecast error
Chapter 8

Aggregate Planning in a
Supply Chain
Learning Objectives
• Identify the decisions that are best solved by aggregate planning.

• Understand the importance of aggregate planning as a supply
chain activity.
• Describe the information needed to produce an aggregate plan.
• Explain the basic trade-offs to consider when creating an

aggregate plan.
• Formulate and solve basic aggregate planning problems using

Microsoft Excel.
Role of Aggregate Planning
in a Supply Chain
• Capacity has a cost and lead times are often long

• Aggregate planning:
process by which a company determines levels of capacity,
production, subcontracting, inventory, stockouts, and pricing
over a specified time horizon
goal is to maximize profit
decisions made at a product family (not SKU) level
time frame of3 to 18 months
how can a firm best use the facilities it has?
Role of Aggregate Planning
in a Supply Chain

• Specify operational parameters over the time horizon
Production rate: Subcontracting
Workforce: Backlog
Overtime: Inventory on hand
Machine capacity level
• All supply chain stages should work together on an aggregate plan

that will optimize supply chain performance
The Aggregate Planning Problem
Given the demand forecast for each period in the planning

•
horizon, determine the production level, inventory level, and the
capacity level for each period that maximizes the firm’s (supply
chain’s) profit over the planning horizon
• Specify the planning horizon (typically 3-18 months)
• Specify the duration of each period
• Specify key information required to develop an aggregate plan
Information Needed for
an Aggregate Plan
Aggregate demand forecast Ft for each Period t over T periods

•
• Production costs
Labor costs, regular time ($/hr) and overtime ($/hr)
Subcontracting costs ($/hr or $/unit)
Cost of changing capacity – hiring or layoff ($/worker), adding or
reducing machine capacity ($/machine)
• Labor/machine hours required per unit
• Inventory holding cost ($/unit/period)
• Stockout or backlog cost ($/unit/period)
• Constraints – overtime, layoffs, capital available, stockouts,
backlogs, from suppliers
Outputs of Aggregate Plan

• Production quantity from regular time, overtime, and
subcontracted time
• Inventory held
• Backlog/stockout quantity
• Machine capacity increase/decrease
• A poor aggregate plan can result in lost sales, lost profits, excess
inventory, or excess capacity
Identifying Aggregate Units of Production
Aggregate unit should be identified in a way that the resulting

•
production schedule can be accomplished in practice
• Focus on the bottlenecks when selecting the aggregate unit and

identifying capacity and production times
• Account for activities such as setups and maintenance
Red Tomato Tools

Setup Net
Material Time/ Average Production Production Percentage
Cost/ Revenue/ Batch Batch Time/ Unit Time/Unit Share of
Family Unit ($) Unit ($) (hour) Size (hour) (hour) Units Sold
A 15 54 8 50 5.60 5.76 10
B 7 30 6 150 3.00 3.04 25
C 9 39 8 100 3.80 3.88 20
D 12 49 10 50 4.80 5.00 10
E 9 36 6 100 3.60 3.66 20
F 13 48 5 75 4.30 4.37 15
Table 8-1
Red Tomato Tools

• Weighted average approach
Material cost per aggregate unit
= 15 x 0.10 + 7 x 0.25 + 9 x 0.20 + 12 x 0.10 + 9 x 0.20 +
13 x 0.15
= $10
• Similarly
Revenue per aggregate unit = $40
Net production time per aggregate unit = 4.00 hours
Aggregate Planning Strategies

• Trade-off between capacity, inventory, backlog/lost sales
• Chase strategy – using capacity as the lever
• Time flexibility from workforce or capacity strategy – using

utilization as the lever
• Level strategy – using inventory as the lever
• Tailored or hybrid strategy – a combination of strategies
Chase Strategy
Vary machine capacity or hire and lay off workers as demand

•
varies
• Often difficult to vary capacity and workforce on short notice
• Expensive if cost of varying capacity is high
• Negative effect on workforce morale
• Results in low levels of inventory
• Used when inventory holding costs are high and costs of
changing capacity are low
Time Flexibility Strategy
Use excess machine capacity

