INTRODUCTION TO

SUPPLY CHAIN
MANAGEMENT

Dr. Pravin Kumar

DTU Delhi
 In the first half of the twentieth
century industry replaced agriculture, in
the second half of the twentieth century –
“service” has replaced “manufacturing” -
and right now, the knowledge industry is
beginning to replace the others.

−−George Kotzmetzk
 Lecture Outline
* Introduction
* What is Supply Chain Management?
* Why is Supply Chain Management
important?
* The origins of Supply Chain Management
* Important Elements of Supply Chain
Management:
- Purchasing
- Operations
- Distribution
- Integration
* Strategies for Supply Chain Management
What is a Supply Chain?
• A supply chain consists of the flow of products
and services Suppliers to the end customers
and in the case of reverse logistics from end
customers to the suppliers.

• Each entity of supply chain is connected by

agents, transportation and storage activities,
and

• Integrated through sharing of information,

planning, and processing activities.
 Flows in a Supply Chain

Information

Product
Supplier Customer
Funds
 Customers,
demand
Sources: Field centers
plants Regional Warehouses:
Warehouses: stocking sinks
vendors
ports stocking points
points

Supply

Inventory &
warehousing
costs
Production/Transportation Transportation
purchase costs
costs Inventory & costs
warehousing
costs
 Typical Supply Chains

Production Distribution
Purchasing Receiving Storage Operations Storage
 Typical Supply Chain for
a Manufacturer

Supplier

Supplier
}
Storage Mfg. Storage Dist. Retailer Customer

Supplier

Suppler
Internal Management Customer
Relationship
Relationship
Management
Management
Typical Supply Chain for
a Service
Supplier

Supplier
} Storage Service Customer
 What is Supply Chain
Management?
The design and management of seamless, value-
added process across organizational boundaries to
meet the real needs of the end customer
-- Institute for Supply Management
Managing supply and demand, sourcing raw
materials and parts, manufacturing and assembly,
warehousing and inventory tracking, order entry and
order management, distribution across all channels,
and delivery to the customer
-- The Supply Chain Council
 What Is the Goal of Supply
Chain Management?
l Supply chain management is concerned with the
efficient integration of suppliers, factories, warehouses
and stores so that merchandise is produced and
distributed:
– In the right quantities
– To the right locations
– At the right time
l In order to
– Minimize total system cost
– Satisfy customer service requirements
 Importance of Supply
Chain Management
Firms practicing Supply Chain Management:

1. Start with key suppliers

2. Move on to other suppliers, customers, and
shippers
3. Integrate second tier suppliers and customers
(second tier refers to the customer’s
customers and the supplier’s suppliers)
 Importance of Supply
Chain Mgt.
* Cost savings and better coordination of resources are
reasons to employ Supply Chain Management
-- Bullwhip Effect- the magnification of safety stocks
and costs based on separate forecasts and
uncoordinated planning and sharing of information
along the supply chain
* Reducing the bullwhip effect occurs through:
-- Process integration- Interdependent activities can
lead to improved quality, reduced cycle time, better
production methods, better forecasts, less safety
stock, etc.
 Important Elements of SCM
Purchasing- Supplier alliances, supplier management,
strategic sourcing

Operations- Demand management, MRP, ERP, JIT,

TQM

Distribution- Transportation management, customer

relationship management, network design,
service response logistics

Integration- Coordination/Integration activities, global

integration problems, performance
measurement
Important Elements of SCM
Purchasing

•Long term relationships

•Supplier management- improved performance
through-
-- Supplier evaluation (determining supplier
capabilities and performance)
-- Supplier certification (third party or internal
certification to assure product quality and service
compliance)
•Strategic partnerships- successful and trusting,
long-term relationships with top-performing
suppliers
 Important Elements of
Supply Chain Management
Operations
-- Demand management- match demand
to available capacity
-- Linking buyers & suppliers via MRP
and ERP systems
-- Use JIT to improve the “pull” of
materials to reduce inventory levels
-- Employ TQM to improve quality
compliance among buyers and suppliers
 Important Elements of
Supply Chain Management
Distribution:
-- Transportation management- tradeoff decisions
between cost & timing of delivery/customer
service via trucks, rail, water & air
-- Customer relationship management- strategies
to ensure deliveries, resolve complaints, improve
communications, & determine service
requirements
-- Network design- creating distribution networks
based on tradeoff decisions between cost &
sophistication of distribution system
 Important Elements of
Supply Chain Management
Integration
-- Supply Chain Integration- when supply chain
participants work for common goals. Requires intrafirm
functional integration. Based on efforts to change
attitudes & adversarial relationships
-- Global Supply Chains- advantages that accrue from
sourcing from larger global market e.g., lower cost &
higher quality suppliers. May involve operating
exposure, which is risk found in foreign settings
-- Supply Chain Performance Measurement- Crucial for
firms to know if procedures are working
 Strategies for SCM

All of the advanced strategies, techniques,

and approaches for Supply Chain
Management focus on:
Global Optimization
Managing Uncertainty
Tools and Strategies for
Optimization

• Decision Support Systems

• Inventory Control
• Network Design
• Design for Logistics
• Cross Docking
 Sequential Optimization
vs.
Global Optimization
Sequential Optimization

Procurement Manufacturing Distribution Demand

Planning Planning Planning Planning

Global Optimization

Supply Contracts/Collaboration/Information Systems and DSS

Procurement Manufacturing Distribution

Demand
Planning Planning Planning
Planning

Source: Duncan McFarlane

 Why is Global
Optimization Hard?

–The supply chain is complex

–Different facilities have conflicting objectives
–The supply chain is a dynamic system
–The power structure changes
–The system varies over time
 Uncertainty

• What is variation?
• What is randomness?
• What tools and approaches help us to
deal with these issues?
 Source of Uncertainties
Factors/Sources Description
Product characteristics Product life cycle, packaging, perishability, mix, or
specification
Process/manufacturing Machine breakdowns, labour problems, process reliability,
etc.
Control/chaos/response Uncertainty as a result of control systems in the supply chain,
uncertainty e.g. inappropriate assumptions in an MRP system
Decision complexity Uncertainty that arises because of multiple dimensions in
decision-making process, e.g. multiple goals, constraints,
long term plan, etc.
Organisation structure organisation culture
and human behaviour
IT/IS complexity The realisation of threats to IT use in the application level,
organisational level and inter-organisational level, e.g.
computer viruses, technical failure, unauthorised physical
access, misuse, etc.
End customer demand Irregular purchases or irregular orders from final recipient of
product or service
 Source of Uncertainties
Factor/Sources Description
Demand Amplification Amplification of Demand due to bullwhip effect
Supplier Supplier performance issues, such as quality problems, late
delivery, etc.
Parallel interaction Parallel interaction refers to the situation where there is
interaction between different channels of the supply chain in
the same tier.
Order forecast horizon/ The longer the horizon, the larger the forecast errors and
lead-time gap hence there is greater uncertainty in the demand forecasts

Chain configuration, Number of parties involved, facilities used or location, etc.

infrastructure and
facilities
Environment political, government policy, macroeconomic and social
issues, competitor behaviour
Disruption/natural earthquake, tsunamis, non-deterministic chaos, etc.
uncertainties
Can’t Forecasting Help?

q Forecasting is always wrong

q The longer the forecast horizon the worse the
forecast
q End item forecasts are even more wrong
 Why is Uncertainty Hard
to Deal With?
* Matching supply and demand is difficult.
* Forecasting doesn’t solve the problem.
* Inventory and back-order levels typically fluctuate
widely across the supply chain.
* Demand is not the only source of uncertainty:
– Lead times
– Yields
– Transportation times
– Natural Disasters
– Component Availability
 Supply Chain Variability
Manufacturer Forecast
of Sales
Volumes

Actual
Consumer
Retailer Warehouse Demand
Retailer Orders to Shop

Production Plan

Time
Source: Tom Mc Guffry, Electronic Commerce and Value Chain Management, 1998
 What Management
Gets...
Volumes

Consumer
Demand

Production Plan

Time
Source: Tom Mc Guffry, Electronic Commerce and Value Chain Management, 1998
 What Management
Wants…
Volumes

Production Plan
Consumer
Demand

Time
Source: Tom Mc Guffry, Electronic Commerce and Value Chain Management, 1998
 Dealing with Uncertainty
• Pull Systems
• Risk Pooling
• Centralization
• Postponement
• Strategic Alliances
• Collaborative Forecasting
 What’s New in Supply
Chains?

• Global competition
• Shorter product life cycle
• New, low-cost distribution channels
• More powerful well-informed customers
• Internet and E-Business strategies
Supply Chain Drivers and
Obstacles
 Drivers of Supply Chain
Performance
How to achieve
Efficiency Responsiveness

Supply chain structure

Logistical
Inventory Transportation Facilities
Drivers

Cross-
Information Sourcing Pricing Functional
Drivers
 1. Inventory

• Convenience: Cycle inventory

• Unstable demand: Seasonal inventory
• Randomness: Safety inventory
• Pipeline inventory
– Work in process or transit
 2. Transportation

• Air
• Truck
• Rail
• Ship
• Pipeline
• Electronic
 3. Facilities

• Production
– Flexible vs. Dedicated
– Flexibility costs
• Inventory-like operations: Receiving,
Prepackaging, Storing, Picking, Packaging,
Sorting, Accumulating, Shipping
– Job Lot Storage: Need more space.
– Crossdocking: Wal-Mart
 4. Information
• Role in the supply chain
– The connection between the various stages in the
supply chain
– Crucial to daily operation of each stage in a
supply chain
• E.g., production scheduling, inventory levels
• Role in the competitive strategy
– Allows supply chain to become more efficient and
more responsive at the same time
– Information technology
– Customer orders automatically sent to the
factory.
 Characteristics of the Good
Information

Information Global Coordinated Supply Chain

Scope Decisions Success

Strategy Analytical Models $$$

Information
• Accurate?
• Accessible?
• Up-to-date?
• In the Correct form?
 5. Sourcing
• Role in the supply chain
– Set of processes required to purchase goods and services in a supply
chain
– Supplier selection, single vs. multiple suppliers, contract negotiation
• Role in the competitive strategy
– Sourcing is crucial. It affects efficiency and responsiveness in a supply
chain
– In-house vs. outsource decisions- improving efficiency and
responsiveness
• Texas Instruments: More than half of the revenue spent for sourcing.
• Cisco sources: Low-end products (e.g. home routers) from China.
• Components of sourcing decisions
– In-house versus outsource decisions
– Supplier evaluation and selection
– Procurement process:
• Every department of a firm buy from suppliers independently, or all together.
 6. Pricing
• Role in the supply chain
– Pricing determines the amount to charge customers in a supply chain
– Pricing strategies can be used to match demand and supply
• Role in the competitive strategy
– Use pricing strategies to improve efficiency and responsiveness
– Low price and low product availability; vary prices by response times
• Amazon: Faster delivery is more expensive
• Components of pricing decisions
– Pricing and economies of scale
– Everyday low pricing versus high-low pricing
– Fixed price versus menu pricing, depending on the product and
services
• Packaging, delivery location, time, customer pick up
• Bundling products; products and services
 Major Obstacles

• Supply Chain is big in the terms of:

– Variety of products/services
– Spoiled customer
– Multiple owners (Procurement, Production, Inventory, Marketing)
/ multiple objectives
– Globalization

Local optimization and lack of global fit

 Major Obstacles
• Dealing with Multiple Owners / Local Optimization
– Information Coordination
• Information sharing / Shyness / Legal and ethical
issues
– Contractual Coordination
• Mechanisms to align local objectives with global
ones
– Without coordination, misleading reliance on metrics:
• Average safety inventory, Average incoming
shipment size, Average purchase price of raw
materials, Revenue
 Major obstacles
• Instability and Randomness:
– Increasing product variety
– Shrinking product life cycles
– Customer fragmentation: Push for customization, segmentation
– Fragmentation of Supply Chain ownership: Globalization

Increasing implied uncertainty

 Common problems
• Lack of relevant SCM metrics: How to measure responsiveness?
• How to measure efficiency, costs, worker performance, etc?
• Poor inventory status information
• Theft: Major problem for furniture retailers.
• Transaction errors: Retailers with inaccurate inventory records
for 65% of SKUs
• Information delays, dated information, incompatible info.
systems
• Misplaced inventory: 16% of items cannot be found at a major
retailer
• Spoilage: active ingredients in the products are losing their
properties
• Product quality and yield
• Lack of visibility in SCs
– Do you know the inventory your distribution centers hold?
– Do you know the inventory your fellow retailer holds?
 Common problems
• Poor delivery status information
• Not knowing the order status
• Poor IT design
• Unreliable, duplicate data
• Security problems: too much or too little
• Ignoring uncertainties
• Internal customer discrimination
• Giving lower priority to internal customers than external
customers
• Poor integration
• Elusive inventory costs
• Accounting systems do not capture opportunity costs
 Push/Pull View of Supply
Chains
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)
Procurement, Customer Order
Manufacturing and
Cycle
Replenishment cycles

PUSH PROCESSES PULL PROCESSES

Customer
Order Arrives
 Supply Chain Managers

The philosophy behind supply chain

management is that by visualizing the
entire supply chain, supply chain
managers can maximize strengths and
efficiencies at each level of the process
to create a highly competitive, customer-
driven supply system that is able to
respond immediately to changes in
supply and demand.
Supply Chain Management

Communicator of customer demand

from point of sale to supplier

Physical flow process that engineers the

movement of goods
 Benefits of Supply
Chain Management

Supply chain oriented companies

commonly report:
• Lower inventory, transportation,
warehousing, and packaging costs
• Greater supply chain flexibility
• Improved customer service
• Higher revenues
• Increased performance and profitability
Supply Chain Integration
Relationship Integration Firm-to-Firm Social
Interactions
Measurement
Integration Operational
Planning and
Technology and Control
Planning Integration
Material and Service
Supplier Integration
Internal Operations Customer
Integration Integration

Customer Integration
 Supply Chain Integration

The ability of two or more

companies to develop social
Relationship
connections that serve to guide
Integration
their interactions when working
together.

The performance assessment of

Measurement the supply chain as a whole that
Integration also holds each individual firm or
business unit accountable for
meeting its own goals
 Supply Chain Integration

The creation and maintenance of

Technology information technology systems
and planning that connect managers across
integration and through the firms in the
supply chain

Requires firms to link seamlessly

Material and to those outsiders that provide
service goods and services to them so
supplier that they can streamline
integration processes and provide quality
customer experiences.
Supply Chain Integration
Internal Links internally performed work
Operations into a seamless process that
Integration stretches across departmental
and/or functional boundaries,
with the goal of satisfying
customer requirements

A competency that enables firms to

Customer offer long-lasting, distinctive, value-
Integration added offerings to those customers
who represent the greatest value to
the firm or supply chain
Key Business Processes
1. Customer relationship management
2. Customer service management
3. Demand management
4. Order fulfillment
5. Manufacturing flow management
6. Supplier relationship management
7. Product development and
commercialization
8. Returns management
Customer Relationship
Management

Customer Allows companies to

Relationship prioritize their marketing
Management
focus on different customer
(CRM) Process
groups according to each
group’s long-term value to
the company or supply chain
 Customer
Service Management
Customer
Service Presents a unified
Management response system to the
Process customer whenever
complaints, concerns,
questions, or comments
are voiced
 Demand Management

Seeks to align supply and

Demand
Management demand throughout the supply
Process chain by anticipating customer
requirements at each level and
create demand-related plans of
action prior to actual customer
purchasing behavior
 Order Fulfillment

A highly integrated process,

Order
Fulfillment often requiring persons from
Process multiple companies and
multiple functions to come
together and coordinate to
create customer satisfaction at
a given place and time
 Manufacturing Flow
Management
Manufacturing Concerned with ensuring
Flow that firms in the supply
Management chain have the needed
Process resources to manufacture
with flexibility and to
move products through a
multi-stage production
process
 Supplier Relationship
Management

Supplier Closely related to the

Relationship manufacturing flow
Management management process and
Process
contains several
characteristics that parallel
the customer relationship
management process
Product Development and
Commercialization

Product Includes the group

Development and activities that facilitates
Commercialization
Process the joint development and
marketing of new
offerings among a group
of supply chain partner
firms
Returns Management

Enables firms to manage

Returns
Management volumes of returned product
Process efficiently, while minimizing
returns-related costs and
maximizing the value of the
returned assets to the firms in
the supply chain
 Logistics

Logistics is…
the process of strategically managing
the efficient flow and storage of raw
materials, in-process inventory, and
finished goods from point of origin to
point of consumption.
 Logistical Components
of the Supply Chain

Sourcing & Procurement

Logistics Information System

Production Scheduling

Supply Order Processing

Chain
Team Inventory Control

Warehouse & Materials Handling

Transportation
Sourcing and Procurement

The Role of Purchasing

u Plan purchasing strategies

u Develop specifications

u Select suppliers

© iStockphoto.com/Maria Toutoudaki
u Negotiate price and service levels

u Reduce costs
 Production Scheduling

Traditional Focus Customer Focus

Push / Pull
Push Pull
Strategy
Start of Inventory- Customer-Order
Production Based Based

Manufacturing Mass Production Mass Customization

Just-in-Time Manufacturing

JIT

A process that redefines and

simplifies manufacturing by
reducing inventory levels and
delivering raw materials at the
precise time they are needed on
the production line.
 Benefits of JIT

§ For manufacturers: reduces raw

material inventories; immediate
shipping of products
§ For suppliers: daily or hourly deliveries
rather than weekly
§ For customers: lower costs; shorter
lead times; products tailored to
customer needs
 Order Processing
An Order Processing
System is…
a system whereby orders are
entered into the supply chain
and filled.

Order processing is becoming more automated

through the use of computer technology known
as ELECTRONIC DATA INTERCHANGE (EDI).
Inventory Control

Inventory A method of developing

Control and maintaining an
System
adequate assortment of
materials or products to
meet a manufacturer’s or
a customer’s demand
 Inventory Control
Tools for managing inventory include:
materials requirement planning (MRP) or
materials management – supplier to
manufacturer
distribution resource planning (DRP) –
manufacturer to end user
automatic replenishment programs – minimal
forecasting
 Warehousing and Materials
Handling

A Materials-Handling
System is…
a method of moving inventory into, within,
and out of the warehouse.