•
• Workforce stable, number of hours worked varies
• Use overtime or a flexible work schedule
• Flexible workforce, avoids morale problems
• Low levels of inventory, lower utilization
• Used when inventory holding costs are high and capacity is
relatively inexpensive
Level Strategy
• Stable machine capacity and workforce levels, constant output

rate
• Inventory levels fluctuate over time
• Inventories carried over from high to low demand periods
• Better for worker morale
• Large inventories and backlogs may accumulate
• Used when inventory holding and backlog costs are relatively low
Aggregate Planning Using
Linear Programming
• Red Tomato Tools

Highly seasonal demand
Develop a forecast
Month Demand Forecast

January 1,600
February 3,000
March 3,200
April 3,800
May 2,200
June 2,200
Table 8-2
Red Tomato Tools
Item Cost

Material cost $10/unit
Inventory holding cost $2/unit/month
Marginal cost of stockout/backlog $5/unit/month
Hiring and training costs $300/worker
Layoff cost $500/worker
Labor hours required 4/unit
Regular time cost $4/hour
Overtime cost $6/hour
Cost of subcontracting $30/unit
Table 8-3
Red Tomato Tools Decision Variables
For t = 1, ..., 6

Wt = Workforce size for month t
Ht = Number of employees hired at the beginning of month t
Lt = Number of employees laid off at the beginning of month t
Pt = Production in month t
It = Inventory at the end of month t
St = Number of units stocked out at the end of month t
Ct = Number of units subcontracted for month t
Ot = Number of overtime hours worked in month t
Red Tomato Tools Objective Function
• Minimize

(Regular-time labor cost + Overtime labor cost + Cost of hiring
and layoffs + Cost of holding inventory + Cost of stocking out +
Cost of subcontracting + Material cost)
6 6 6 6
Minå 640Wt + å 6Ot + å 300H t + å 500Lt
t=1 t=1 t=1 t=1
6 6 6 6
+å 2I t + å 5St + å10Pt + å 30Ct
t=1 t=1 t=1 t=1
Red Tomato Tools Constraints
All for t = 1,..., 6

• Workforce, hiring, and layoff constraints

Wt = W t –1+H t – Lt
• Capacity constraints
Ot
Pt £ 40Wt +
4
• Inventory balance constraints
I t –1 + Pt + Ct = Dt + St –1 + I t – St
• Overtime limit constraints
Ot £ 10Wt
Red Tomato Tools
(I 0 + IT ) / 2 + (å I ) T –1

t=1 t
Average inventory =
T
Average time
é
ê (I 0 + IT ) / 2 +
=ê
(å ) T –1
t=1
ù
It ú
ú
é
ê
ê
( T –1ù
åt=1 Dt ú
ú
)
in inventory ê T ú ê T ú
ë û ë û
Red Tomato Tools
Total cost over planning horizon = $422,275

Revenue over planning horizon = 40 x 16,000 = $640,000

No.
No. Laid Total
Period Hired Off, Workforc Overtim Inventor Stockout Subcontrac Productio
,t , Ht Lt e Size, Wt e, Ot y, It , St t, Ct n, Pt
0 0 0 80 0 1,000 0 0
1 0 15 65 0 1,983 0 0 2,583
2 0 0 65 0 1,567 0 0 2,583
3 0 0 65 0 950 0 0 2,583
4 0 0 65 0 0 267 0 2,583
5 0 0 65 0 117 0 0 2,583
6 0 0 65 0 500 0 0 2,583
Table 8-4
Red Tomato Tools

Average
seasonal 
(I0  I6 ) / 2   I   5,367  895
5
t 1 t
inventory T 6
895
Average flow time = = 0.34 = 0.34 months
2,667
Red Tomato Tools
• Higher demand variability
Month Demand Forecast