Most manufacturers today have moved to

AUTOMATED materials-handling systems to
minimize the amount of handling.
 Transportation

Airways

Water

Pipelines

Motor Carriers

Railroads
Transportation Mode Choice

§ Cost
§ Transit time
§ Reliability
§ Capability
§ Accessibility
§ Traceability
Criteria for Ranking
Modes of Transportation
Trends in Supply Chain
Management

Advanced computer technology

Outsourcing of logistics functions

Electronic distribution
 Advanced Computer
Technology

u Automatic identification systems

- Bar coding
- Radio frequency technology

u Communications technology

u Supply chain software systems

 Outsourcing Logistics
Functions

Outsourcing Benefits

u Reduce inventories

u Locate stock at fewer plants and distribution

centers

u Provide same or better levels of service

 Electronic Distribution

Electronic Distribution is…

a distribution technique that includes
any kind of product or service that
can be distributed electronically,
whether over traditional forms such
as fiber-optic cable or through
satellite transmission of electronic
signals.
 Green Supply Chain
Management
• Requires integrating green thinking into all
phases of the supply chain
– Green materials sourcing
– Environmental impact of packaging,
shipment, use
– Incorporate end-of-life management
• Recycling
• Clean disposal
Global Logistics and Supply
Chain Management

Logistical challenges of global markets:

• Understanding and coping with the
legalities of trade in other countries
• Uncertainty regarding shipping
Supplier Relationship
Management
 Managing Purchasing
and Supply Relationships
 Selection of a supply base
Stage Supply base
Innocence The organisation uses a large number of suppliers and
selects them in a random fashion. There is clear scope
for improvement.
Awareness The organisation still uses a large number of suppliers,
but most spending is on just a few of them.
Understanding The organisation has reduced the number of its
suppliers still further, and appreciates the benefits of a
good working relationship with suppliers.
Competence There is a partnership with suppliers for key
procurement items. There is multi-sourcing of other
(non-key) items.
Excellence There is a continually-reviewed programme to optimise
the supply base so as to achieve strategic objectives.
Features of transactional purchasing

Competitive bidding for contracts

Many competing suppliers
Typically standard products
Wide supply markets
No need for or benefit from a high degree of trust
No supplier power
 Collaborative Relationships
• Benefits of doing business together arise from ideas of sharing
as well as exchanging
• Buying organisation seeks to develop a long-term relationship
with supplier
• Both organisations share common interests, both benefit from
adding value in the supply chain
• Supplier participates with buyer looking for improvements and
innovations
• Both parties jointly set targets for improvements in cost and
quality
• Meet regularly to discuss progress
• Proactive relationship looking for improvements
• NOT a long-term COSY customer-supplier relationship
Customer-supplier relationship develops
over time through

• Growing trust, length of relationship provides

reassurance
• Customer reducing the number of suppliers it deals with.
• Supplier assigning specific assets to the exclusive use of
working on orders for that customer.
 Collaborative relationships – the
benefits
Benefits of a collaborative relationship to the supplier
• The buyer will appoint a vendor manager to develop the
relationship. The supplier will always know who to deal with in the
buyer organisation.
• The vendor manager will introduce the supplier to the managers
in the organisation responsible for buying decisions.
• The supplier will be kept informed of the buyer’s forward plans.

• The supplier will gain a much better understanding of the buyer

organisation and its needs.
• The buyer and supplier will set up joint quality-improvement
teams, that both parties will benefit from.
• The supplier is likely to get more business from the buyer, as a
preferred supplier.
 Collaborative relationships – the
benefits
Benefits of a collaborative relationship to the buyer
• The buyer focuses attention on improving the relationship with
key suppliers.

• The supplier’s awareness of the buyer’s requirements will mean

that the supplier is more likely to be successful in meeting
them.
• The supplier will be actively involved with the buyer in the
quality improvement process.
• The supplier should develop a high level of trust and
confidence in the buyer.
 Collaborative v Competitive
Relationships
• Competitive approach squeezes the profit margins of the
supplier, and by doing so the buying organisation obtains
some of the value that the supplier would otherwise keep
for himself
• Developing collaborative relationships takes time and effort
– unrealistic to try creating more of these relationships than
a buyer can effectively manage
• Where a failure in supply would not be damaging, it is not
worth the time and effort to create a collaborative
relationship
 Why develop customer and supplier
relationships?
• Supply chains compete, not companies
• Most opportunities for reducing costs and enhancing value
in the supply chain occur at the interface between supply
chain partners
• Adding to the competitiveness of a supply chain calls for a
value-added exchange of information between the supply
chain partners
• The integration of the supply chain implies the integration of
process in the supply chain
• Achieving supply chain competitiveness requires a collective
determination of strategy by the supply chain partners
Features of a true supply partnership

• Joint mutual search for greater efficiency and competitiveness

• Joint planning for the future by the customer and the supplier
• Agreed and shared objectives
• Understanding that it takes a joint effort to eliminate waste
from the supply chain to achieve competitive advantage
• Transparency and openness
• Seeks to meet and exceed each other’s expectations
• Relationship is one of equal partners
• Prepared and agreed exit strategy in the event that the
relationship should come to an end
 Relationship types and characteristics
Relationship Characteristics
type
Adversarial Buyer and supplier are ‘opponents’, each striving to obtain
relationship advantages at the other’s expense. There is little trust,
communication and cooperation, and there may even be conflict.
Arm’s length This is a distant relationship where the buyer does not need
relationship frequent access to the supplier. Purchases are infrequent and of
low volume, and the trouble of a closer relationship is not
justified.
Transactional This is very similar to an arm’s length relationship, with perhaps a
relationship more frequent requirement on the part of the buyer, but still
referring to low-value, low-risk supplies.
Closer tactical This refers to a situation where the trouble of a close,
relationship collaborative relationship is not quite justified, but where the
buyer is concerned to ensure that he is dealing with a very
competent supplier, who perhaps also coordinates the activities of
other suppliers.
Thanks
 Inventory
Management and
Risk Pooling
Dr. Pravin Kumar
 Case: Swimsuit Production

• Fashion items have short life cycles, high

variety of competitors
• Swimsuit products
– New designs are completed
– One production opportunity
– Based on past sales, knowledge of the industry,
and economic conditions, the marketing
department has a probabilistic forecast
– The forecast averages about 13,000, but there is a
chance that demand will be greater or less than
this.
Swimsuit Demand Scenarios

Demand Scenarios

30% 0.28
Probability

25% 0.22
20%
0.18
15% 0.11 0.11 0.1
10%
5%
0%

Sales
 Swimsuit Costs
• Production cost per unit (C): $80
• Selling price per unit (S): $125
• Salvage value per unit (V): $20
• Fixed production cost (F): $100,000
• Q is production quantity, D: demand
• Profit =
Revenue - Variable Cost - Fixed Cost +
Salvage
 Swimsuit Scenarios
• Scenario One:
– Suppose you make 12,000 jackets and demand ends
up being 13,000 jackets.
– Profit = 125(12,000) - 80(12,000) - 100,000 = $440,000
• Scenario Two:
– Suppose you make 12,000 jackets and demand ends
up being 11,000 jackets.
– Profit = 125(11,000) - 80(12,000) - 100,000 + 20(1000) = $
335,000
Probability of Profitability Scenarios
with Production = 10,000 Units
• Probability of demand being 8000 units =
11%
– Probability of profit of $140,000 = 11%
• Probability of demand being 12000 units =
28%
– Probability of profit of $140,000 = 28%
• Total profit = Weighted average of profit
scenarios
 Swimsuit Best Solution
• Find order quantity that maximizes
weighted average profit.
• Question: Will this quantity be less than,
equal to, or greater than average demand?
 What to Make?

• Average demand is 13,000

• Look at marginal cost Vs. marginal profit
– if extra jacket sold, profit is 125-80 = 45
– if not sold, cost is 80-20 = 60
• So we will make less than average
• Thus, Marginal Cost > Marginal Profit
=> optimal production quantity <
average demand.
 Swimsuit Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity
 Swimsuit Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity
 Swimsuit Expected Profit

Expected Profit

$400,000

$300,000
Profit

$200,000

$100,000

$0
8000 12000 16000 20000
Order Quantity
 Swimsuit :
Important Observations
• Tradeoff between ordering enough to meet
demand and ordering too much
• Several quantities have the same average profit
• Average profit does not tell the whole story

• Question: 9000 and 16000 units

lead to about the same average
profit, so which do we prefer?
 Probability of Outcomes

100%
90%
80%
Probability

70%
60% Q=9000
50%
40% Q=16000
30%
20%
10%
0%

Profit
 Risk-Reward Tradeoffs
• Production Quantity = 9000 units
– Profit is:
• either $200,000 with probability of about 11 %
• or $305,000 with probability of about 89 %
• Production quantity = 16,000 units.
– Distribution of profit is not symmetrical.
– Losses of $220,000 about 11% of the time
– Profits of at least $410,000 about 50% of the time
• With the same average profit, increasing the production
quantity:
– Increases the possible risk
– Increases the possible reward
 Key Points from this Model

• The optimal order quantity is not necessarily

equal to average forecast demand
• The optimal quantity depends on the
relationship between marginal profit and
marginal cost
• As order quantity increases, average profit
first increases and then decreases
• As production quantity increases, risk
increases. In other words, the probability of
large gains and of large losses increases
 Initial Inventory
• Suppose that one of the jacket designs is a
model produced last year.
• Some inventory is left from last year
• Assume the same demand pattern as before
• If only old inventory is sold, no setup cost

• Question: If there are 5000 units remaining,

what should Snow Time do? What should they
do if there are 10,000 remaining?
Initial Inventory and Profit

500000
400000
Profit

300000
200000
100000
0
00

00

00

00

0
00

50

00

50
50

65

80

95

11

12

14

15
Production Quantity
Initial Inventory and Profit

500000
400000
Profit

300000
200000
100000
0
00

00

00

00

0
00

50

00

50
50

65

80

95

11

12

14

15
Production Quantity
Initial Inventory and Profit

500000
400000
Profit

300000
200000
100000
0
00

00

00

00

0
00

50

00

50
50

65

80

95

11

12

14

15
Production Quantity
 Manufacturer Initial Inventory =
5,000
• If nothing is produced, average profit =
225,000 (from the figure) + 5,000 x 80 = 625,000
 Observations
• The optimal order quantity is not
necessarily equal to forecast, or average,
demand.
• As the order quantity increases, average
profit typically increases until the
production quantity reaches a certain
value, after which the average profit starts
decreasing.
• Risk/Reward trade-off: As we increase the
production quantity, both risk and reward
increases.
 What If the Manufacturer Has an
Initial Inventory?
• Trade-off between:
– Using on-hand inventory to meet demand and
avoid paying fixed production cost: need
sufficient inventory stock
– Paying the fixed cost of production and not
have as much inventory
EXAMPLE 3-2
 Profit

100000
200000
300000
400000
500000

0
5000
6000
7000
8000
9000
10000
11000
12000
13000
Production Quantity

14000
15000
16000
 EXAMPLE 3-3
Suppose the manufacturer offers to buy unsold swimsuits
from the retailer for $55. Under this contract, the solid line in
Figure 3-7 illustrates the retailer’s average profit while the
dotted line represents the manufacturer’s average profit. The
figure shows that in this case the retailer has an incentive to
increase its order quantity to 14,000 units, for a profit of
$513,800, while the manufacturer’s average profit increases
to $571,900. Thus, the total average profit for the two parties
increases from $1010,700 ( = $470,700 + $540,000) in the
sequential supply chain to $1085,700 ( = $513,800 +
$571,900) when a buy-back contract is used.
 EXAMPLE 3-4
• Suppose the swimsuit manufacturer and retailer have a
revenue-sharing contract, in which the manufacturer agrees to
decrease the wholesale price from $80 to $60, and, in return,
the retailer provides 15 percent of the product revenue to the
manufacturer. Under this contract, the solid line in Figure 3-8
illustrates the retailer’s average profit while the dotted line
represents the manufacturer’s average profit. The figure shows
that, in this case, the retailer has an incentive to increase his
order quantity to 14,000 (as in the buy-back contract) for a profit
of $504,325, and this order increase leads to increased
manufacturer’s profit of $481,375, in spite of lower wholesale
prices. Thus, the supply chain total profit is $985,700 ( =
$504,325 + $481,375). That is, the reduction in the wholesale
price coupled with revenue sharing leads to increased profits
for both parties.
 EXAMPLE 3-5

In the swimsuit example, the only relevant data in this case are
the selling price, $125; the salvage value, $20; the variable
production costs, $35; and the fixed production cost. In this
case, the cost that the retailer charges the manufacturer is
meaningless, since we are only interested in external costs and
revenues. Evidently, in this case the supply chain marginal
profit, 90 = 125 − 35, is significantly higher than the marginal
loss, 15 = 35 − 20, and hence the supply chain will produce
more than average demand. Indeed, Figure 3-9 suggests that in
this global optimization strategy, the optimal production quantity
is 16,000 units, which implies an expected supply chain profit of
$1,014,500.
 Multiple Order Opportunities
REASONS
• To balance annual inventory holding costs and annual fixed order
costs.
• To satisfy demand occurring during lead time.
• To protect against uncertainty in demand.

TWO POLICIES
• Continuous review policy
– inventory is reviewed continuously
– an order is placed when the inventory reaches a particular level or reorder point.
– inventory can be continuously reviewed (computerized inventory systems are
used)

• Periodic review policy

– inventory is reviewed at regular intervals
– appropriate quantity is ordered after each review.
– it is impossible or inconvenient to frequently review inventory and place orders if
necessary.
 Continuous Review Policy
• Daily demand is random and follows a normal
distribution.
• Every time the distributor places an order from the
manufacturer, the distributor pays a fixed cost, K, plus an
amount proportional to the quantity ordered.
• Inventory holding cost is charged per item per unit time.
• Inventory level is continuously reviewed, and if an order
is placed, the order arrives after the appropriate lead
time.
• If a customer order arrives when there is no inventory on
hand to fill the order (i.e., when the distributor is stocked
out), the order is lost.
• The distributor specifies a required service level.
 Continuous Review Policy
• AVG = Average daily demand faced by the
distributor
• STD = Standard deviation of daily demand faced
by the distributor
• L = Replenishment lead time from the supplier to
the
• distributor in days
• h = Cost of holding one unit of the product for
one day at the distributor
• α = service level. This implies that the probability
of stocking out is 1 - α
 Continuous Review Policy
• (Q,R) policy – whenever inventory level
falls to a reorder level R, place an order for
Q units
• What is the value of R?
 Continuous Review Policy
• Average demand during lead time: L x
AVG
• Safety stock: z × STD × L

• Reorder Level, R: L × AVG + z × STD × L

2K × AVG
• Order Quantity, Q: Q = h
Service Level & Safety Factor, z
Service 90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 99.9%
Level

z 1.29 1.34 1.41 1.48 1.56 1.65 1.75 1.88 2.05 2.33 3.08

z is chosen from statistical tables to ensure

that the probability of stockouts during lead time is exactly 1 - α
Inventory Level Over Time
FIGURE 2-9: Inventory level as a function of time in a (Q,R) policy

Inventory level before receiving an order = z × STD × L

Inventory level after receiving an order = Q + z × STD × L

Average Inventory = Q
2 + z × STD × L
Continuous Review Policy Example
• A distributor of TV sets that orders from a
manufacturer and sells to retailers
• Fixed ordering cost = $4,500
• Cost of a TV set to the distributor = $250
• Annual inventory holding cost = 18% of
product cost
• Replenishment lead time = 2 weeks
• Expected service level = 97%
 Continuous Review Policy
Example
Month Sept Oct Nov. Dec. Jan. Feb. Mar. Apr. May June July Aug

Sales 200 152 100 221 287 176 151 198 246 309 98 156

Average monthly demand = 191.17

Standard deviation of monthly demand = 66.53

Average weekly demand = Average Monthly Demand/4.3

Standard deviation of weekly demand = Monthly standard deviation/√4.3
 Continuous Review Policy
Example

Parameter Average weekly Standard Average Safety Reorder

demand deviation of demand stock point
weekly demand during lead
time
Value 44.58 32.08 89.16 86.20 176

0.18 × 250
Weekly holding cost = = 0.87
52

2 × 4,500 × 44 .58
Optimal order quantity = Q= = 679
.87

Average inventory level = 679/2 + 86.20 = 426

 2.2.7. Variable Lead Times
• Average lead time, AVGL
• Standard deviation, STDL.
• Reorder Level, R:

R = AVG× AVGL+ z AVGL× STD2 + AVG2 × STDL2

Amount of safety stock= z AVGL × STD 2

+ AVG 2
× STDL2

2 K × AVG
Order Quantity = Q =
h
 2.2.8. Periodic Review Policy
• Inventory level is reviewed periodically at regular
intervals
• An appropriate quantity is ordered after each review
• Two Cases:
– Short Intervals (e.g. Daily)
• Define two inventory levels s and S
• During each inventory review, if the inventory position falls below s,
order enough to raise the inventory position to S.
• (s, S) policy
– Longer Intervals (e.g. Weekly or Monthly)
• May make sense to always order after an inventory level review.
• Determine a target inventory level, the base-stock level
• During each review period, the inventory position is reviewed
• Order enough to raise the inventory position to the base-stock level.
• Base-stock level policy
 (s,S) policy

• Calculate the Q and R values as if this were a

continuous review model
• Set s equal to R
• Set S equal to R+Q.
 Base-Stock Level Policy
• Determine a target inventory level, the base-
stock level
• Each review period, review the inventory
position is reviewed and order enough to raise
the inventory position to the base-stock level
• Assume:
r = length of the review period
L = lead time
AVG = average daily demand
STD = standard deviation of this daily demand.
 Base-Stock Level Policy
• Average demand during an interval of r + L
days= ( r + L ) × AVG

• Safety Stock= z × STD × r + L

 Base-Stock Level Policy

FIGURE 2-10: Inventory level as a function of time in a periodic

review policy
 Base-Stock Level Policy
Example
• Assume:
– distributor places an order for TVs every 3 weeks
– Lead time is 2 weeks
– Base-stock level needs to cover 5 weeks
• Average demand = 44.58 x 5 = 222.9
• Safety stock = 1.9 × 32.8 × 5
• Base-stock level = 223 + 136 = 359
• Average inventory level = 3×442 .58 + 1.9 × 32.08 × 5 = 203.17

• Distributor keeps 5 (= 203.17/44.58) weeks of supply.

 Service Level Optimization
• Optimal inventory policy assumes a
specific service level target.
• What is the appropriate level of service?
– May be determined by the downstream
customer
• Retailer may require the supplier, to maintain a
specific service level
• Supplier will use that target to manage its own
inventory
– Facility may have the flexibility to choose the
appropriate level of service
Service Level Optimization

FIGURE 2-11: Service

level inventory versus
inventory level as a
function of lead time
 Trade-Offs
• Everything else being equal:
– the higher the service level, the higher the
inventory level.
– for the same inventory level, the longer the
lead time to the facility, the lower the level of
service provided by the facility.
– the lower the inventory level, the higher the
impact of a unit of inventory on service level
and hence on expected profit
 Retail Strategy
• Given a target service level across all
products determine service level for each
SKU so as to maximize expected profit.
• Everything else being equal, service level
will be higher for products with:
– high profit margin
– high volume
– low variability
– short lead time
 2.3 Risk Pooling
• Demand variability is reduced if one
aggregates demand across locations.
• More likely that high demand from one
customer will be offset by low demand
from another.
• Reduction in variability allows a decrease
in safety stock and therefore reduces
average inventory.
 Demand Variation
• Standard deviation measures how much
demand tends to vary around the average
– Gives an absolute measure of the variability
• Coefficient of variation is the ratio of
standard deviation to average demand
– Gives a relative measure of the variability,
relative to the average demand
 Acme Risk Pooling Case
• Electronic equipment manufacturer and
distributor
• 2 warehouses for distribution in New York and
New Jersey (partitioning the northeast market
into two regions)
• Customers (that is, retailers) receiving items
from warehouses (each retailer is assigned a
warehouse)
• Warehouses receive material from Chicago
• Current rule: 97 % service level
• Each warehouse operate to satisfy 97 % of
demand (3 % probability of stock-out)
 New Idea
• Replace the 2 warehouses with a single
warehouse (located some suitable place) and
try to implement the same service level 97 %
• Delivery lead times may increase
• But may decrease total inventory investment
considerably.
 Historical Data
PRODUCT A
Week 1 2 3 4 5 6 7 8
Massachusetts 33 45 37 38 55 30 18 58

New Jersey 46 35 41 40 26 48 18 55

Total 79 80 78 78 81 78 36 113

PRODUCT B
Week 1 2 3 4 5 6 7 8
Massachusetts 0 3 3 0 0 1 3 0
New Jersey 2 4 3 0 3 1 0 0
Total 2 6 3 0 3 2 3 0
 Summary of Historical Data
Statistics Product Average Demand Standard Coefficient of
Deviation of Variation
Demand
Massachusetts A 39.3 13.2 0.34

Massachusetts B 1.125 1.36 1.21

New Jersey A 38.6 12.0 0.31

New Jersey B 1.25 1.58 1.26

Total A 77.9 20.71 0.27

Total B 2.375 1.9 0.81

 Inventory Levels
Product Average Safety Stock Reorder Q
Demand Point
During Lead
Time
Massachusetts A 39.3 25.08 65 132

Massachusetts B 1.125 2.58 4 25

New Jersey A 38.6 22.8 62 31

New Jersey B 1.25 3 5 24

Total A 77.9 39.35 118 186

Total B 2.375 3.61 6 33

 Savings in Inventory
• Average inventory for Product A:
– At NJ warehouse is about 88 units
– At MA warehouse is about 91 units
– In the centralized warehouse is about 132 units
– Average inventory reduced by about 36 percent
• Average inventory for Product B:
– At NJ warehouse is about 15 units
– At MA warehouse is about 14 units
– In the centralized warehouse is about 20 units
– Average inventory reduced by about 43 percent
 Critical Points
• The higher the coefficient of variation, the greater the
benefit from risk pooling
– The higher the variability, the higher the safety stocks
kept by the warehouses. The variability of the demand
aggregated by the single warehouse is lower
• The benefits from risk pooling depend on the behavior of
the demand from one market relative to demand from
another
– risk pooling benefits are higher in situations where
demands observed at warehouses are negatively
correlated
• Reallocation of items from one market to another
easily accomplished in centralized systems. Not
possible to do in decentralized systems where
they serve different markets
 Centralized vs. Decentralized
Systems
• Safety stock: lower with centralization
• Service level: higher service level for the same
inventory investment with centralization
• Overhead costs: higher in decentralized system
• Customer lead time: response times lower in the
decentralized system
• Transportation costs: not clear. Consider
outbound and inbound costs.
 Managing Inventory in the
Supply Chain
• Inventory decisions are given by a single
decision maker whose objective is to
minimize the system-wide cost
• The decision maker has access to inventory
information at each of the retailers and at the
warehouse
• Echelons and echelon inventory
– Echelon inventory at any stage or level of
the system equals the inventory on hand
at the echelon, plus all downstream
inventory (downstream means closer to
the customer)
Echelon Inventory

FIGURE 2-13: A serial supply chain

 Reorder Point with Echelon
Inventory
• Le = echelon lead time,
– lead time between the retailer and the
distributor plus the lead time between the
distributor and its supplier, the wholesaler.
• AVG = average demand at the retailer
• STD = standard deviation of demand at
the retailer
• Reorder point R = L × AVG + z × STD × L
e e
4-Stage Supply Chain Example
• Average weekly demand faced by the
retailer is 45
• Standard deviation of demand is 32
• At each stage, management is attempting
to maintain a service level of 97% (z=1.88)
• Lead time between each of the stages,
and between the manufacturer and its
suppliers is 1 week
 Costs and Order Quantities

K D H Q

retailer 250 45 1.2 137

distributor 200 45 .9 141
wholesaler 205 45 .8 152
manufacturer 500 45 .7 255
 Reorder Points at Each Stage
• For the retailer, R=1*45+1.88*32*√1 = 105
• For the distributor, R=2*45+1.88*32*√2 =
175
• For the wholesaler, R=3*45+1.88*32*√3 =
239
• For the manufacturer, R=4*45+1.88*32*√4
= 300
 More than One Facility at Each
Stage
• Follow the same approach
• Echelon inventory at the warehouse is the
inventory at the warehouse, plus all of the
inventory in transit to and in stock at each of the
retailers.
• Similarly, the echelon inventory position at the
warehouse is the echelon inventory at the
warehouse, plus those items ordered by the
warehouse that have not yet arrived minus all
items that are backordered.
Warehouse Echelon Inventory

FIGURE 2-14: The warehouse echelon inventory

 Practical Issues
• Periodic inventory review.
• Tight management of usage rates, lead times, and
safety stock.
• Reduce safety stock levels.
• Introduce or enhance cycle counting practice.
• ABC approach.
• Shift more inventory or inventory ownership to
suppliers.
• Quantitative approaches.
FOCUS: not reducing costs but reducing inventory levels.
Significant effort in industry to increase inventory turnover
Annual_ Sales
Inventory_ Turnover_ Ratio =
Average_ Inventory_ Level
 Inventory Turnover Ratios for
Different Manufacturers
Industry Upper quartile Median Lower quartile

Electronic 8.1 4.9 3.3

components and
accessories

Electronic computers 22.7 7.0 2.7

Household audio and 6.3 3.9 2.5

video equipment

Paper Mills 11.7 8.0 5.5

Industrial chemicals 14.1 6.4 4.2

Bakery products 39.7 23.0 12.6

Books: Publishing 7.2 2.8 1.5
and printing
 Forecasting
RULES OF FORECASTING
• The forecast is always wrong.
• The longer the forecast horizon, the
worse the forecast.
• Aggregate forecasts are more accurate.
 Utility of Forecasting
• Part of the available tools for a manager
• Despite difficulties with forecasts, it can be
used for a variety of decisions
• Number of techniques allow prudent use
of forecasts as needed
 Techniques
• Judgment Methods
– Sales-force composite
– Experts panel
– Delphi method
• Market research/survey
• Time Series
– Moving Averages
– Exponential Smoothing
• Trends
– Regression
– Holt’s method
• Seasonal patterns – Seasonal decomposition
• Trend + Seasonality – Winter’s Method
• Causal Methods
 The Most Appropriate
Technique(s)
• Purpose of the forecast
• How will the forecast be used?
• Dynamics of system for which forecast will
be made
• How accurate is the past history in
predicting the future?
 SUMMARY
• Matching supply with demand a major challenge
• Forecast demand is always wrong
• Longer the forecast horizon, less accurate the
forecast
• Aggregate demand more accurate than
disaggregated demand
• Need the most appropriate technique
• Need the most appropriate inventory policy
Thanks
nventory Management and Risk Pooling
Sport Obermeyer-
Obermeyer Case Study

Pravin Kumar
24-08-2018

University School of Management and Entrepreneurship

DTU Delhi
port Obermeyer- About the compan

• Sport Obermeyer’s origins traced to 1947.

• Klaus Obermeyer designed and introduced a variety of skiwear and ski
equipment products.
• Over the years, Sport Obermeyer developed into a prominent competitor
in the U.S. skiwear market: estimated sales in 1992 were $32.8 million.
• The company held a commanding 45 percent share of the children’s
skiwear market and an 11 percent share of the adult skiwear market.
• Columbia Sportswear was a lower-price,
price, high-volume-per-style
high competitor
whose sales had increased rapidly during the previous three years.
• By 1992 Columbia had captured about 23 percent of the adult ski-jacket
market
port Obermeyer- About the compan
• Obermeyer offered a broad line of fashion ski apparel, including parkas,
vests, ski suits, shells, ski pants,, sweaters, turtlenecks, and accessories.
accessories
• Obermeyer products were offered in five different “genders”: men’s,
women’s, boys’, girls’, and pre-schoolers’.
schoolers’.
• The company divided its adult male customers into four types, dubbed
Fred, Rex, Biege, and Klausie.
• Freds had a tendency to buy basic styles and colors.
• High-tech Rex was an affluent, image-conscious skier who liked to sport the
latest technologies in fabrics.
• In contrast, Biege was a hard-corecore mountaineering-type
mountaineering skier.
• A Klausie was a flamboyant, high-profile
profile skier or snowboarder who wore
the latest styles.
 oduct variety, Obermeyer women’s
arkas
Main Problem of Sport Obermeyer

• Sport Obermeyer faced each year— —committing to specific production

quantities for each skiwear item the company would offer in the
coming year’s line.
• Sport Obermeyer would start to make firm commitments for
producing its 1993-1994 line of fashion skiwear with scant
information about how the market would react to the line.
• In fact, no clear indications had yet emerged about how end-
consumers were responding to the company's current 1992-1993
1992
line.
Main Problem of Sport Obermeyer

• Obermeyer’s new line offered strong designs,

designs
• But the ultimate success of the line was highly dependent on how
well the company was able to predict market response to different
styles and colors.
• Feedback from retailers on the 1993-1994
1993 line wouldn’t begin to
surface until the Las Vegas trade show next March.
• Inaccurate forecasts of retailer demand had become a growing
problem at Obermeyer
• In recent years greater product variety and more intense competition
had made accurate predictions increasingly difficult.
Main Problem of Sport Obermeyer
• Two scenarios resulted —both painful.
• On one hand, at the end of each season, the company was
saddled with excess merchandise for those styles and colors that
retailers had not purchased;
• Styles with the worst selling records were sold at deep discounts,
often well below their manufactured cost.
• On the other hand, the company frequently ran out of its most
popular items; although popular products were clearly desirable,
considerable income was lost each year because of the
company's inability to predict which products would become
best-sellers.
 Forecasting Strategy

• The Company had changed the company’s usual practice of having

the committee, which comprised six key Obermeyer managers, make
production commitments based o the group’s consensus.
• Instead, hoping to gather more complete information, he had asked
each member independently to forecast retailer demand for each
Obermeyer product.
• Now it was up to him to make use of the forecasts generated by the
individuals in the group.
• He noted the discrepancies between different committee members'
forecasts.
 Operational Strategy
• A second issue the company faced was how to allocate production between
factories in Hong Kong and China.
• Last year, almost a third of Obermeyer’s parkas had been made in China.
• This year, the company planned to produce half of its parkas in China.
• Labor costs in China were extremely low.
• Yet the company had some concerns about the quality and reliability of Chinese
operations.
• The plants in China typically required larger minimum order quantities than those
in Hong Kong and were subject to stringent quota restrictions by the U.S.
government.
• How should the company all of these differences into a well-founded decision
about where to source each product?
 The Order Cycle

• In the United States,, most retail sales of skiwear occurred between

September and January, with peak sales occurring in December and
January.
• Most retailers requested full delivery of their orders prior to the start
of the retail season;
• Sport Obermeyer attempted to deliver coordinated collections of its
merchandise into retail stores by early September.
• Nearly two years of planning and production activity took place prior
to the actual sale of products to consumers.
LANNING AND PRODUCTION CYCLE, OBERMEYER 199
1994 LINEṁ
LANNING AND PRODUCTION CYCLE, OBERMEYER 1993
1994 LINE
 The Design Process

• Each year, a major trade show for ski equipment and apparel was held
in Las Vegas.
• The March 1992 Las Vegas show had provided additional input to the
design process for the 1993-1994
1994 line.
• By May 1992, the design concepts were finalized; sketches were sent
to Obersport for prototype production in July.
• Prototypes were usually made from leftover fabric from the previous
year since the prototype garments would be used only internally by
Obermeyer management for decision-making
decision purposes.
• Obermeyer refined the designs based on the prototypes and finalized
designs by September 1992.
 The Design Process

• During the Las Vegas trade show, most retailers placed their orders;
• Obermeyer usually received orders representing 80 percent of its
annual volume by the week following the Las Vegas show.
• With this information in hand, Obermeyer could forecast its total
demand with great accuracy.
• It was important that Obersport place dyeing/printing instructions
and component orders quickly since some suppliers’ lead times were
as long as 90 days.
• Cutting and sewing of Obermeyer’s first production order would
begin in February 1993.
How demand forecasts improve with
increasing information

Initial Forecast Updated Forecast, Final Forecast,

Incorporating Incorporating First 80%
First 20% of Sales Data of Sales Data
Shipment to Obermeyer Warehouse

• During June and July, Obermeyer garments were transported by ship

from Obersport's Hong Kong warehouse to Seattle, from which they
were trucked to Obermeyer’s Denver warehouse. (Shipment took
approximately six weeks.)
• Most goods produced in August were air-shipped
air to Denver to ensure
timely delivery to retailers.
• In addition, for goods manufactured in China, air freighting was often
essential due to strict quota restrictions in certain product categories.
• The U.S. government limited the number of units that could be
imported from China into the United States.
 The Supply Chain

• Obermeyer sourced most of its outerwear products through Obersport.

• In recent years, Wally had worked with Obersport to “pre-position”
(purchase prior to the season and hold in inventory) greige fabric.
• Different types of fabrics were purchased for use as shell (outer) fabric and
lining fabric. Approximately 10 types of shell fabrics were required each
year.
• Obersport purchased shell fabric from vendors in the United States, Japan,
Korea, Germany, Austria, Taiwan,, and Switzerland. Lining fabric was
sourced primarily from Korea and Taiwan.
 The Supply Chain

• Each greige fabric would later be dyed and/or printed as necessary;

each shell fabric was typically offered in 8 to 12 colors and prints.
• Immediately after receiving production instructions from Sport
Obermeyer, Obersport asked subcontractors to dye or print fabric.
• Dyeing subcontractors required a lead time of 45-60
45 days and a
minimum order quantity of 1,000 yards.
• Printing subcontractors required a minimum of 3,000 yards; printing
lead times were also 45-50 days.
• A typical adult’s parka,, for example, required 2.25 to 2.5 yards of 60”
width shell fabric.
 The Supply Chain
• Obersport also had to ensure the availability of a variety of other
components such as D-rings, buckles,, snaps, buttons, zippers, pull-strings
pull
with attached castings,, and various labels and tags. Buckles, Drings, pull-
strings, and buttons were procured locally in Hong Kong and had a 15- to
30-day lead time.
• Most zippers were purchased from YKK, a large Japanese zipper
manufacturer.
• Approximately 60 percent of Obersport’s zipper requirements were
sourced from YKK's Hong Kong factory, where standard zippers were
manufactured.
• The lead time for these zippers was 60 days.
• The remainder was nonstandard zippers, which were sourced from Japan
with at least 90-day lead times—sometimes
sometimes longer.
PROCUREMENT INFORMATION FOR OBERMEYER’S PARKA
COMPONENTS
 Cut & Sew
• Workers in Hong Kong worked about 50 percent faster than their
Chinese counterparts.
• A parka line in Hong Kong that required 10 workers to complete all
operations might require 40 workers in China.
• For parkas, the minimum production quantity for a style was 1,200
units in China and 600 units in Hong Kong.
Kong
• Obermeyer produced about 200,000 parkas each year.
• The maximum capacity available to the company for cutting and
sewing was 30,000 units a month;
• This included the production capacity at all factories available to make
Sport Obermeyer products.
Comparison Of Operations In Hong
Kong And China
 Production Planning

• Obermeyer earned 24 percent of wholesale price (pre-tax)

(pre on each
parka it sold,
• And that units left unsold at the end of the season were sold at a loss
that averaged 8 percent of wholesale price.
• Wally needed to commit 10,000 units for the first phase of
production.
• The remaining 10,000 units could be deferred until after the Las Vegas
show.
• To complete the planning decision, Wally would also need to decide
which styles to make in Hong Kong and which would be better to
produce in China.
mple Buying Committee Forecasts,
Styles of Women’s Parkas
ASE DISCUSSION QUESTIONS

1. Using the sample data given in Table 3-19,

3 make a recommendation
for how many units of each style Wally should make during the initial
phase of production. Assume that all of the 10 styles in the sample
problem are made in Hong Kong and that Wally’s initial production
commitment must be at least 10,000 units. Ignore price differences
among styles in your initial analysis.
analysis
2. Can you come up with a measure of risk associated with your ordering
policy? This measure should be quantifiable.
quantifiable
3. Repeat your methodology and assume now that all 10 styles are made
in China. What is the difference (if any) between the two initial
production commitments?
ASE DISCUSSION QUESTIONS

4. What operational changes would you recommend to Wally to

improve performance?
5. How should Wally think (both short-term
short and long-term) about
sourcing in Hong Kong versus China? What kind of sourcing policy do
you recommend?
Probable Solutions
nswer 1
• Assumptions to be made:
a) All production activities are being carried out in Hong Kong. Thus
the minimum order quantity for any style must be 60 units/month.
b) Initial production commitment must be at least 10,000 units.
c) Order is being placed in November. Therefore number of months
till the Las Vegas show (to be held in March) is equal to 4. Thus,
minimum order quantity/item for this period should be 240.