January 1,000
February 3,000
March 3,800
April 4,800
May 2,000
June 1,400
Table 8-5
Average
seasonal =
(I 0 + IT ) / 2 + (å I ) = 6,450 = 1,075
T –1
t=1 t
inventory T 6
Red Tomato Tools

No.
No. Laid Total
Hire Off, Workforce Overtime, Inventor Stockout, Subcontract Production,
Period, t d, Ht Lt Size, Wt Ot y, It St , Ct Pt
0 0 0 80 0 1,000 0 0
1 0 15 65 0 2,583 0 0 2,583
2 0 0 65 0 2,167 0 0 2,583
3 0 0 65 0 950 0 0 2,583
4 0 0 65 0 0 1,267 0 2,583
5 0 0 65 0 0 683 0 2,583
6 0 0 65 0 500 0 0 2,583
Table 8-6
1,075
Average flow time = = 0.40 months
2,667
Red Tomato Tools

• Lower hiring and layoff costs
Average
seasonal =
(I 0 + IT ) / 2 + (å I ) = 2,500 = 417
T –1
t=1 t
inventory T 6
417
Average flow time   0.16 months
2,667
Red Tomato Tools

No.
No. Laid Total
Period Hired Off, Workforc Overtime Inventor Stockout Subcontrac Production
,t , Ht Lt e Size, Wt , Ot y, It , St t, Ct , Pt
0 0 0 80 0 1,000 0 0
1 0 35 45 0 1,200 0 0 2,267
2 0 0 45 0 0 0 0 2,267
3 42 0 87 0 300 0 0 2,267
4 0 0 87 0 0 1,267 0 2,267
5 0 26 61 0 250 683 0 2,267
6 0 0 61 0 500 0 0 2,267
Table 8-7
Forecast Error in Aggregate Plans
• Forecast errors must be considered

• Safety inventory
• Safety capacity
Use overtime as a form of safety capacity
Carry extra workforce permanently as a form of safety capacity
Use subcontractors as a form of safety capacity
Build and carry extra inventories as a form of safety inventory
Purchase capacity or product from an open or spot market as a
form of safety capacity
Aggregate Planning In Excel
For t = 1, ..., 6

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

Figure 8-1

Figure 8-2

Figure 8-3

Figure 8-4
Building a Rough Master Production
Schedule
• Disaggregate an aggregate plan

Setup Setup
Time/ Averag Production Numbe Time Productio
Batch e Batch Time/Unit Production r of (hours n Time
Family (hour) Size (hour) Quantity Setups ) (hours)
A 8 50 5.60 258 5 40 1,445
B 6 150 3.00 646 4 24 1,938
C 8 100 3.80 517 5 40 1,965
D 10 50 4.80 258 5 50 1,238
E 6 100 3.60 517 5 30 1,861
F 5 75 4.30 387 5 25 1,664
Table 8-8
The Role of IT in Aggregate Planning
• The ability to handle large problems

• The ability to handle complex problems (through either nonlinear
optimization or linear approximations)
• The ability to interact with other core IT systems such as

inventory management and sourcing
Inventory Planning and Economic Theory-
Aberrations

• Available evidence indicates that Indian industries, by and large do
not show any serious concern for inventory ordering and carrying
costs. What are the main reasons for their indifference to scientific
inventory management techniques?
• What adaptations of Just In Time (JIT) practices do you visualize

emerging in the Indian environment in the near future?
Implementing Aggregate Planning in
Practice
Think beyond the enterprise to the entire supply chain

•
• Make plans flexible because forecasts are always inaccurate
• Rerun the aggregate plan as new data emerge
• Use aggregate planning as capacity utilization increases
• Identify the decisions that are best solved by aggregate planning