Basis for deciding on style will be Coefficient of Variation and not

Standard Deviation.
Orders to be placed:
xplanation
• Obermeyer must order the maximum amount of those
styles with the minimum value for CoVar. The reason is
that the variation of their forecasted demand is lesser
than the others. Now, the value for % to
be ordered has been derived as:
% to be ordered= (1 - CoVar - 0.02)*100%
0.02 in the above formula corresponds to 2%. This 2%
has been kept as a precaution against actual demand
falling way below the forecasted demand.
demand
• For Isis this safety margin has been increased to 5% as the
CoVar for Isis and other brands is way beyond the ones with
the minimum CoVar (Styles with figures from 0.13 till 0.19).
• The figure for Anita has been derived by adhering to the
minimum order quantity per style of 240. The idea is to delay
ordering as much as possible as the March show in Las Vegas
provided information which led to greater accuracy in
forecasting. Hence the Total Quantity being ordered is
10,308 units.
nswer 2
• The Coefficient of Variation (COV) is determined in order to analyse the
risk associated with each product line.
line
• To determine the associated risk for each product line a benchmark of
COV was used and quantify risk with the assumption that styles with a
COV below 0.2 is considered a low risk item while any item
with a COV higher than 0.2 is considered a high risk item.
item
• As the minimum production requirements for an order is only 600 units
versus the 1,200 units required in China, it is recommended that any
high risk item be produced in Hong Kong because they are more
flexible, produce higher quality items. Also, with higher variability and
higher risk it is safe to order from locations with low minimum order
quantity requirement.
nswer 3
xplanation

• As explained above, the maximum order size is decided on the basis

of the minimum value of CoVar.. Keeping the logic consistent with the
one used for Hong Kong, for the low risk items – Assault, Seduced,
Entice, Gail and Electra – the maximum possible order has been
placed taking into account the same proportion for safety stock as
well.
• For the high risk items – Daphne, Isis, Anita, Teri, Stephanie –the
order quantity has been kept at the minimum possible amount. Also,
the order quantity for each style safely crosses the figure of 240
(minimum quantity to be ordered for 4 months production in Hong
Kong). Since the minimum order quantity is double that of Hong
Kong, the amount for each of these items becomes 480.
Answer 4

Following are the operations changes recommended to Wally to

improve performance.
• Improve the demand forecasts made by buying committee. Should
use a weighted average method instead of just using a simple
average.
• Obtaining market feedback earlier than Las Vegas which can help
converting some Speculative production to Reactive production. For
maximising the value of this feedback Sport Obermeyer’s should
include both small and large retailers & Urban and Resort retailers.
• Predicting customer demand for individual styles and also if possible
reducing number of styles being handled.
nswer 5
Thanks
MATERIALS
REQUIREMENT
PLANNING
30-08-2018

Pravin Kumar

University School of Management and Entrepreneurship

DTU Delhi
 Lecture Outline

• Material Requirements Planning (MRP)

• MRP Logic and Product Structure Trees
• Time Fences
• MRP Example
• MRP II and Lot Sizing
Material Requirements Planning

• Materials requirements planning (MRP) is a

means for determining the number of parts,
components, and materials needed to produce
a product
• MRP provides time scheduling information
specifying when each of the materials, parts,
and components should be ordered or
produced
• Dependent demand drives MRP
• MRP is a software system
 Bill-of-Material
Product Structure Tree

Bicycle(1)
P/N 1000

Handle Bars (1) Frame Assembly (1)

P/N 1001 P/N 1002

Wheels (2) Frame (1)

P/N 1003 P/N 1004
Example 1: Product Structure for “Awesome” A
 Time-Phased Product Structure

Must have D and E completed here so

production can begin on B
Start production of D
1 week
D 2 weeks to produce

2 weeks B
E
A
2 weeks
E 1 week
2 weeks 1 week
G 3 weeks C
1 week F
D
1 2 3 4 5 6 7 8
 (1) Lead Times
A
A 1 Week
B 2 Week
C 1 Week
B (2) C (3) D 1 Week
E 2 Week
F 3 Week
E (2) F (2) G 2 Week
D (2) E (2)

G (1) D (2) Total Unit Demand

Week 10 50 A
 Week 1 2 3 4 5 6 7 8 9 10
Required 50
A (LT=1) Order Placement 50
Required 100
B (LT=2) Order Placement 100
Required 150
C (LT=1) Order Placement 150
Required 600 200
D (LT=1) Order Placement 600 200
Required 200 300
E (LT=2) Order Placement 200 300
Required 300
F (LT=3) Order Placement 300
Required 300
G (LT=2) Order Placement 300
 Example 2
Given the product structure tree for “A” and the lead time and demand information
below, provide a materials requirements plan that defines the number of units of each
component and when they will be needed

Product Structure Tree for Assembly A Lead Times

A 1 day
A B 2 days
C 1 day
D 3 days
E 4 days
B(4) C(2) F 1 day

Total Unit Demand

Day 10 50 A
D(2) E(1) D(3) F(2) Day 8 20 B (Spares)
Day 6 15 D (Spares)
 First, the number of units of “A” are scheduled
backwards to allow for their lead time. So, in the
materials requirement plan below, we have to place
an order for 50 units of “A” on the 9th day to receive
them on day 10.

Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
Order Placement 50

LT = 1 day
 Next, we need to start scheduling the components that make up “A”. In the case of
component “B” we need 4 B’s for each A. Since we need 50 A’s, that means 200 B’s.
And again, we back the schedule up for the necessary 2 days of lead time.

Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
Order Placement 50
B Required 20 200
Order Placement 20 200

LT = 2
Spares

A 4x50=200

B(4) C(2)

D(2) E(1) D(3) F(2)

 12
Finally, repeating the process for all components, we have the final materials
requirements plan:

Day: 1 2 3 4 5 6 7 8 9 10
A Required 50
LT=1 Order Placement 50
B Required 20 200
LT=2 Order Placement 20 200
C Required 100
LT=1 Order Placement 100
D Required 55 400 300
LT=3 Order Placement 55 400 300
E Required 20 200
LT=4 Order Placement 20 200
F Required 200
LT=1 Order Placement 200

A
Part D: Day 6
B(4) C(2) 40 + 15 spares

D(2) E(1) D(3) F(2)

 Master Production Schedule (MPS)
• Time-phased plan specifying how many and
when the firm plans to build each end item

Aggregate Plan
(Product Groups)

MPS
(Specific End Items)
 Types of Time Fences
• Frozen
– No schedule changes allowed within this window
• Moderately Firm
– Specific changes allowed within product groups as
long as parts are available
• Flexible
– Significant variation allowed as long as overall
capacity requirements remain at the same levels
 Example of Time Fences

Moderately
Frozen Firm Flexible

Capacity
Forecast and available
capacity
Firm Customer Orders

8 15 26

Weeks
 Material Requirements Planning System

• Based on a master production schedule, a material

requirements planning system:
– Creates schedules identifying the specific parts
and materials required to produce end items

– Determines exact unit numbers needed

– Determines the dates when orders for those

materials should be released, based on lead
times
 17

Aggregate Forecasts
Firm orders
product of demand
from known
plan from random
customers
customers

Engineering Master production

Schedule (MPS) Inventory
design
transactions
changes

Material
planning
Bill of (MRP Inventory
material computer record file
file program)
Secondary reports
Primary reports
Exception reports
Planned order schedule for Planning reports
inventory and production Reports for performance
control control
©The McGraw-Hill Companies, Inc., 2004
 Bill of Materials (BOM) File
A Complete Product Description
• Materials
• Parts
• Components
• Production sequence
• Modular BOM
– Subassemblies
• Super BOM
– Fractional options
 Inventory Records File

• Each inventory item carried as a separate file

– Status according to “time buckets”

• Pegging
– Identify each parent item that created demand
 Primary MRP Reports
• Planned orders to be released at a future time
• Order release notices to execute the planned
orders
• Changes in due dates of open orders due to
rescheduling
• Cancellations or suspensions of open orders due
to cancellation or suspension of orders on the
master production schedule
• Inventory status data
 Secondary MRP Reports
• Planning reports, for example, forecasting
inventory requirements over a period of time
• Performance reports used to determine
agreement between actual and programmed
usage and costs
• Exception reports used to point out serious
discrepancies, such as late or overdue orders
 Additional MRP Scheduling Terminology
• Gross Requirements

• Scheduled receipts

• Projected available balance

• Net requirements

• Planned order receipt

• Planned order release

 MRP Example 3

Item On-Hand Lead Time (Weeks)

X X 50 2
A 75 3
B 25 1
A(2) B(1) C 10 2
D 20 2

C(3) C(2) D(5)

Requirements include 95 units (80 firm orders and 15 forecast) of X

in week 10
 Day: 1 2 3 4 5 6 7 8 9 10
X Gross requirements 95
X LT=2 Scheduled receipts
Proj. avail. balance 50 50 50 50 50 50 50 50 50 50
On- Net requirements 45
hand Planned order receipt 45
50 Planner order release 45
A Gross requirements 90
A(2) LT=3 Scheduled receipts
Proj. avail. balance 75 75 75 75 75 75 75 75
On- Net requirements 15
hand Planned order receipt 15
75 Planner order release 15
B Gross requirements 45
It takes 2 LT=1 Scheduled receipts
Proj. avail. balance 25 25 25 25 25 25 25 25
A’s for each On- Net requirements 20
X hand Planned order receipt 20
25 Planner order release 20
C Gross requirements 45 40
LT=2 Scheduled receipts
Proj. avail. balance 10 10 10 10 10
On- Net requirements 35 40
hand Planned order receipt 35 40
10 Planner order release 35 40
D Gross requirements 100
LT=2 Scheduled receipts
Proj. avail. balance 20 20 20 20 20 20 20
On- Net requirements 80
hand Planned order receipt 80
20 Planner order release 80
 Day: 1 2 3 4 5 6 7 8 9 10
X Gross requirements 95
X LT=2 Scheduled receipts
Proj. avail. balance 50 50 50 50 50 50 50 50 50 50
On- Net requirements 45
hand Planned order receipt 45
50 Planner order release 45
A Gross requirements 90
A(2) B(1) LT=3 Scheduled receipts
Proj. avail. balance 75 75 75 75 75 75 75 75
On- Net requirements 15
hand Planned order receipt 15
75 Planner order release 15
B Gross requirements 45
LT=1 Scheduled receipts
It takes 1 B
Proj. avail. balance 25 25 25 25 25 25 25 25
for each X On- Net requirements 20
hand Planned order receipt 20
25 Planner order release 20
C Gross requirements 45 40
LT=2 Scheduled receipts
Proj. avail. balance 10 10 10 10 10
On- Net requirements 35 40
hand Planned order receipt 35 40
10 Planner order release 35 40
D Gross requirements 100
LT=2 Scheduled receipts
Proj. avail. balance 20 20 20 20 20 20 20
On- Net requirements 80
hand Planned order receipt 80
20 Planner order release 80
 Day: 1 2 3 4 5 6 7 8 9 10
X Gross requirements 95
X LT=2 Scheduled receipts
Proj. avail. balance 50 50 50 50 50 50 50 50 50 50
On- Net requirements 45
hand Planned order receipt 45
50 Planner order release 45
A Gross requirements 90
A(2) B(1) LT=3 Scheduled receipts
Proj. avail. balance 75 75 75 75 75 75 75 75
On- Net requirements 15
hand Planned order receipt 15
75 Planner order release 15
C(3) B Gross requirements 45
LT=1 Scheduled receipts
Proj. avail. balance 25 25 25 25 25 25 25 25
On- Net requirements 20
hand Planned order receipt 20
25 Planner order release 20
It takes 3 C’s C Gross requirements 45 40
LT=2 Scheduled receipts
for each A Proj. avail. balance 10 10 10 10 10
On- Net requirements 35 40
hand Planned order receipt 35 40
10 Planner order release 35 40
D Gross requirements 100
LT=2 Scheduled receipts
Proj. avail. balance 20 20 20 20 20 20 20
On- Net requirements 80
hand Planned order receipt 80
20 Planner order release 80
 Day: 1 2 3 4 5 6 7 8 9 10
X Gross requirements 95
X LT=2 Scheduled receipts
Proj. avail. balance 50 50 50 50 50 50 50 50 50 50
On- Net requirements 45
hand Planned order receipt 45
50 Planner order release 45
A Gross requirements 90
A(2) B(1) LT=3 Scheduled receipts
Proj. avail. balance 75 75 75 75 75 75 75 75
On- Net requirements 15
hand Planned order receipt 15
75 Planner order release 15
C(3) C(2) B Gross requirements 45
LT=1 Scheduled receipts
Proj. avail. balance 25 25 25 25 25 25 25 25
On- Net requirements 20
hand Planned order receipt 20
25 Planner order release 20
It takes 2 C’s C Gross requirements 45 40
LT=2 Scheduled receipts
for each B Proj. avail. balance 10 10 10 10 10
On- Net requirements 35 40
hand Planned order receipt 35 40
10 Planner order release 35 40
D Gross requirements 100
LT=2 Scheduled receipts
Proj. avail. balance 20 20 20 20 20 20 20
On- Net requirements 80
hand Planned order receipt 80
20 Planner order release 80
 Day: 1 2 3 4 5 6 7 8 9 10
X Gross requirements 95
X LT=2 Scheduled receipts
Proj. avail. balance 50 50 50 50 50 50 50 50 50 50
On- Net requirements 45
hand Planned order receipt 45
50 Planner order release 45
A Gross requirements 90
A(2) B(1) LT=3 Scheduled receipts
Proj. avail. balance 75 75 75 75 75 75 75 75
On- Net requirements 15
hand Planned order receipt 15
75 Planner order release 15
C(3) C(2) D(5) B Gross requirements 45
LT=1 Scheduled receipts
Proj. avail. balance 25 25 25 25 25 25 25 25
On- Net requirements 20
hand Planned order receipt 20
25 Planner order release 20
It takes 5 D’s for C Gross requirements 45 40
LT=2 Scheduled receipts
each B Proj. avail. balance 10 10 10 10 10
On- Net requirements 35 40
hand Planned order receipt 35 40
10 Planner order release 35 40
D Gross requirements 100
LT=2 Scheduled receipts
Proj. avail. balance 20 20 20 20 20 20 20
On- Net requirements 80
hand Planned order receipt 80
20 Planner order release 80
 Closed Loop MRP
Production Planning
Master Production Scheduling
Material Requirements Planning
Capacity Requirements Planning

No
Realistic? Feedback
Feedback
Yes
Execute:
Capacity Plans
Material Plans
 Manufacturing Resource Planning
(MRP II)

• Goal: Plan and monitor all resources of a

manufacturing firm (closed loop):
– manufacturing
– marketing
– finance
– engineering
• Simulate the manufacturing system
AGGREGATE PLANNING Pravin Kumar
OVERVIEW OF PLANNING LEVELS
Short-range plans (Detailed plans)
- Machine loading
- Job assignments

Intermediate plans (General levels)

- Employment
- Output

Long-range plans
- Long term capacity
- Location / layout
PLANNING HORIZON
Aggregate planning: Intermediate-range
range capacity planning, usually
covering 2 to 12 months.

Long range

Intermediate
range
Short
range

Now 2 months 1 Year

AGGREGATE PLANNING
• Combines appropriate resources into general terms
• Part of a larger production planning system
• Disaggregation breaks the plan down into greater detail
• Disaggregation results in a master production schedule
PLANNING SEQUENCE
Economic,
Corporate Aggregate
Aggregate
competitive,
strategies demand
demand
and political
and policies forecasts
forecasts
conditions

Establishes operations
Business Plan
and capacity strategies

Establishes
Aggregate plan
operations capacity

Establishes schedules
Master schedule
for specific products
AGGREGATE PLANNING INPUTS
Resources Costs
- Workforce - Inventory carrying
- Facilities - Back orders
- Hiring/firing
Demand forecast - Overtime
Policies - Inventory changes
- Subcontracting - subcontracting
- Overtime
- Inventory levels
- Back orders
AGGREGATE PLANNING OUTPUTS
Total cost of a plan
Projected levels of inventory
- Inventory
- Output
- Employment
- Subcontracting
- Backordering
 DEMAND OPTIONS
Pricing

Promotion

Back orders

New demand
CAPACITY OPTIONS
Hire and layoff workers
Overtime/slack time
Part-time workers
Inventories
Subcontracting
AGGREGATE PLANNING STRATEGIES
Maintain a level workforce
Maintain a steady output rate
Match demand period by period
Use a combination of decision
variables
BASIC STRATEGIES
Level capacity strategy:
- Maintaining a steady rate of regular-time
time output while meeting variations in demand by a combination
of options.

Chase demand strategy:

- Matching capacity to demand; the planned output for a period is set at the expected demand for that
period.
CHASE APPROACH
Advantages
- Investment in inventory is low
- Labor utilization in high

Disadvantages
- The cost of adjusting output rates and/or workforce levels
LEVEL APPROACH
Advantages
- Stable output rates and workforce

Disadvantages
- Greater inventory costs
- Increased overtime and idle time
- Resource utilizations vary over time
AGGREGATE PLANNING OPTIONS
Option Advantages Disadvantages Some Comments
Changing Changes in human Inventory holding cost Applies mainly to
inventory resources are may increase. production, not
levels gradual or none; no Shortages may service, operations.
abrupt production result in lost sales.
changes.

Varying Avoids the costs of Hiring, layoff, and Used where size of
workforce size other alternatives. training costs may labor pool is large.
by hiring or be significant.
layoffs
AGGREGATE PLANNING OPTIONS

Option Advantages Disadvantages Some Comments

Varying Matches seasonal Overtime premiums; Allows flexibility
production fluctuations without tired workers; may within the
rates through hiring/ training not meet demand. aggregate plan.
overtime or costs.
idle time

Sub-contracting Permits flexibility Loss of quality Applies mainly in

and smoothing of control; reduced production settings.
the firm’s output. profits; loss of future
business.
 AGGREGATE PLANNING OPTIONS
Option Advantages Disadvantages Some Comments
Using part-time Is less costly and High turnover/ Good for unskilled
workers more flexible than training costs; jobs in areas with
full-time workers. quality suffers; large temporary
scheduling difficult. labor pools.

Influencing Tries to use excess Uncertainty in Creates marketing

demand capacity. Discounts demand. Hard to ideas. Overbooking
draw new match demand to used in some
customers. supply exactly. businesses.
AGGREGATE PLANNING OPTIONS
Option Advantages Disadvantages Some Comments
Back ordering May avoid overtime. Customer must be Many companies
during high- Keeps capacity willing to wait, but back order.
demand constant. goodwill is lost.
periods

Counter- Fully utilizes May require skills or Risky finding products

seasonal resources; allows equipment outside or services with
product and stable workforce. the firm’s areas of opposite demand
service mixing expertise. patterns.
TECHNIQUES FOR AGGREGATE PLANNING
1. Determine demand for each period
2. Determine capacities for each period
3. Identify policies that are pertinent
4. Determine units costs
5. Develop alternative plans and costs
6. Select the best plan that satisfies objectives. Otherwise return to step 5.
5
ROOFING SUPPLIER EXAMPLE 1
Production Demand Per Day
Month Expected Demand Days (computed)
Jan 900 22 41
Feb 700 18 39
Mar 800 21 38
Apr 1,200 21 57
May 1,500 22 68
June 1,100 20 55
6,200 124

Average Total expected demand

requirement =
Number of production days
6,200
= = 50 units per day
124
 ROOFING SUPPLIER EXAMPLE 1
Forecast demand

70 – Level production using average

monthly forecast demand
60 –

50 –

40 –

30 –

0 –
Jan Feb Mar Apr May June = Month
ê ê ê ê ê ê
22 18 21 21 22 20 = Number of
working days
ROOFING SUPPLIER EXAMPLE 2
Cost Information
Inventory carrying cost $ 5 per unit per month
Subcontracting cost per unit $10 per unit
Average pay rate $ 5 per hour ($40 per day)
$ 7 per hour
Overtime pay rate
(above 8 hours per day)
Labor-hours to produce a unit 1.6 hours per unit
Cost of increasing daily production rate (hiring and $300 per unit
training)
Cost of decreasing daily production rate (layoffs) $600 per unit
ROOFING SUPPLIER EXAMPLE 2
Monthly
Production at Demand Inventory Ending
Month 50 Units per Day Forecast Change Inventory
Jan 1,100 900 +200 200
Feb 900 700 +200 400
Mar 1,050 800 +250 650
Apr 1,050 1,200 -150 500
May 1,100 1,500 -400 100
June 1,000 1,100 -100 0
1,850
Total units of inventory carried over from one
month to the next = 1,850 units
Workforce required to produce 50 units per day = 10 workers
ROOFING SUPPLIER EXAMPLE 2
Costs Calculations
Inventory carrying $9,250 (= 1,850 units carried x $5
per unit)
unit
Regular-time labor 49,600 (= 10 workers x $40 per
day x 124 days)
Other costs (overtime,
hiring, layoffs,
subcontracting) 0
Total cost $58,850

Total units of inventory carried over from one

month to the next = 1,850 units
Workforce required to produce 50 units per day = 10 workers
ROOFING SUPPLIER EXAMPLE 2
7,000 –