• Understand the importance of aggregate planning as a supply
chain activity
• Describe the information needed to produce an aggregate plan
• Explain the basic trade-offs to consider when creating an

aggregate plan
• Formulate and solve aggregate planning problems using Microsoft

Excel
Chapter 9

Sales and Operations Planning:
Planning Supply and Demand in a
Supply Chain
Learning Objectives
• Manage supply to improve synchronization in a supply chain in

the face of predictable variability.
• Manage demand to improve synchronization in a supply chain in

the face of predictable variability.
• Use sales and operations planning to maximize profitability when

faced with predictable variability in a supply chain.
Responding to Predictable Variability in a
Supply Chain
• Predictable variability is change in demand that can be forecasted

• Can cause increased costs and decreased responsiveness in the
supply chain
• Two broad approaches

Manage supply using capacity, inventory, subcontracting, and
backlogs
Manage demand using short-term price discounts and trade
promotions
Managing Supply
Managing capacity

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

• Leveling capacity forces inventory to build up in anticipation of
seasonal variation in demand
• Carrying low levels of inventory requires capacity to vary with

seasonal variation in demand or enough capacity to cover peak
demand during season
Managing Demand
• Promotion at Red Tomato and Green Thumb

Item Cost
Material cost $10/unit
Inventory holding cost $2/unit/month
Marginal cost of stockout/backlog $5/unit/month
Hiring and training costs $300/worker
Layoff cost $500/worker
Labor hours required 4/unit
Regular time cost $4/hour
Overtime cost $6/hour
Cost of subcontracting $30/unit
Table 9-1
Managing Demand

Figure 9-1
Managing Demand

Revenue over planning horizon = $640,000
Profit over planning horizon = $217,725
Average
seasonal =
(I 0 + I 6 ) / 2 + (å I ) = 5,367 = 895
5
t=1 t
inventory T 6
Average average inventory 895

flow time = = = 0.34 months
average sales 2,667
The Timing of a Promotion
• Impact of the promotion on demand

• Cost of holding inventory
• Cost of changing the level of capacity
• Product margins
• Increase in demand from

Market growth
Stealing share
Forward buying
When to Promote
• Is it more effective to promote during the peak period of off-

peak?
• Analyze the impact of a promotion on demand and the resulting

optimal aggregate plan
Promotion in January

Figure 9-2
Promotion in January

• Lower seasonal inventory

• A somewhat lower total cost
• A higher total profit
Promotion in April

Figure 9-3
Promotion in April

• Higher seasonal inventory

• A somewhat higher total cost
• A slightly smaller total profit
Discount Leads to
Large Increase in Consumption
• Promotion in January

Figure 9-4
Discount Leads to

• Higher total profit than base case
Discount Leads to
• Promotion in April

Figure 9-5
Discount Leads to

• Much higher level of seasonal inventory

• Uses more stockouts and subcontracting
• Revenues increase
• Overall profits higher
Supply Chain Performance

Percentage Percentage
Regular Promotion Promotion of Increase of Forward Average
Price Price Period in Demand Buying Profit Inventory
$40 $40 NA NA NA $217,725 895
$40 $39 January 10% 20% $221,485 523
$40 $39 April 10% 20% $211,283 938
$40 $39 January 100% 20% $242,810 208
$40 $39 April 100% 20% $247,320 1,492
$31 $31 NA NA NA $ 73,725 895
$31 $30 January 100% 20% $ 84,410 208
$31 $30 April 100% 20% $ 69,120 1,492
Table 9-2
Impact on Promotion Timing
Factor Impact on Timing of Promotion/Forward

Buy
High forward buying Favors promotion during low-demand periods
High ability to steal market share Favors promotion during peak-demand periods
High ability to increase overall market Favors promotion during peak-demand periods
High margin Favors promotion during peak-demand periods
Low margin Favors promotion during low-demand periods
High manufacturer holding costs Favors promotion during low-demand periods
High costs of changing capacity Favors promotion during low-demand periods
High retailer holding costs Decreases forward buying by retailer
High promotion elasticity of consumer Decreases forward buying by retailer
Table 9-3
Conclusions on Promotion
Average inventory increases if a promotion is run during the peak