6,000 – Reduction
of inventory
5,000 – Cumulative level 6,200 units
Cumulative demand units

production using
4,000 – average monthly
forecast requirements

3,000 –

2,000 – Cumulative forecast

requirements
1,000 –
Excess inventory

–
Jan Feb Mar Apr May June
ROOFING SUPPLIER EXAMPLE 3
Demand Per Day
Month Expected Demand Production Days (computed)
Jan 900 22 41
Feb 700 18 39
Mar 800 21 38
Apr 1,200 21 57
May 1,500 22 68
June 1,100 20 55
6,200 124

Minimum requirement = 38 units per day

 ROOFING SUPPLIER EXAMPLE 3
Forecast demand

70 –
Production rate per working day

Level production using

60 – lowest monthly
forecast demand
50 –

40 –

30 –

0 –
Jan Feb Mar Apr May June = Month
ê ê ê ê ê ê
22 18 21 21 22 20 = Number of
working days
ROOFING SUPPLIER EXAMPLE 3
Cost Information
Inventory carrying cost $ 5 per unit per month
Subcontracting cost per unit $10 per unit
Average pay rate $ 5 per hour ($40 per day)
$ 7 per hour
Overtime pay rate
(above 8 hours per day)
Labor-hours to produce a unit 1.6 hours per unit
Cost of increasing daily production rate (hiring and $300 per unit
training)
Cost of decreasing daily production rate (layoffs) $600 per unit
ROOFING SUPPLIER EXAMPLE 3

In-house production = 38 units per day

x 124 days
= 4,712 units
Subcontract units = 6,200 - 4,712
= 1,488 units
 ROOFING SUPPLIER EXAMPLE 3
In-house production = 38 units per day
x 124 days
= 4,712 units
Costs Calculations
Regular-time labor $37,696 (= 7.6 workers x $40 per
day x 124 days)
Subcontracting 14,880 (= 1,488 units x $10 per
unit)

Total cost $52,576

ROOFING SUPPLIER EXAMPLE 4
Production Demand Per Day
Month Expected Demand Days (computed)
Jan 900 22 41
Feb 700 18 39
Mar 800 21 38
Apr 1,200 21 57
May 1,500 22 68
June 1,100 20 55
6,200 124

Production = Expected Demand

 ROOFING SUPPLIER EXAMPLE 4
Forecast demand and
monthly production
70 –
Production rate per working day

60 –

50 –

40 –

30 –

0 –
Jan Feb Mar Apr May June = Month
ê ê ê ê ê ê
22 18 21 21 22 20 = Number of
working days
ROOFING SUPPLIER EXAMPLE 4
Cost Information
Inventory carrying cost $ 5 per unit per month
Subcontracting cost per unit $10 per unit
Average pay rate $ 5 per hour ($40 per day)
$ 7 per hour
Overtime pay rate
(above
above 8 hours per day)
Labor-hours to produce a unit 1.6 hours per unit
Cost of increasing daily production rate (hiring and $300 per unit
training)
Cost of decreasing daily production rate (layoffs) $600 per unit
ROOFING SUPPLIER EXAMPLE 4
Basic Production Extra Cost of Extra Cost of
Daily Cost (demand x Increasing Decreasing
Forecast Prod 1.6 hrs/unit x Production (hiring Production (layoff
Month (units) Rate $5/hr) cost) cost) Total Cost
Jan 900 41 $ 7,200 — — $ 7,200
$1,200
Feb 700 39 5,600 — 6,800
(= 2 x $600)
$600
Mar 800 38 6,400 — 7,000
(= 1 x $600)
$5,700
Apr 1,200 57 9,600 — 15,300
(= 19 x $300)
$3,300
May 1,500 68 12,000 — 15,300
(= 11 x $300)
$7,800
June 1,100 55 8,800 — 16,600
(= 13 x $600)
$49,600 $9,000 $9,600 $68,200
 COMPARISON OF THREE PLANS
Cost Plan 1 Plan 2 Plan 3

Inventory carrying $ 9,250 $ 0 $ 0

Regular labor 49,600 37,696 49,600
Overtime labor 0 0 0
Hiring 0 0 9,000
Layoffs 0 0 9,600
Subcontracting 0 14,880 0
Total cost $58,850 $52,576 $68,200

Plan 2 is the lowest cost option

MATHEMATICAL APPROACHES
§ Useful for generating strategies
§ Transportation Method of Linear
Programming
§ Produces an optimal plan

§ Management Coefficients Model

§ Model built around manager’s experience and
performance

§ Other Models
§ Linear Decision Rule
§ Simulation
 OTHER MODELS
Linear Decision Rule
§ Minimizes costs using quadratic cost curves
§ Operates over a particular time period

Simulation
§ Uses a search procedure to try different
combinations of variables
§ Develops feasible but not necessarily optimal
solutions
Dell Case: Improving the Flexibility
of the Desktop Supply Chain

Pravin Kumar
30-08-2018

University School of Management and Entrepreneurship

DTU Delhi
Agenda

• L6 vs. L5 Value Comparison

• Root Causes Analysis

• Project Methodology & Next Steps

• Lessons Learned

2
Critical Components of a Desktop PC
& Major Component Manufacturers

Chipset
Motherboard
AMD
Intel ASUS
Foxconn
Intel
MiTAC
Printed Circuit
Board Desktop PC
BTI Electronics Acer
Compeq Apple
GCE Dell
Desktop Chassis Fujitsu Siemens
Plato Electronic
ASUS Gateway
Flextronics HP
LAN Chip Foxconn Lenovo/IBM
Broadcom MiTAC 3
Company list is not comprehensive.
Intel Lite-On Images used on this page belong to the respective companies.
L6 vs. L5
L6

MB
5 Weeks
China Dell
Integration Supplier Customer
Logistics Manufacturing
Center
Chassis

L5 3rd Party Integrator

(managed by Equipment
Manufacturers)

: L5 additional cost
MB
1 Week
Dell
Supplier Manufacturing
Chassis Logistics
Center Customer
5 Weeks
Problem Statement

Since July 2004, Dell and its contract manufacturers (CMs)

have had to adapt an increasing % of L5 manufacturing:
1. Empty chassis are shipped by ocean (L5) to Dell US &
Europe first. Motherboards are then air-freighted to Dell
US & Europe.
2. Dell incurs motherboard expedite/air-freight cost and 3rd-
party integration cost.
3. CMs incur cost for idle labor dedicated for MB-chassis
integration.

5
L6 vs. L5: Value Comparison

L6 L5
• Integrated offshore & outside a Dell facility • Integrated inside a Dell facility
• Integrated motherboard-inside chassis • Chassis shipped on water
shipped on water • Motherboards shipped by air
+ Labor savings + Increased supply chain flexibility
+ MB air-freighting costs are eliminated – Increased motherboard air-
+ Reduced motherboard packaging costs freighting costs
– Reduced supply chain flexibility – 3rd-party integration cost in US
– More motherboards need to be re-worked – Separate logistical costs for
in the event of an MB ECN chassis and motherboards

L6 is more cost-effective than L5.

6
L5 Driving Increasing Operational
Cost
Costs of air-freighting MBs and 3PI integration have been increasing.

Worldwide
Procurement
Expedite Council
established

7
AMF includes 3PI integration cost. EMF and APJ don’t as integration is done in Dell factory.
 L6 vs. L5 Shipments:
% Comparison
L5%
Dell Worldwide L5 vs. L6 Shipments Received
L6%
100%
from a Typical Contract Manufacturer
7% 6% 5% 4% 6% 4%
11% 9% 10%
14% 15%
90%
27%
80%

70% L5 shipped %
has been
60% increasing since
50%
March 2005.
93% 94% 95% 96% 94% 96%
89% 91% 90%
86% 85%
40%
73%
30%

20%

10%

0%
Jul-04 Aug-04 Sep-04 Oct-04 Nov-04 Dec-04 Jan-05 Feb-05 Mar-05 Apr-05 May-05 Jun-05

8
Root Causes Analysis

Majority of expedites are caused by chipset supply

shortage.
3.8%
8.3%

Chipset supplier decommit

or supply issues

24.5% Quality/Eng Issues

Dell Forecast Accuracy

63.5%
NPI

AMF Expedite $ by Root Cause (January to June ’05)

9
Project Methodology

BPI project team established to evaluate the

following 6 scenarios:
1. Keep as current: 3rd-Party Integrator (3PI) managed by
Equipment Manufacturers
2. DAO Cellular Integration: Enable the Dell factory work cells
to perform L5àL10 mfg work
3. Offline Integration: Keep the current L6àL10 mfg process
unchanged; add a separate facility to handle MB-chassis
integration work
a. At SLC (Supplier Logistics Center)
b. At a Dell-leased building
4. 3PI managed directly by Dell
5. L6 from Equipment Manufacturers’ Mexico plants 10
Factors to Considered

For each of the 6 scenarios, BPI project team assessed the

following attributes:
1. Process smoothness & sustainability
2. Cost per box
3. Product quality
4. Capital investment
5. Material handling/cost-accounting
6. Logistics

Project Goal:
Identify the optimal scenario
based on these input attributes.
11
 Complexity Analysis

Option 2 Option 2
Option 1 (original) (revised) Option 3A Option 3B Option 4 Option 5
Worldwide Procurement 10 1 1 1 1 5 10
Regional Procurement 8 5 5 5 5 5 10
Master Scheduler 5 5 5 5 5 5 5
Production Control 5 10 10 7 7 7 5
Operations 1 10 10 5 5 1 1
DAO Quality 5 10 10 5 5 1 1
Processing Engineering 1 10 10 5 5 1 1
Supplier Quality Eng
(Regional) 10 1 1 1 1 5 7
Supplier Quality Eng
(Global) 1 1 1 1 1 1 10
Cost Accounting 5 1 1 10 10 10 1
Inventory Control 1 5 5 5 7 10 1
Logistics 5 1 1 5 5 5 10
Total: 57 60 60 55 57 56 62
Cost per Box $10.07 $7.00 $7.90 $7.54 $7.70 $7.61 $7.00
Legend:
The “Cost per Box” data has been modified to respect Dell’s data confidentiality.
Option 1: EM-managed 3PI Option 2: Integration at DAO work cells
Option 3A: Integration at SLC/hub Option 3B: Integration at Dell-leased bldg
12
Option 4: Dell-managed 3PI Option 5: Integrated chassis from Mexico
Option 2 vs. 4: Value Comparison

Option 2: Integration at DAO Work Cells Option 4: Dell-managed 3PI

+ Lower capital expenditure investment + Dell has direct control over the 3PI
+ Less impact to business if chipset supply + More clear definition of quality issues
reverts to 100% L6 ownership
+ Fit the Dell Direct model better + Less manufacturing infrastructure
– Increased inbound & scheduling change required, less impact on
complexity existing supply chain network

– More part numbers to manage + Little additional capital expenditure

investment, little lead time change
– Factory thru-put rate is downgraded
– Only an incremental change from the
original manufacturing design

Option 4 enables Dell to focus on the more value-

added portion of the MB-chassis integration. 13
Lessons Learned

1. Supply chain coordination requires involvement from all

partners in the chain (customer, supplier, sub-tier
suppliers).
2. A well-planned strategy complements strong operational
execution ability from supply chain partners.
3. Change management requires 3 key ingredients:
• Top-down leadership
• Bottom-up engagement
• Cross-functional coordination
4. Qualitative judgment is just as important as or more
critical than quantitative analysis.
5. Working in a bi-lingual/bi-regional setting has its perks
and challenges. 14
Discussion and Q&A

Questions and Thoughts

15
Back-up

16
 Manufacturing Costs: L5 > L6.

Costs Common to L5 and L6

Costs of doing either L5 or L6: Type
Raw material costs Materials
China materials transportation costs Logistics
China assembler's cost (Foxconn performing L1-->L5) Labor
Chassis ocean-shipping cost Logistics
Chassis US transportation cost (trucks, rail) Logistics
Chassis inventory holding cost at SLC Inventory Holding
US assembler's cost at Dell (from L7-->L10) Labor

L6 Only Costs
Costs of doing L6, rather than L5: Type
China assembler's cost (Foxconn performing L6) Labor
L5 Only Costs
Costs of doing L5, rather than L6: Type
Motherboard packaging cost Materials
Motherboard air-freight/expedite cost Logistics
Motherboard US transportation cost Logistics
Motherboard inventory holding cost at SLC Inventory Holding
Chassis & motherboard US transportation cost
(from SLC to local/regional integrator and back) Logistics
Local/regional integration cost (Accurate, Saberex) Labor 17
Motherboard rework cost at Dell Labor/Quality
Dell L5 mgmt cost (e.g. Expedite Council) Labor
 Pros & Cons of the 6 Options

Description Pros Cons

1 Current • Least impact for Ops & PE • Most expensive option
Process, EM- • Dell does not own inventory during MB- • WWP and Regional Procure. have more intense EM and
managed 3PI chassis integration at 3PI 3PI mgmt/coordination
• Most difficult option for SQE
2 L6 at Dell work • Less complex for WWP • Long ramp time of new builders
cells • SQE mgmt is reduced • Difficult for PC to run deviations of both L5 and L6 in
• L5 and L6 parts are ordered and tracked one process simultaneously
independently à clear-cut Cost Accounting • Work cells config need to change à Greatest impact
• Easiest option for Logistics for Ops and PE
• DAO Quality concern from an L5-L6 hybrid mfg model

3 L6 at Dell SLC • Less complex for WWP • Most complex for Cost Accounting
A • SQE mgmt is reduced • Extra PC and IC headcounts required
3 L6 at Dell- • Less complex for WWP • Most complex for Cost Accounting and IC
B leased external • SQE mgmt is reduced • Extra PC and IC headcounts required
location
• Requires additional lease commitment

4 Dell-managed • Easiest option for Ops & PE • Most complex for Cost Accounting and IC – difficult to
3PI • DAO Quality expected to improve as Dell manage Parts Cost at a Dell-managed 3PI
directly manages 3PI
5 L6 from EM • Lowest possible cost compared to China L6 • Requires Regional Procure. to manage L6 out of EM
(China, Mexico, • Overall easiest option for Dell facilities from China, Mexico, and possibly other regions.
and/or • Increased SQE mgmt
elsewhere) • Most manageable for Master Sch./COC, PC,
IC, Ops, and DAO Quality 18
• Multi-regional logistics coordination is a concern.
Supply Chain Integration
Pravin Kumar
24-08-2018

University School of Management and Entrepreneurship

DTU Delhi
 Push-Based Supply Chains
l Production and distribution decisions based on long-term forecasts.
l Manufacturer’s demand forecasts is based on orders received from the
retailer’s warehouses.
l Longer reaction time to changing marketplace:
l Inability to meet changing demand patterns.
l Obsolescence of supply chain inventory as demand for certain
products disappears.
l Variability of orders received much larger than the variability in
customer demand due to the bullwhip effect.
l Excessive inventories due to the need for large safety stocks
l Larger and more variable production batches
l Unacceptable service levels
l Product obsolescence
 Bullwhip Effect in Push-
Based Supply Chains
l Leads to inefficient resource utilization
l Planning and managing are much more difficult.
l Not clear how a manufacturer should determine production capacity?
Transportation capacity?
l Peak demand?
l Average demand?
l Results:
l Higher transportation costs
l Higher inventory levels and/or higher manufacturing costs
l more emergency production changeovers
 Pull-Based Supply Chains
l Production and distribution demand driven
l Coordinated with true customer demand rather than forecast
demand
l firm does not hold any inventory and only responds to specific
orders.
l Intuitively attractive:
l Reduced lead times through the ability to better anticipate incoming
orders from the retailers.
l Reduced inventory since inventory levels increase with lead times
l Less variability in the system
l Decreased inventory at the manufacturer’s plant due to the reduction
in variability.
 Implementation of Pull-
Based Systems
l Often difficult to implement
l when lead times are long
limpractical to react to demand information.
l more difficult to take advantage of economies of scale
l Advantages and disadvantages of push and pull supply chains:
l new supply chain strategy that takes the best of both.
l Push–pull supply chain strategy
 Push-Pull Strategy
l Some stages of the supply chain operated in a push-based
manner
l typically the initial stages
l Remaining stages employ a pull-based strategy.
l Interface between the push-based stages and the pull-based
stages is the push–pull boundary.
 Supply Chain Timeline

FIGURE 1: Push-pull supply chains

 General Strategy
l Make a part of the product to stock – generic
product
l The point where differentiation has to be
introduced is the push-pull boundary
l Based on extent of customization, the position of
the boundary on the timeline is decided
Impact of Demand Uncertainty
and Economies of Scale
l Demand Uncertainty:
l Higher demand uncertainty leads to a preference for pull strategy.
l Lower demand uncertainty leads to an interest in managing the supply
chain based on a long-term forecast: push strategy.
l Economies of scale:
l The higher the importance of economies of scale in reducing cost
l The greater the value of aggregating demand
l The greater the importance of managing the supply chain based on
long-term forecast, a push-based strategy.
l Economies of scale are not important
l Aggregation does not reduce cost
l A pull-based strategy makes more sense.
 Implementing a Push–Pull
Strategy
l Achieving the appropriate design depends on many factors:
l product complexity
l manufacturing lead times
l supplier–manufacturer relationships.
l Many ways to implement a push–pull strategy
l location of the push–pull boundary.
lDell locates the boundary at the assembly point
lFurniture manufacturers locate the boundary at the
production point
 Impact of the Push-Pull
Strategy
l Push portion
l Low uncertainty
l Service level not an issue
l Focus on cost minimization.
l Long lead times
l Complex supply chain structures
l Cost minimization achieved by:
l better utilizing resources such as production and distribution
capacities
l minimizing inventory, transportation, and production costs.
l Supply Chain Planning processes are applied.
 Impact of the Push-Pull
Strategy
l Pull portion
l High uncertainty
l Simple supply chain structure
l Short cycle time
l Focus on service level.
l Achieved by deploying a flexible and responsive
supply chain
l Order-fulfillment processes are applied
Characteristics of the Push and
Pull Portions of the Supply
Chain
Portion Push Pull
Objective Minimize cost Maximize service level

Complexity High Low

Focus Resource allocation Responsiveness

Lead time Long Short
Processes Supply chain planning Order fulfillment
 Interactions of the Two
Portions
l Only at the push-pull boundary
l Typically through buffer inventory
l Different role for the inventory in each portion
l In the push portion, buffer inventory is part of the output generated
by the tactical planning process
l In the pull system, it represents the input to the fulfillment process.
l Interface is forecast demand
l Forecast based on historical data obtained from the pull portion
l Used to drive the supply chain planning process and determine the
buffer inventory.
 The Impact of Lead Time
l Longer the lead time, more important it is to implement a push
based strategy.
l Typically difficult to implement a pull strategy when lead times
are so long that it is hard to react to demand information.
 Impact of Lead Time