•
period and decreases if the promotion is run during the off-peak
period
• Promoting during a peak-demand month may decrease overall

profitability if there is a small increase in consumption and a
significant fraction of the demand increase results from a forward
buy
Conclusions on Promotion
As consumption increase from discounting grows and forward

•
buying becomes a smaller fraction of the demand increase from a
promotion, it is more profitable to promote during the peak
period
• As the product margin declines, promoting during the peak-

demand period becomes less profitable
Implementing Sales and Operations
Planning in Practice
• Coordinate planning across enterprises in the supply chain

• Take predictable variability into account when making strategic
decisions
• Design S&OP to understand and manage the drivers of demand

usage
• Ensure that the S&OP process modifies plans as the reality or

forecasts change
Manage supply to improve synchronization in a supply chain in

•
the face of predictable variability
• Manage demand to improve synchronization in a supply chain in

the face of predictable variability
• Use sales and operations planning to maximize profitability when

faced with predictable variability in a supply chain
Chapter 10

Coordination in a Supply Chain
Learning Objectives
• Describe supply chain coordination and the bullwhip effect, and

their impact on supply chain performance.
• Identify obstacles to coordination in a supply chain.
• Discuss managerial levers that help achieve coordination in a

supply chain.
• Understand the different forms of collaborative planning,

forecasting, and replenishment possible in a supply chain.
Lack of Supply Chain Coordination
and the Bullwhip Effect
• Supply chain coordination – all stages of the chain take actions

that are aligned and increase total supply chain surplus
• Requires that each stage share information and take into account
the effects of its actions on the other stages
• Lack of coordination results when:

Objectives of different stages conflict
Information moving between stages is delayed or distorted
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
• Results from a loss of supply chain coordination
Demand at Different Stages

Figure 10-1
The Effect on Performance
• Supply chain lacks coordination if each stage optimizes only its

local objective
• Reduces total profits
• Performance measures include
Manufacturing cost
Inventory cost
Replenishment lead time
Transportation cost
Labor cost for shipping and receiving
Level of product availability
Relationships across the supply chain
The Effect on Performance
Performance Measure Impact of the Lack of

Coordination
Manufacturing cost Increases
Inventory cost Increases
Replenishment lead time Increases
Transportation cost Increases
Shipping and receiving cost Increases
Level of product availability Decreases
Profitability Decreases
Table 10-1
Obstacles to Coordination
in a Supply Chain
• Incentive Obstacles

• Information Processing Obstacles
• Operational Obstacles
• Pricing Obstacles
• Behavioral Obstacles
Incentive Obstacles
• Occur when incentives offered to different stages or participants

in a supply chain lead to actions that increase variability and
reduce total supply chain profits
• Local optimization within functions or stages of a supply chain
• Sales force incentives
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
• Lack of information sharing
Operational Obstacles
• Occur when placing and filling orders lead to an increase in

variability
• Ordering in large lots
• Large replenishment lead times
• Rationing and shortage gaming
Operational Obstacles

Figure 10-2
Pricing Obstacles
• When pricing policies for a product lead to an increase in

variability of orders placed
• Lot-size based quantity decisions
• Price fluctuations
Pricing Obstacles

Figure 10-3
Behavioral Obstacles
• Problems in learning within organizations that contribute to

information distortion
Each stage of the supply chain views its actions locally and is
unable to see the impact of its actions on other stages
Different stages of the supply chain react to the current local
situation rather than trying to identify the root causes
Different stages of the supply chain blame one another for the
fluctuations
No stage of the supply chain learns from its actions over time
A lack of trust among supply chain partners causes them to be
opportunistic at the expense of overall supply chain performance
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
Aligning Goals and Incentives
• Align goals and incentives so that every participant in supply

chain activities works to maximize total supply chain profits
• Align goals across the supply chain
• Align incentives across functions
• Pricing for coordination
• Alter sales force incentives from sell-in (to the retailer) to sell-
through (by the retailer)
Improving Information Visibility and
Accuracy
• Sharing point of sale data

• Implementing collaborative forecasting and planning
• Designing single-stage control of replenishment

Continuous replenishment programs (CRP)
Vendor managed inventory (VMI)
Improving Operational Performance
• Reducing replenishment lead time

• Reducing lot sizes
• Rationing based on past sales and sharing information to limit

gaming
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
• Stabilizing pricing
• Building strategic partnerships and trust
Continuous Replenishment and Vendor-
Managed Inventories
• A single point of replenishment

• CRP – wholesaler or manufacturer replenishes based on POS
data
• VMI – manufacturer or supplier is responsible for all decisions

regarding inventory
• Substitutes
Collaborative Planning, Forecasting, and
Replenishment (CPFR)
• Sellers and buyers in a supply chain may collaborate along any or

all of the following
Strategy and planning
Demand and supply management
Execution
Analysis
• Retail event collaboration
• DC replenishment collaboration
Common CPFR Scenarios

Where Applied in Industries Where
CPFR Scenario Supply Chain Applied
Retail event Highly promoted All industries other than
collaboration channels or categories those that practice EDLP
DC replenishment Retail DC or distributor Drugstores, hardware,
collaboration DC grocery
Store replenishment Direct store delivery or Mass merchants, club
collaboration retail DC-to-store stores
delivery
Collaborative Apparel and seasonal Department stores,
assortment planning goods specialty retail
Table 10-2
• Store replenishment collaboration

• Collaborative assortment planning
• Organizational and technology requirements for successful CPFR
• Risks and hurdles for a CPFR implementation

Figure 10-4
Learning Objectives
• 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
• Describe supply chain coordination and the bullwhip effect, and

their impact on supply chain performance
• Identify obstacles to coordination in a supply chain
• Discuss managerial levers that help achieve coordination in a

supply chain
• Understand the different forms of CPFR possible in a supply chain

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Chapter 1

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

Discuss the goal of a supply chain, and explain the impact of

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Describe the cycle and push/pull views of a supply chain.

• Classify the supply chain macro processes in a firm.

All stages involved, directly or indirectly, in fulfilling a customer

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Includes manufacturers, suppliers, transporters, warehouses,

• Within each company, the supply chain includes all functions

• Customer is an integral part of the supply chain

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• May be more accurate to use the term “supply network” or “supply

• Typical supply chain stages: customers, retailers, distributors,

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Maximize overall value created

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Example: A customer purchases a wireless router from Best Buy

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Supply chain incurs costs (information, storage, transportation,

• Supply chain profitability is total profit to be shared across all

Success should be measured by total supply chain profitability, not

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Customer is the only source of revenue.

• Sources of cost includes flows of information, products, or funds

• Effective supply chain management is the management of flows

• Wal-Mart, $1 billion sales in 1980 to $408 billion in 2010

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Webvan folded in two years

• Borders, $4 billion in 2004 to $2.8 billion in 2009

• Dell, $56 billion in 2006, adopted new supply chain strategies

• Supply chain strategy or design

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Supply chain planning

• Supply chain operation

• Decisions about the structure of the supply chain and what

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Strategic supply chain decisions

• Supply chain design must support strategic objectives.

• Supply chain design decisions are long-term and expensive to

• Definition of a set of policies that govern short-term operations.

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Starts with a forecast of demand in the coming year

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Must consider in planning decisions—demand uncertainty,

• Time horizon is weekly or daily.

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Supply chain configuration is fixed and operating policies are

• Goal is to implement the operating policies as effectively as

• Allocate orders to inventory or production, set order due dates,

• Much less uncertainty (short time horizon).

• Cycle view: processes in a supply chain are divided into a series

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Push/Pull view: processes in a supply chain are divided into two

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Supply chain processes fall into one of two categories depending

Copyright © 2013 Dorling Kindersley (India) Pvt. Ltd.

• Pull: Here execution is initiated in response to a customer order

• Push: Here execution is initiated in anticipation of customer

• Push/pull boundary separates push processes from pull