FIGURE 2: Matching supply chain strategies with products: the

impact of lead time and demand uncertainty
 Impact of Lead Time
l Box A
l Items with short lead time and high demand uncertainty
l Pull strategy should be applied as much as possible.
l Box B
l Items with long supply lead time and low demand uncertainty.
l Appropriate supply chain strategy is push.
l Box C
l items with short supply lead time and highly predictable demand.
l Continuous replenishment strategy
l Suppliers receive POS data
l They use these data to prepare shipments at previously agreed-upon intervals
l A pull strategy at the production and distribution stages and push at the retail outlets.
l Box D
l Items with long lead times are long and unpredictable demand
l Inventory is critical in this type of environment
l Requires positioning inventory strategically in the supply chain
 Demand-Driven Strategies

l Requires integrating demand information into the supply chain

planning process
l Demand forecast:
l Use historical demand data to develop long-term estimates of expected
demand
l Demand shaping:
l Firm determines the impact of various marketing plans such as promotion,
pricing discounts, rebates, new product introduction, and product withdrawal
on demand forecasts.
 Forecast Errors Are Always
Present
l High demand forecast error has a detrimental impact on supply chain performance
l Approaches to improve accuracy
l Aggregate forecasts are more accurate,
l Select the push–pull boundary so that demand is aggregated over one or
more of the following dimensions:
l Across products/geography/time
l Use market analysis and demographic and economic trends to improve forecast
accuracy.
l Determine the optimal assortment of products by store
l Reduce the number of SKUs competing in the same market.
l Incorporate collaborative planning and forecasting processes with your customers
l Demand forecast by SKU by location has to be supported by the supply chain
l Interaction of demand planning and tactical supply planning
l Iterative process
 The Impact of the Internet
on Supply Chain Strategies
l Expectation that increasing use of the internet would solve a
lot of the business problems
l Reality was very different
l Many of the problems in the internet-based businesses were
related to logistics strategies
 E-Business
l E-business: a collection of business models and processes
motivated by Internet technology and focusing on improvement
of extended enterprise performance.
l E-commerce: ability to perform major commerce transactions
electronically.
 Key Observations
l Internet technology is the force behind the business change.
l Focus on the extended enterprise
l Business-to-consumer (B2C)
l “direct to customer,”
l Retail activities over the Internet, and includes products,
insurance, banking, and so forth.
l Business-to-business (B2B)
l Conducted over the Internet predominantly between businesses.
l Includes:
l electronic sourcing (the so-called eSourcing)
l reverse auctions
l collaboration with suppliers and vendors to achieve common
goals.
 Grocery Industry
l Typical supermarket employs a push-based strategy
l Peapod was built on pure pull strategy with no inventory and no facilities.
l Significant service problems with high stockout rates
l Changed to a push–pull strategy by setting up a number of warehouses
l Warehouse covers a large geographical area
l Aggregated demand
l Other challenges:
l Reducing transportation costs
l Short response time
l Low customer density
l Products have low demand uncertainty
l high economies of scale in transportation cost
l push-based strategy is more appropriate.
 Book Industry
l Initial model of Amazon.com a pure pull system with no warehouses and no
stock.
l Ingram Book Group supplied most of Amazon’s customer demand.
l As volume and demand increased:
l Amazon’s service level was affected by Ingram Book’s distribution capacity
l Using Ingram Book in the first few years allowed Amazon.com to avoid
inventory costs but significantly reduced profit margins.
l As demand increased distributor no longer required.
l Current Amazon.com:
l Several warehouses around the country where most of the titles are stocked.
l Inventory at the warehouses is managed using a push strategy
l Demand satisfied based on individual requests, a pull strategy.
l Slow moving low volume books and CDs are not stocked at Amazon distribution
centers
l Amazon orders those when demand arrives.
 General Retail Industry
l Late to respond to competition from virtual stores and to
recognize the opportunities provided by the Internet.
l Brick-and-mortar companies are adding an Internet shopping
component to their offering.
l Already have the distribution and warehousing
infrastructure
l Click-and-mortar firms
l High-volume, fast-moving products stocked in stores
lPush strategy
l Low-volume, slow-moving products are stocked centrally
lPush-Pull strategy
 Traditional Fulfillment
Versus e-Fulfillment
Traditional fulfillment E-fulfillment

Supply chain strategy Push Push–pull

Shipment Bulk Parcel
Reverse logistics Small part of the Important and highly
business complex
Delivery destination Small number of stores Large number of
geographically
dispersed customers
Lead times Relatively long Relatively short
 Summary

l Implementation of push-pull strategies and demand-

driven strategies have helped many companies to
improve performance, reduce costs, increase service
levels.
l Companies need to:
l Identify the appropriate supply chain strategy for individual
products.
l Case for no physical infrastructure or inventory is tenuous
l Push–pull strategy
l advocates holding inventory
l although it pushes the inventory upstream in the supply chain.
SOURCING DECISIONS IN
A SUPPLY CHAIN
Pravin Kumar
OUTLINE
The Role of Sourcing in a Supply Chain
Supplier Scoring and Assessment
Supplier Selection and Contracts
Design Collaboration
The Procurement Process
Sourcing Planning and Analysis
Making Sourcing Decisions in Practice
Benefits and Risks of outsourcing
Outsourcing strategies
13-2
 THE ROLE OF SOURCING IN A SUPPLY CHAIN
Sourcing is the set of business processes
required to purchase goods and services.
Sourcing processes include:
-Supplier scoring and assessment
-Supplier selection and contract negotiation
-Design collaboration
-Procurement
-Sourcing planning and analysis
13-3
BENEFITS OF EFFECTIVE SOURCING
DECISIONS
Better economies of scale can be achieved if orders are
aggregated
More efficient procurement transactions can significantly
reduce the overall cost of purchasing
Design collaboration can result in products that are
easier to manufacture and distribute, resulting in lower
overall costs
Good procurement processes can facilitate coordination
with suppliers
Appropriate supplier contracts can allow for the sharing
of risk
Firms can achieve a lower purchase price by increasing
competition through the use of auctions 13-4
 SUPPLIER SCORING AND ASSESSMENT
Supplier performance should be compared
on the basis of the supplier’s impact on total
cost
There are several other factors besides
purchase price that influence total cost

13-5
 SUPPLIER ASSESSMENT FACTORS

Replenishment Lead Time Pricing Terms

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

13-6
SUPPLIER SELECTION- AUCTIONS
AND NEGOTIATIONS
Supplier selection can be performed through
competitive bids, reverse auctions, and direct
negotiations
Supplier evaluation is based on total cost of using a
supplier
Auctions:
-Sealed-bid first-price auctions
-English auctions
-Dutch auctions
-Second-price (Vickery) auctions
13-7
SUPPLIER SELECTION- AUCTIONS AND
NEGOTIATIONS
Sealed first-price auction, also known as a first-
price sealed-bid auction (FPSB). In this type of
auction, all bidders simultaneously submit sealed
bids so that no bidder knows the bid of any other
participant. The highest bidder pays the price
they submitted.
English auction, also known as an open ascending
price auction. This type of auction is arguably the
most common form of auction in use today.
Participants bid openly against one another, with
each subsequent bid higher than the previous bid.
SUPPLIER SELECTION- AUCTIONS AND
NEGOTIATIONS
Dutch auction also known as an open descending price
auction. In the traditional Dutch auction the auctioneer
begins with a high asking price which is lowered until
some participant is willing to accept the auctioneer's
price. The winning participant pays the last announced
price.
Vickrey auction, also known as a sealed-bid second-price
auction. This is identical to the sealed first-price auction
except that the winning bidder pays the second highest
bid rather than their own.
 CONTRACTS AND SUPPLY CHAIN
PERFORMANCE
Contracts for Product Availability and Supply Chain
Profits
- Buyback Contracts
- Revenue-Sharing Contracts
- Quantity Flexibility Contracts
Contracts to Coordinate Supply Chain Costs
Contracts to Increase Agent Effort
Contracts to Induce Performance Improvement

13-10
 CONTRACTS FOR PRODUCT
AVAILABILITY AND SUPPLY CHAIN
PROFITS
Many shortcomings in supply chain performance occur
because the buyer and supplier are separate organizations
and each tries to optimize its own profits.
Total supply chain profits might therefore be lower than if the
supply chain coordinated actions to have a common objective
of maximizing total supply chain profits.
An approach to dealing with this problem is to design a
contract that encourages a buyer to purchase more and
increase the level of product availability.
The supplier must share in some of the buyer’s demand
uncertainty.
13-11
 CONTRACTS FOR PRODUCT AVAILABILITY AND SUPPLY CHAIN
PROFITS: BUYBACK CONTRACTS
Supplier allows a retailer to return unsold inventory up to a
specified amount at an agreed upon price.
Supplier increases the optimal order quantity for the retailer,
resulting in higher product availability and higher profits for both
the retailer and the supplier
This is most effective for products with low variable cost, such as
music, software, books, magazines, and newspapers.
Downside is that buyback contract results in surplus inventory that
must be disposed of, which increases supply chain costs.
It can also increase information distortion through the supply chain
because the supply chain reacts to retail orders, not actual
customer demand.
13-12
 CONTRACTS FOR PRODUCT AVAILABILITY AND SUPPLY CHAIN
PROFITS: REVENUE SHARING CONTRACTS
The buyer pays a minimal amount for each unit purchased
from the supplier but shares a fraction of the revenue for
each unit sold.
Decreases the cost per unit charged to the retailer, which
effectively decreases the cost of overstocking.
It can result in supply chain information distortion, however,
just as in the case of buyback contracts.

13-13
 CONTRACTS FOR PRODUCT AVAILABILITY AND SUPPLY CHAIN
PROFITS: QUANTITY FLEXIBILITY CONTRACTS

It allows the buyer to modify the order (within limits) as

demand visibility increases closer to the point of sale.
Better matching of supply and demand
Increased overall supply chain profits if the supplier has
flexible capacity.
Lower levels of information distortion than either buyback
contracts or revenue sharing contracts.

13-14
CONTRACTS TO COORDINATE SUPPLY CHAIN COSTS

Differences in costs at the buyer and supplier can lead to

decisions that increase total supply chain costs.
Example: Replenishment order size placed by the buyer. The
buyer’s EOQ does not take into account the supplier’s costs.
A quantity discount contract may encourage the buyer to
purchase a larger quantity (which would be lower costs for
the supplier), which would result in lower total supply chain
costs.
Quantity discounts lead to information distortion because of
order batching.
13-15
 CONTRACTS TO INCREASE AGENT EFFORT

There are many instances in a supply chain where an agent

acts on the behalf of a principal and the agent’s actions
affect the reward for the principal.

Example: A car dealer who sells the cars of a manufacturer,

as well as those of other manufacturers.

13-16
 CONTRACTS TO INDUCE PERFORMANCE IMPROVEMENT

A buyer may want performance improvement from a supplier

who otherwise would have little incentive to do so.
A shared savings contract provides the supplier with
a fraction of the savings that result from the performance
improvement.
Particularly effective where the benefit from improvement
accrues primarily to the buyer, but where the effort for the
improvement comes primarily from the supplier.

13-17
 DESIGN COLLABORATION

80 percent of the cost of a purchased part is fixed in the design

phase.
Design collaboration with suppliers can result in reduced cost,
improved quality, and decreased time to market.
Important to employ design for logistics, design for
manufacturability.
Manufacturers must become effective design coordinators
throughout the supply chain.

13-18
 THE PROCUREMENT PROCESS
The process in which the supplier sends product in response to
orders placed by the buyer.
Goal is to enable orders to be placed and delivered on
schedule at the lowest possible overall cost.
Two main categories of purchased goods:
- Direct materials: components used to make finished goods
- Indirect materials: goods used to support the operations of
a firm.

13-19
THE PROCUREMENT PROCESS

Focus for direct materials should be on improving

coordination and visibility with supplier.
Focus for indirect materials should be on decreasing
the transaction cost for each order.
Procurement for both should consolidate orders where
possible to take advantage of economies of scale
and quantity discounts.
 SOURCING PLANNING AND ANALYSIS
A firm should periodically analyze its procurement spending and
supplier performance and use this analysis as an input for future
sourcing decisions.
Procurement spending should be analyzed by part and supplier to
ensure appropriate economies of scale.
Supplier performance analysis should be used to build a portfolio
of suppliers with complementary strengths
- Cheaper but lower performing suppliers should be used to supply
base demand
- Higher performing but more expensive suppliers should be used
to buffer against variation in demand and supply from the other
source
13-21
ISSUES RELATED TO SUPPLIER
SELECTION
The objective of managing the supply chain is to synchronize
the requirement of customers with the flow of materials from
suppliers in order to balance between conflicting goals of
high customer service, low inventory, and low unit cost

The supplier selection problem deals with

issues related to the selection of right
suppliers and their quota allocation.
BUYERS PROBLEM…
Make or buy decisions i.e., use a supplier or
not.
Use more / fewer or other supplier i.e.,
determination of number of suppliers.
Replacing the current supplier ?
How to deal with supplier.
SUPPLIER CHARACTERISTICS

1. Quality/Price ratio.
2. Delivery.
3. Flexibility.
4. Technical ability.
5. Information and market services.
6. Reputation.
7. Location
SUPPLIER CHAR…. (CONTINUED)

8. Technical innovativeness.
9. Previous contact with buyers.
10. Reciprocity.
11. Personal benefits received by buyers.
12. Required order size.
13. After sales support.
14. Financing.
ATTRIBUTES AND LEVEL OF SUPPLIER
PERFORMANCE
On time delivery
1. Seldom/few times.
2. Most time.
3. Almost always.
Quality
1. Poor (more than 5% defectives).
2. Good (2-5% defectives).
3. Excellent (less than 2% defectives).
ATTRIBUTES AND LEVEL OF SUPPLIER
PERF… (CONTINUED)
Price/cost
1. Above the target price (5%).
2. Approximately equal to target price.
3. Below the target price (3%).
Professionalism
1. Not highly professional.
2. Highly professional.
ATTRIBUTES AND LEVEL OF SUPPLIER
PERF… (CONTINUED)
Responsiveness to buyer
1. Low level of responsiveness.
2. Moderate level of responsiveness.
3. High level of responsiveness.
Quality of relationship with supplier.
1. Poor.
2. Good.
3. Excellent.
DECISIONS METHODS IN SUPPLIER
SELECTION.
Buy/not buy ?
More/fewer
More/fewer suppliers criteria.
Replacing current suppliers. All supplier audit
criteria really
necessary. Bidder
list/approved Quotation
Problem formulation vendors analysis
Order
Formulation of criteria allocation
Qualifications

Final selection
Qualitative tools

Quantitative tools
METHODS FOR SUPPORTING PRE
QUALIFICATION OF SUPPLIERS

Conjunctive Screening.
A supplier is acceptable if the supplier equals or
exceeds the minimum score on each criterion.
Disjunctive Screening.
A supplier is acceptable if the supplier at least
equals or exceeds the minimum score on one criterion.
METHODS FOR SUPPORTING PRE
QUALIFICATION OF SUP…
(CONTINUED)

Lexicographical screening
Criteria are ranked in order of importance. Suppliers
are first evaluated on the most important criterion.
Suppliers that passed that criterion are then
evaluated on second criterion and so on.
AN EXAMPLE OF SUPPLIER
SELECTION PROBLEM FOR
SINGLE ITEM
ATTRIBUTES AND SUB-ATTRIBUTES
OF SUPPLIERS.

1. Reliability (C1)
• Lead time (A1)
• Defect rate (A2)
• Perfect order fulfillment (A3)
2. Flexibility & Responsiveness (C2)
• Production flexibility (A4)
• Transport flexibility (A5)
• Supply Chain response time (A6)
3. Service (C3)
• On time delivery (A7)
• Base of communication (A8)
4. Cost (C4)
• Material cost (A9)
• Transportation cost (A10)
ANALYTICAL HIERARCHY FOR SUPPLIER
EFFICIENCY
SUPPLIER
EFFICIENCY

C1 C2 C3 C4

A1 A2 A3 A4 A5 A6 A7 A8 A9 A10

Supplier 1 Supplier 2 Supplier 3 Supplier 4

 ANALYTIC HIERARCHY PROCESS
(AHP)
AHP was developed by Saaty in 1965.
It is a multi-criteria decision-making tool which considers a number
of criteria and sub-criteria in different hierarchical levels.
All the criteria are compared to each other pair-wise.
The available information is decomposed into a hierarchy of
alternatives and criteria.
The information is then synthesized to determine the relative
ranking of alternatives.
Both qualitative and quantitative information can be compared
using informed judgments to derive weights and priorities.
INDUSTRIAL ENGG. & MANAGEMENT, 1/E PRAVIN KUMAR, PEARSON EDUCATION 36
 Decision Matrix

C- criteria, W-weight, C1 C2 C3 C4
A- alternative W1 W2 W3 W4
A1 a11 a12 a13 a1n
A2 a21 a22 a23 a2n
A3 a31 a32 a33 a3n
A4 m1 m2 m3 mn

i = 1,…, m. (number of alternatives),

j= 1,…, n. (no. of criteria)

37
AHP (Analytic Hierarchy Process)
Basic Procedure:
1. Decompose the problem into a hierarchy
2. Make pair-wise comparisons and establish priorities among the
elements in the hierarchy
3. Synthesize the results (to obtain the overall ranking of
alternatives w.r.t. goal)
4. Evaluate the consistency of judgement
Steps:
1. Develop the ratings for each decision alternative for each criterion by

• developing a pair-wise comparison matrix

for each criterion
• normalizing the resulting matrix

• averaging the values in each row to get the corresponding rating

• calculating and checking the

consistency ratio
38
2. Develop the weights for the criteria by

• developing a pair-wise comparison matrix for each

criterion
• normalizing the
resulting matrix
• averaging the values in each row to get the corresponding rating

• calculating and checking the consistency ratio

3. Calculate the weighted average rating for each

decision alternative. Choose the one with the highest
score.

39
Rating and Description of Criteria:

Rating Description
1 Equally preferred
3 Moderately preferred
5 Strongly preferred
7 Very strongly preferred
9 Extremely strongly preferred

Values 2, 4, 6, or 8 may also be assigned and represent preferences

halfway between the integers on either side.

n 1 2 3 4 5 6 7 8
RI 0 0 0.52 .89 1.11 1.25 1.35 1.4

40
Example – Car Selection Problem

w KBC corporation is planning to buy few cars for

its transport section. The following four criteria
has been identified for the selection of the car:
• Price
• Mileage per litre (MPL)
• Comfort
• Style
Use AHP to select the best of three cars named A, B and C
from the market.

41
Hierarchical Structure of Car Selection Problem

Car
Selection

Price MPL Comfort Style

Car A Car B Car C

42
 Priority of Criteria

Price MPL Comfort Style Priority

Price 1 3 2 2 0.398

MPL 1/3 1 1/4 ¼ 0.085

Comfort 1/2 4 1 1/2 0.218

Style 1/2 4 2 1 0.299

43
Price Car A Car B Car C Priority
Car A 1 1/3 1/4 0.123
Car B 3 1 1/2 0.320
Car C 4 2 1 0.577

MPL Car A Car B Car C Priority

Car A 1 1/4 1/6 0.087
Car B 4 1 1/3 0.274
Car C 6 3 1 0.639

44
Comfort Car A Car B Car C Priority
Car A 1 2 8 0.539
Car B 1/2 1 6 0.341
Car C 1/8 1/6 1 0.066

Style Car A Car B Car C Priority

Car A 1 1/3 4 0.265
Car B 3 1 7 0.655
Car C 1/4 1/7 1 0.080

45
Using AHP to Develop an Overall Priority Ranking
w The procedure used to compute the overall priorities for each decision
alternative by using the priority for each criterion as a weight that
reflects its importance.
w The overall priority for each decision alternative is obtained by
summing the products of the criterion priority times the priority of its
decision alternative.
w For example overall car A priority = .398 (.123) + .085 (.087) +
0.218 (.593) + .299 (.265)

Alternative Priority
Car A 0.265

Car B 0.421

Car C 0.314

46
Consistency Index

1. Multiply each column of the pair-wise comparison matrix by the

corresponding weight.
2. Divide of sum of the row entries by the corresponding weight.
3. Compute the average of the values from step 2, denote it by Lmax.
4. The approximate CI is

λmax − n
CI =
n −1
n 1 2 3 4 5 6 7 8
Consistency Ratio:
RI 0 0 0.52 .89 1.11 1.25 1.35 1.4

CR = CI / RI
•In practice, a CR of 0.1 or below is considered acceptable.
•Any higher value at any level indicate that the judgements warrant
47
re-examination.
 Consistency of Comfort Matrix

 1 2 8  0.539 
1/ 2 1 6   0.341 =
  
1/ 8 1/ 6 6  0.066 

1  2  8   0 .593   0 .682   0 .528  1 .803 

0 .593 1 / 2  + 0 .341 1  + 0 .066  6  =  0 .297  +  0 .341  +  0 .396  = 1 .034 
1 / 8  1 / 6  1   0 .074   0 .057   0 .066   0 .197 
1 .803 / 0 .593 = 3 .040 , 1.034/0.34 1 = 3.032, 0.197/0.66 = 2.985
λ = (3.040 + 3.032 + 2.985)/3 = 3.019
CI = (3.019 - 3)/2 = 0.010
RI = 0.58
CR = 0.01/0.58 = 0.017 48
ATTRIBUTES AND SUB-ATTRIBUTES
OF SUPPLIERS
1. Reliability (C1)
• Lead time (A1)
• Defect rate (A2)
• Perfect order fulfillment (A3)
2. Flexibility & Responsiveness (C2)
• Production flexibility (A4)
• Transport flexibility (A5)
• Supply Chain response time (A6)
3. Service (C3)
• On time delivery (A7)
• Base of communication (A8)
4. Cost (C4)
• Material cost (A9)
• Transportation cost (A10)
ANALYTICAL HIERARCHY FOR SUPPLIER
EFFICIENCY
SUPPLIER
EFFICIENCY

C1 C2 C3 C4

A1 A2 A3 A4 A5 A6 A7 A8 A9 A10

Supplier 1 Supplier 2 Supplier 3 Supplier 4

 INFORMATION REGARDING THE SUPPLIERS

supplier Lead Defect Perfect Producti Transpo Supply On Rating Mate Transpo
Time Rate Order on rtation Chain time for rial rtation
(days) (%) Fulfillme Flexibilit Flexibili response deliver base of cost cost ($)
nt (%) y (%) ty (%) time y (%) comm ($)
(Days) unicati
on
S1 4 0.03 95 5 5 2 90 0.3 9 7
S2 3 0.02 90 4 9 4 80 0.9 5 5
S3 3 0.025 90 4 10 3 70 0.9 8 6
S4 5 0.01 98 7 7 3 95 0.4 7 8
PRIORITY OF CRITERIA

0.6 0.57

0.5

0.4
priority

0.3 0.267

0.2

0.089
0.1 0.067

0
C1 C2 C3 C4
criteria
PRIORITY OF SUB CRITERIA
0.45 0.43

0.4

0.35

0.3
Priority

0.25

0.2
0.17

0.15 0.14

0.1
0.07 0.067
0.06
0.05 0.03 0.025 0.02
0.017

0
A1 A2 A3 A4 A5 A6 A7 A8 A9 A10
Sub-criteria
RATING OF SUPPLIERS

29 32 supplier-1
Supplier-2
22 17
supplier-3
supplier-4
Objective (1) Total value of purchase.
Objective(2) Total defective.
Objective (3) Total cost.
Constraint (4) Total demand.
Constraint (5) Capacity of supplier-1.
Constraint (6) capacity of supplier-2.
Constraint (7) Capacity of supplier-3.
Constraint (8) Capacity of supplier-4.
Objective Value -I Value-II
Function
Total value of 4050 5085*
purchase

Total defects 350* 490

Total cost 2,62,000* 2,90,000

 0 ; Z 1 ≤ 4050
 ( 5085 − Z 1 )

µ (Z 1 ) =  1 − ; 4050 ≤ Z 1 ≤ 5085 − − − (14 )
 1035
 1 ; Z 1 ≥ 5085

1 ; Z 2 ≤ 350
 ( Z 2 − 350 )

µ (Z 2 ) =  1 − ; 350 ≤ Z 2 ≤ 490 − − − − − (15 )
 140
 0 ; Z 2 ≥ 490

1 ; Z 3 ≤ 2 , 62 , 000

 ( Z − 2 , 62 , 000 )
µ (Z 3 ) = 1 − 3 ; 2 , 62 , 000 ≤ Z 3 ≤ 2 , 90 , 000 − − (16 )
 28 , 000
 0 ; Z 3 ≥ 2 , 90 , 000
Maximize λ

(5085 − Z 1 )
λ ≤ 1− , − − − − (17)
1035
( Z 2 − 350)
λ ≤ 1− , − − − (18)
140
( Z 3 − 2, 62, 000)
λ ≤ 1− , − − − (19)
28, 000

Subject to constraint (4) to (8)

MAX = λ;
-1035*λ + Z1 >= 4050;
140*λ + Z2 <= 490;
28000*λ + Z3 <= 290000;
Z1-0.318*X1 - 0.173*X2-0.219*X3-0.290*X4=0;
Z2-0.03*X1 - 0.02*X2 - 0.025*X3 -
0.01*X4=0;
Z3 - 12*X1 - 14*X2 - 13*X3 - 16*X4=0;
X1 + X2 + X3 + X4 = 20000;
X1 <= 4000;
X2 <= 1500;
X3 <= 10000;
X4 <= 5000;
Using LINGO software.

λ= 0.3928
Z1= 5012
Z2= 435
Z3= Rs. 2,73,000
X1= 3500
X2= 1500
X3= 10000
X4=5000
OTHER METHODS USED FOR SUPPLIER
SELECTION

Analytical Network Process.(ANP)

Interpretive Structural modeling.(ISM)
Data Envelopment Analysis.(DEA)
Mathematical Programming (MP), etc.
SUPPLY CHAIN RISK
MANAGEMENT
Pravin Kumar
Introduction
■ Supply chain risks can be categorized into disruptions,
delays, systems, forecast, intellectual property,
procurement, receivables, inventory, and capacity.
capacity
■ Supply chain risk management isn’t just about identifying
and mitigating against natural disasters and other “big”
events but there are countless other risks associated,
■ some include: daily fluctuations
luctuations in demand and supply,
rapid growth, changes to the supplier base, changes to IT
systems, and counterfeit and contaminated products.
products
■ Information risk can be viewed as a factor that contributes
to supply chain risks.
■ Information risk can be defined as the probability of loss
arising because of incorrect, incomplete, or illegal access to
information.
bullwhip effect”,
■ Under this definition, the “bullwhip effect that is the
distortion and amplification of demand information as it
moves up the supply chain can be categorized as one of the
factors in information risk.
Dimensions of Supply Chain Risks

■ physical dimension;
■ informational dimension;
■ financial dimension;
■ security dimension;
■ relationship dimension; and
■ corporate social responsibility dimension.
Why are today’s supply
chains so vulnerable?

● Widespread adoption of ‘lean’ practices

● The move to off-shore

shore manufacturing and sourcing

● Out-sourcing
sourcing and reduction in the supplier base

● Global consolidation of suppliers

● Centralised production and distribution

All of which combine to make supply chains vulnerable

to disruption
Supply chain risk (i)
“The entire Japanese vehicle industry ground to a halt
following an earthquake that stopped production of piston
rings for engines provided by Riken, the industry leader in
the domestic market.

Toyota, in particular, was forced to stop operations at all 12

of its domestic plants.”

Financial Times, 24 July 2007

Supply chain risk (ii)
“A fire at a key Philips semiconductor factory in 2000
caused a worldwide shortage of the radio frequency chips
used by both Nokia and Ericsson. Nokia immediately lined
up another source and redesigned other chips so they could
be produced elsewhere. However, Ericsson responded more
slowly and lost an estimated $400 million in mobile phone
handsets.”

MIT Sloan Management Review

Summer 2006
Supply chain risk is systemic

• The biggest risk to business continuity

may lie outside the company in the wider
supply chain

• The complexity and inter-connectedness

inter
of modern supply chains increases their
vulnerability to disruption

• Environmental risks are outside our

control, but systemic risk is created
through our own decisions
There are two generic categories of supply
chain risk
• Supply chains comprise nodes and links

• Nodes – organisational risk

• Links – network risk

 Supply Chain Risk Management

“The identification and management of risks within the

supply chain and risks external to it through a
coordinated approach amongst supply chain members
to reduce supply chain vulnerability as a whole”.

“Avoiding the loss of customer confidence and the

erosion of shareholder value resulting from supply
chain disruption.”
Risk = probability of occurrence x consequences
The risk management challenge

High
Consequence/
Impact

Low

Low High
Probability of Occurence

• Where can we reduce the probability?

• How can we reduce the consequence?
The five sources of risk

■ Supply risk

■ Demand risk

■ Process risk

■ Control risk

■ Environmental risk
Location of risk in the supply chain

SUPPLY PROCESS DEMAND

RISK RISK RISK

NETWORK/
CONTROL
RISK

Environmental Risk
 The five sources of supply chain risk

Demand Risk Supply Risk Process Risk

• Loss of major accounts • Dependency on key suppliers • Manufacturing yield varia

• Volatility of demand • Consolidation in supply markets • Lengthy set-up times and
• Concentration of customer • Quality and management issues
arising from off-shore
off sourcing
inflexible processes
• Equipment reliability
base
• Potential disruption at 2nd tier level • Limited capacity/bottlene
• Short life cycles • Length and variability of • Outsourcing key busines
• Innovative competitors replenishment lead-times
lead processes

Network/Control Risk Environment Risk

• Asymmetric power relationships • Natural disasters
• Poor visibility along the pipeline • Terrorism and war
• Inappropriate rules that distort demand • Regulatory changes
• Lack of collaborative planning and forecasts • Tax, duties and quotas
• Bullwhip effects due to multiple echelons • Strikes
Global business : Singer Sewing
Machines

hBody
Body shells from USA

hMotors from Brazil

hDrive
Drive Shafts from Italy

hAssembled
Assembled in Taiwan

hSold
Sold around the world
 Pipeline Inventories
• Due to the length and increased uncertainty of global product
pipelines, both planned and unplanned inventories may be higher
than optimal
Illustrative inventory comparison: domestic vs.
global product pipelines each with customer
demand of 10 per week
Domestic Pipeline = 70 units inventory

Plant Transit DC Transit

20 20 20 10

Global Pipeline = 170 units inventory

Plant Transit
Transit Origin Ocean Destination Transit DC
30 10
20 Forwarder Transit Forwarder 20 30
20 20 20
Information Technology

■ The information technology focuses on the management of

information flows and represents a philosophy of managing
technology and processes in such a way that the enterprise
optimizes the delivery of goods, services and information
from the supplier to the customer.
 Application of IT in a supply chain

■ information sharing; ■ enhanced collaboration;

■ better integration; ■ reduced transaction costs;
■ access to global markets; ■ product and service customizatio
■ global partnerships; ■ increased agility; and
■ changed production methods; ■ real time information capture.
■ improved customer service;
Information Risks

■ Risk is the combination of the two basic dimensions:

possible consequences and associated uncertainties.
■ The focus of supply chain risk management is to
understand, and try to avoid, the devastating ripple effects
that disasters or even minor business disruptions can have
in a supply chain.
Classification of Information risks

■ information security/breakdown risks;

■ forecast risks;
■ intellectual property rights risks; and
■ IT/IS outsourcing risks.
Information security/breakdown risks
Hackers, viruses and worms
■ Viruses, worms and Trojans are common menace to information
systems.
■ In a supply chain Tier II and Tier III level suppliers who are
generally small and medium enterprises, are the ones most
susceptible to such problems.
■ Common reasons are non-availability
availability of funds and lack of
information security policy.
■ Also as technology has made web an integral and necessary
part of a business operation, hackers are using this technique
to find confidential information which they use as backdoor
entry into a company’s innermost secrets.
Spyware
■ It is a program that resides on computers linked to the
internet and surreptitiously collects various types of
personal information.
■ So in a supply chain they may pose threat by illegal transfer
of proprietary information.
Internal employee frauds.
■ This is one of the important information risks faced by
organizations.
■ Some of the common reasons are employee attrition,
intentional/ unintentional disclosure of proprietary
information or in some cases personal vendetta against the
company.
Distributed denial of services attacks
■ The three most common categories of DDoS are bandwidth
consumption, resource starvation, and resource exploitation.
■ These attacks interrupt legitimate access to the networks that may
ultimately result in interruption to supply chain operations.
Natural disasters and terrorist attacks
■ Tsunami,, hurricanes (e.g. Katrina and Rita), fires or terrorist attacks
like 9/11 have brought forth the importance of not only data backu
but have made organizations to seriously think of mirror sites to
keep the flow of information uninterrupted in a supply chain.
■ Also the omnipresent internet technology could be leveraged by the
terrorists to sieve contents of government web sites and find
potential targets, identify or exploit weaknesses, obtain and
integrate disparate information.
Forecast risks
■ Forecast risks results from a mismatch between a
company’s projections and actual demand.
■ All kinds of information distortions in a supply chain, often
lead to the forecast risks.
Major causes of information distortion are:
Ø promotions and incentives that lead to forward buying;
Ø Lack of knowledge of end-customer
customer demand at upstream
locations leading to inaccurate demand forecast
updating;
Ø order batching leading to higher volatility in orders;
Ø price fluctuation; and
Ø rationing and shortage gaming.
Intellectual property rights (IPR) risks
■ Intellectual property right (IPR) is a right given over a
creation of the mind and to exclusively exploit it for a certain
period of time.
■ In a supply chain context ownership of knowledge and its
legal use in cooperative development activities to make
rapid innovations with quick diffusion to the market place
and fair sharing of benefits are the key means to success.
■ With a growing trend for outsourcing non-core
non activities,
risks associated with intellectual property have become
important.
■ In the last decade China and India has emerged as low cost
destinations but these countries have a poor track record of
IP protection.
IT/IS outsourcing risks
■ Pervasive adoption of IT has made information technology
outsourcing (ITO) a growing multi-billion
multi dollar industry.
■ IT outsourcing is broadly defined as a decision taken by an
organization to contract-out
out or sell the organization's IT
assets, people and/or activities to a third-party
third supplier,
who in exchange provides and manages assets and services
for monetary returns over an agreed time period.
Managing supply chain risk

● Map the supply chain

● Identify the critical paths
● Utilise cause and effect analysis (TQM tools)
● Implement supply chain event management
● Adopt agile practices
● Formalise supply chain risk management
Identify the critical path(s)

Critical paths are characterised by:-

by:

• long lead-times
• no short-term
term alternative source of supply
• bottlenecks
• high levels of identifiable risk (i.e. supply, demand,
process, control and environmental risk)
Use cause and effect analysis

e.g.

● pareto analysis
● asking ‘why?’ five times
● fishbone charts
● failure mode and effects analysis

80% of disruptions will share 20% of the causes

 Asking “why?” five times

1. Q. Why did the machine stop?

A. There was an overload and the fuse blew.

2. Q. Why was there an overload?

A. The bearing was not sufficiently lubricated.

3. Q. Why was it not sufficiently lubricated?

A. The lubrication pump was not pumping sufficiently.

4. Q. Why was it not pumping sufficiently?

A. The shaft of the pump was worn and rattling.

5. Q. Why was the shaft worn?

A. There was no strainer and metal scrap got in.

Repeating why five times like this can help uncover the root problem and
correct it. If this procedure were not carried through, one might simply
replace the fuse or the pump shaft. In that case the problem would
reoccur in a few months.

Taiichi Ohno
Toyota Production System
Cause and effect analysis

No Stock Lead-Time
Available Too Short
Materials
Supply Problem Failure to Inflexible
Achieve Plan Systems
Forecasting
Capacity Problems
Failure to Constraint
Deliver on
Time Inadequate
Communications Poor Process
Control
Inadequate
Supplier
Poor Management
Scheduling
Carrier Quality
Performance Problems
Failure mode and effects analysis
(FMEA)

• Asks three questions:

- What could go wrong?
- What effect would this failure have?
- What are the key causes of this failure?

• Provides an assessment of risk for each

possible failure:
S = severity of effect
O = likelihood of occurrence
D = likelihood of detection
 Agility holds the key
Agile supply chains are designed to respond rapidly to
unpredictable change. They are based upon a number of
principles:-

• Very close connection to final marketplace

• Visibility of real demand
• High levels of synchronicity upstream and
downstream
• Organisational focus on processes rather than
functions
• Advanced level of collaborative planning with
supply chain partners
• Continuous search for time compression
opportunities
Robust or resilient?
• A robust process can be defined as “a process able to
deal with reasonable variability”

• A resilient supply chain can be defined as “a supply

chain with the ability to recover quickly from
unexpected events impacting supply chain
performance”

A robust process can deal with reasonable variability in

input whilst maintaining good control over output
variability. It has some resilience but is it capable of
recovery from an event that causes exceptionally high
levels of variability in input or output requirement?
Characteristics of Robust and Resilient supply chains
Robust Resilient
‘Lean thinking’ central to Risk mitigation central to supply chain management
supply chain management
Lean Agile
Strong Elastic
Internal quality control Internal and external risk management
Responsive to reasonable Capable of responding to sudden and significant variation in input
variation in input
Low inventory levels Built in spare capacity and buffers at critical nodes
throughout
Supply chain Velocity Supply chain Velocity & Acceleration
A culture of quality A culture of risk and quality awareness
awareness (i.e. Six
Sigma)
Processes are stable and under control
Non-value
value adding activities and processes removed
Creating a Resilient Supply Chain: Strategic Approach
Supply Chain
Understanding
Supply Chain Supply Base
Design Strategy

1. Supply Chain
(re)engineering Collaborative
Visibility Planning

The Resilient 2. Supply Chain

4. Agility
Supply Chain Collaboration

Supply Chain
Velocity Intelligence
3. Supply Chain
Risk Management
Supply Chain Culture
Consider risk in
Continuity
decision making
Teams
Board level
responsibility &
leadership
Betting on Uncertain
Demand:
Newsvendor Model
The Newsboy Model: an Example
Mr. Tan, a retiree, sells the local newspaper at
a Bus terminal. At 6:00 am, he meets the
news truck and buys # of the paper at $4.0
and then sells at $8.0. At noon he throws
the unsold and goes home for a nap.

If average daily demand is 50 and he buys

just 50 copies daily, then is the average
daily profit =50*4 =$200?
NO!
 Betting on Uncertain Demand
• You must take a firm bet (how much stock
to order) before some random event
occurs (demand) and then you learn that
you either bet too much or too little

• More examples: Products for the

Christmas season; Nokia’s new set,
winter coats, New-Year Flowers, …
 Bossini -- Winter Clothes

• Season: Dec. – Jan./Feb.

• Purchase of key materials (fabrics,

dyeing/printing, …) takes long times (upto
90 days)

• Into the selling season, it is too late!

 Seattle
Denver Hong
Kong
Case: Sport
Obermeyer
 The SO Supply Chain
Shell Fabric

Lining Fabric Subcontractors

Insulation mat.
Cut/Sew Distr Ctr Retailers
Snaps

Zippers

Others
Textile Suppliers Obersport Obermeyer Retailers
 Order Cycle
and Supply Chain(cont’d)
Design Phase
Obermeyer Obersport Retailer
Design Order receipt Materials Retail
Month activities and prod'n planning management Production activities
Jan-92
Feb-92 Design process
begins
Mar-92 Las Vegas show
for 92-93 line
Apr-92
May-92 Concepts finalized

Jun-92
Jul-92 Sketches sent to
Obersport
Aug-92 Prototype production
Sep-92 Designs finalized Prototype production
Oct-92 Sample production
 Order Cycle
and Supply Chain(cont’d)
Obermeyer
Production Phase Obersport Retailer
Design Order receipt Materials Retail
Month activities and prod'n planning management Production activities
Nov-92 Place first production Receive first order Sample production
order with Obersport *Calculate fabric and
comp. Requirements
*Order components
*Place print dye orders
Dec-92 Sample production
Jan-93 Chinese new year vac. Chinese new year vac.
Feb-93 Full-scale production
Mar-93 *Las Vegas show for Receive second order Full-scale production
93-94 line(80% of re- *calculate fabric and
tailers' initial orders comp. Requirement
received *order components
*Place second produ- *place print dye orders
ction order with
Obersport
Apr-93 Additional retailer or- Full-scale production
ders received
May-93 Additional retailer or- Full-scale production
ders received
Jun-93 Additional retailer or- Full-scale production
ders received Ship finished goods
Jul-93 Full-scale production
Ship finished goods
Aug-93 Full-scale production 93-94 line deliv.
Airfreight fin. Goods to tetailers
 Order Cycle
and Supply Chain(cont’d)
Selling Phase
Obermeyer Obersport Retailer
Design Order receipt Materials Retail
Month activities and prod'n planning management Production activities
Sep-93 Retail selling
period
Oct-93 Retail selling
period
Nov-93 Retail selling
period
Dec-93 Retailer replenishment Peak retail selling
orders reeceived period
Jan-94 Retailer replenishment Peak retail selling
orders reeceived period
Feb-94 Retailer replenishment Retail selling
orders reeceived period
Mar-94 Retail selling
period
Apr-94 Retail selling
period
O’Neill’s Hammer 3/2 wetsuit

11-13
 Hammer 3/2 timeline and economics
Generate forecast
of demand and Economics:
submit an order • Each suit sells for
to TEC Spring selling season p = $180
• TEC charges
c = $110 per suit
Nov Dec Jan Feb Mar Apr May Jun Jul Aug • Discounted suits
sell for v = $90
Receive order Left over
from TEC at the units are
end of the discounted
month

• The “too much/too little problem”:

– Order too much and inventory is left over at the end of the
season
– Order too little and sales are lost.
• Marketing’s forecast for sales is 3200 units.
11-14
 Newsvendor model
implementation steps
• Gather economic inputs:
– Selling price, production/procurement cost, salvage
value of inventory
• Generate a demand model:
– Use empirical demand distribution or choose a
standard distribution function to represent demand,
e.g. the normal distribution, the Poisson distribution.
• Choose an objective:
– e.g. maximize expected profit or satisfy a fill rate
constraint.
• Choose a quantity to order.
11-15
The Newsvendor Model:

Develop a Forecast

Just one approach

11-16
Historical forecast performance at O’Neill
7000

6000
.

5000
Actual demand

4000

3000

2000

1000

0
0 1000 2000 3000 4000 5000 6000 7000
Forecast

Forecasts and actual demand for surf wet-suits from the previous season
11-17
 Empirical distribution of forecast accuracy
Product description Forecast Actual demand Error* A/F Ratio**
JR ZEN FL 3/2 90 140 -50 1.56
EPIC 5/3 W/HD 120 83 37 0.69
JR ZEN 3/2 140 143 -3 1.02
WMS ZEN-ZIP 4/3 170 163 7 0.96
HEATWAVE 3/2 170 212 -42 1.25
JR EPIC 3/2 180 175 5 0.97
WMS ZEN 3/2 180 195 -15 1.08
ZEN-ZIP 5/4/3 W/HOOD 270 317 -47 1.17
WMS EPIC 5/3 W/HD 320 369 -49 1.15 100%
EVO 3/2 380 587 -207 1.54
JR EPIC 4/3 380 571 -191 1.50
90%
WMS EPIC 2MM FULL 390 311 79 0.80 80%
HEATWAVE 4/3 430 274 156 0.64
ZEN 4/3 430 239 191 0.56
70%

Probability
EVO 4/3 440 623 -183 1.42 60%
ZEN FL 3/2 450 365 85 0.81
HEAT 4/3 460 450 10 0.98 50%
ZEN-ZIP 2MM FULL 470 116 354 0.25 40%
HEAT 3/2 500 635 -135 1.27
WMS EPIC 3/2 610 830 -220 1.36 30%
WMS ELITE 3/2 650 364 286 0.56 20%
ZEN-ZIP 3/2 660 788 -128 1.19
ZEN 2MM S/S FULL 680 453 227 0.67 10%
EPIC 2MM S/S FULL 740 607 133 0.82 0%
EPIC 4/3 1020 732 288 0.72
WMS EPIC 4/3 1060 1552 -492 1.46 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75
JR HAMMER 3/2 1220 721 499 0.59
HAMMER 3/2 1300 1696 -396 1.30 A/F ratio
HAMMER S/S FULL 1490 1832 -342 1.23 Empirical distribution function for the historical A/F ratios.
EPIC 3/2 2190 3504 -1314 1.60
ZEN 3/2 3190 1195 1995 0.37
ZEN-ZIP 4/3 3810 3289 521 0.86
WMS HAMMER 3/2 FULL 6490 3673 2817 0.57
* Error = Forecast - Actual demand
** A/F Ratio = Actual demand divided by Forecast
How do we know “actual d’d” if it
exceeded forecast? 11-18
 Normal distribution tutorial
• All normal distributions are characterized by two parameters, mean = µ and
standard deviation = σ
• All normal distributions are related to the standard normal that has mean = 0
and standard deviation = 1.
• For example:
– Let Q be the order quantity, and (µ, σ) the parameters of the normal
demand forecast.
– Prob{demand is Q or lower} = Prob{the outcome of a standard normal
is z or lower}, where

Q−µ
z= or Q = µ + z × σ
σ
– (The above are two ways to write the same equation, the first allows you
to calculate z from Q and the second lets you calculate Q from z.)
– Look up Prob{the outcome of a standard normal is z or lower} in the
Standard Normal Distribution Function Table.
11-19
 Converting between Normal distributions
0.0180
Start with 0.0160 Center the
µ= 100, 0.0140
distribution over 0
σ= 25, 0.0120
by subtracting the
0.0100
Q = 125 0.0080 mean
0.0060
0.018
0.0040
0.016
0.0020
0.014
-
0 25 50 75 100 125 150 175 200 0.012
0.01
0.008
0.006
0.004
0.45
0.002
Q−µ
0.40
0
z= 0.35

σ
-100 -75 -50 -25 0 25 50 75 100
0.30

125 − 100 0.25

= 0.20
25 0.15 Rescale the x and y
=1 0.10
axes by dividing by
0.05

0.00 the standard

-4 -3 -2 -1 0 1 2 3 4
deviation
11-20
 Using historical A/F ratios to choose a Normal
distribution for the demand forecast

• Start with an initial forecast generated from hunches, guesses, etc.

– O’Neill’s initial forecast for the Hammer 3/2 = 3200 units.
• Evaluate the A/F ratios of the historical data:
Actual demand 1. Why not just order/buy 3200 units? It
A/F ratio = is the most likely outcome!
Forecast
2. Forecasts always are biased, so
order less than 3200
3. Gross margin is 40%, should order
• Set the mean of the normal distribution to more, if is a hit
Expected actual demand = Expected A/F ratio × Forecast

• Set the standard deviation of the normal distribution to

Standard deviation of actual demand =
Standard deviation of A/F ratios × Forecast

11-21
 Empirical distribution of forecast accuracy
Product description Forecast Actual demand Error* A/F Ratio**
JR ZEN FL 3/2 90 140 -50 1.56
EPIC 5/3 W/HD 120 83 37 0.69
JR ZEN 3/2 140 143 -3 1.02
WMS ZEN-ZIP 4/3 170 163 7 0.96
HEATWAVE 3/2 170 212 -42 1.25
JR EPIC 3/2 180 175 5 0.97
WMS ZEN 3/2 180 195 -15 1.08
ZEN-ZIP 5/4/3 W/HOOD 270 317 -47 1.17
WMS EPIC 5/3 W/HD 320 369 -49 1.15 100%
EVO 3/2 380 587 -207 1.54
JR EPIC 4/3 380 571 -191 1.50
90%
WMS EPIC 2MM FULL 390 311 79 0.80 80%
HEATWAVE 4/3 430 274 156 0.64
ZEN 4/3 430 239 191 0.56
70%

Probability
EVO 4/3 440 623 -183 1.42 60%
ZEN FL 3/2 450 365 85 0.81
HEAT 4/3 460 450 10 0.98 50%
ZEN-ZIP 2MM FULL 470 116 354 0.25 40%
HEAT 3/2 500 635 -135 1.27
WMS EPIC 3/2 610 830 -220 1.36 30%
WMS ELITE 3/2 650 364 286 0.56 20%
ZEN-ZIP 3/2 660 788 -128 1.19
ZEN 2MM S/S FULL 680 453 227 0.67 10%
EPIC 2MM S/S FULL 740 607 133 0.82 0%
EPIC 4/3 1020 732 288 0.72
WMS EPIC 4/3 1060 1552 -492 1.46 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75
JR HAMMER 3/2 1220 721 499 0.59
HAMMER 3/2 1300 1696 -396 1.30 A/F ratio
HAMMER S/S FULL 1490 1832 -342 1.23 Empirical distribution function for the historical A/F ratios.
EPIC 3/2 2190 3504 -1314 1.60
ZEN 3/2 3190 1195 1995 0.37
ZEN-ZIP 4/3 3810 3289 521 0.86
WMS HAMMER 3/2 FULL 6490 3673 2817 0.57
* Error = Forecast - Actual demand
** A/F Ratio = Actual demand divided by Forecast

11-22
 Table 11.2
Product description Forecast Actual demand A/F Ratio* Rank Percentile**
ZEN-ZIP 2MM FULL 470 116 0.25 1 3.0%
ZEN 3/2 3190 1195 0.37 2 6.1%
ZEN 4/3 430 239 0.56 3 9.1%
WMS ELITE 3/2 650 364 0.56 4 12.1%
WMS HAMMER 3/2 FULL 6490 3673 0.57 5 15.2%
JR HAMMER 3/2 1220 721 0.59 6 18.2%
HEATWAVE 4/3 430 274 0.64 7 21.2%
ZEN 2MM S/S FULL 680 453 0.67 8 24.2%
EPIC 5/3 W/HD 120 83 0.69 9 27.3%
EPIC 4/3 1020 732 0.72 10 30.3%
WMS EPIC 2MM FULL 390 311 0.80 11 33.3%
ZEN FL 3/2 450 365 0.81 12 36.4%
EPIC 2MM S/S FULL 740 607 0.82 13 39.4%
ZEN-ZIP 4/3 3810 3289 0.86 14 42.4%
WMS ZEN-ZIP 4/3 170 163 0.96 15 45.5%
JR EPIC 3/2 180 175 0.97 16 48.5%
HEAT 4/3 460 450 0.98 17 51.5%
JR ZEN 3/2 140 143 1.02 18 54.5%
WMS ZEN 3/2 180 195 1.08 19 57.6%
WMS EPIC 5/3 W/HD 320 369 1.15 20 60.6%
ZEN-ZIP 5/4/3 W/HOOD 270 317 1.17 21 63.6%
ZEN-ZIP 3/2 660 788 1.19 22 66.7%
HAMMER S/S FULL 1490 1832 1.23 23 69.7%
HEATWAVE 3/2 170 212 1.25 24 72.7%
HEAT 3/2 500 635 1.27 25 75.8%
HAMMER 3/2 1300 1696 1.30 26 78.8%
WMS EPIC 3/2 610 830 1.36 27 81.8%
EVO 4/3 440 623 1.42 28 84.8%
WMS EPIC 4/3 1060 1552 1.46 29 87.9%
JR EPIC 4/3 380 571 1.50 30 90.9%
EVO 3/2 380 587 1.54 31 93.9%
JR ZEN FL 3/2 90 140 1.56 32 97.0%
EPIC 3/2 2190 3504 1.60 33 100.0%
* A/F Ratio = Actual demand divided by Forecast
** Percentile = Rank divided by total number of suits (33)
If the coming year is a similar to the last year,
i.e., the forecasting errors are similar, then,

• There is a 3% chance that demand will be

800 units or fewer (0.25*3200)
• There is a 90.9% chance demand is 150%
of the forecast or lower (or 1.5*3200 = 4,800)
 O’Neill’s Hammer 3/2 normal distribution forecast

Product description Forecast Actual demand Error A/F Ratio

JR ZEN FL 3/2 90 140 -50 1.5556
EPIC 5/3 W/HD 120 83 37 0.6917
JR ZEN 3/2 140 143 -3 1.0214
WMS ZEN-ZIP 4/3 170 156 14 0.9176

… … … … …
ZEN 3/2 3190 1195 1995 0.3746
ZEN-ZIP 4/3 3810 3289 521 0.8633
WMS HAMMER 3/2 FULL 6490 3673 2817 0.5659
Average 0.9975
Standard deviation 0.3690
Expected actual demand = 0.9975 × 3200 = 3192
Standard deviation of actual demand = 0.369 × 3200 = 1181

• O’Neill should choose a normal distribution with mean 3192 and

standard deviation 1181 to represent demand for the Hammer 3/2
during the Spring season.
11-25
Empirical vs normal demand distribution

1.00
0.90
0.80
0.70
.

0.60
Probability

0.50
0.40
0.30
0.20
0.10
0.00
0 1000 2000 3000 4000 5000 6000
Quantity
Empirical distribution function (diamonds) and normal distribution function with
mean 3192 and standard deviation 1181 (solid line)
11-26
The Newsvendor Model:

The order quantity that

maximizes expected profit

11-27
 “Too much” and “too little” costs

• Co = overage cost
– The cost of ordering one more unit than what you would have
ordered had you known demand.
– In other words, suppose you had left over inventory (i.e., you
over ordered). Co is the increase in profit you would have
enjoyed had you ordered one fewer unit.
– For the Hammer 3/2 Co = Cost – Salvage value = c – v = 110 –
90 = 20
• Cu = underage cost
– The cost of ordering one fewer unit than what you would have
ordered had you known demand.
– In other words, suppose you had lost sales (i.e., you under
ordered). Cu is the increase in profit you would have enjoyed had
you ordered one more unit.
– For the Hammer 3/2 Cu = Price – Cost = p – c = 180 – 110 = 70
11-28
 Balancing the risk and benefit of ordering a unit
• Ordering one more unit increases the chance of overage …
– Expected loss on the Qth (+1) unit = Co x F(Q)
– F(Q) = Distribution function of demand = Prob{Demand <= Q)
• … but the benefit/gain of ordering one more unit is the reduction in
the chance of underage:
– Expected gain on the Qth (+1) unit = Cu x (1-F(Q))

80

70 § As more units are

.

60 Expected gain
ordered, the expected
Expected gain or loss

50 benefit from ordering one

40
unit decreases while the
30
Expected loss expected loss of ordering
20
one more unit increases.
10

0
0 800 1600 2400 3200 4000 4800 5600 6400
th
As we deal with large
Q unit ordered
numbers, we omit +1 11-29
 Newsvendor expected profit
maximizing order quantity
• To maximize expected profit order Q units so that the
expected loss on the Qth unit equals the expected gain
on the Qth unit:

Co × F (Q) = Cu × (1 − F (Q ))
Cu
F (Q) =
• Rearrange terms in the above equation -> Co + Cu
• The ratio Cu / (Co + Cu) is called the critical ratio.

• Hence, to maximize profit, choose Q such that we don’t

have lost sales (i.e., demand is Q or lower) with a
probability that equals the critical ratio
11-30
Finding the Hammer 3/2’s expected profit maximizing order
quantity with the empirical distribution function
• Inputs:
– Empirical distribution function table; p = 180; c = 110; v = 90; Cu = 180-
110 = 70; Co = 110-90 =20
• Evaluate the critical ratio:
Cu 70
= = 0.7778
Co + Cu 20 + 70
• Lookup 0.7778 in the empirical distribution function table
– If the critical ratio falls between two values in the table, choose the one
that leads to the greater order quantity (choose 0.788 which
corresponds to A/F ratio 1.3)
Product description Forecast Actual demand A/F Ratio Rank Percentile
…

…
HEATWAVE 3/2 170 212 1.25 24 72.7%
HEAT 3/2 500 635 1.27 25 75.8%
HAMMER 3/2 1300 1696 1.30 26 78.8%
…

…
• Convert A/F ratio into the order quantity A round-up
rule! See p235.
Q = Forecast * A / F = 3200 *1.3 = 4160.
11-31
 Hammer 3/2’s expected profit maximizing order quantity
using the normal distribution

• Inputs: p = 180; c = 110; v = 90; Cu = 180-110 = 70; Co = 110-90 =20;

critical ratio = 0.7778; mean = µ = 3192; standard deviation = σ = 1181

• Look up critical ratio in the Standard Normal Distribution Function Table:

z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389

– If the critical ratio falls between two values in the table, choose the
greater z-statistic
– Choose z = 0.77
• Convert the z-statistic into an order quantity: Q = µ + z × σ
= 3192 + 0.77 ×1181 = 4101 11-32
APPENDIX: Derivation of the Newsvendor model optimal solution
[These notes are for reference only – not included in the exam]

In elementary calculus, we know that extreme points of a smooth, differentiable function

f(x) can be obtained by solving the equation d f(x)/dx = 0. Here we consider a
more complex case, when the function is an integral. A result in real analysis shows (the
proof is omitted here), that if we have a function:

h( y )

F ( y) = ∫ f ( x, y ) dx , then its extreme values can be found by solving:

g ( y)

∂ f ( x, y )
h( y ) h( y )
d d d h( y ) d g ( y)
dy g ∫( y ) ∫
F ( y) = f ( x, y) dx = 0 = dx + f ( h( y ), y) − f ( g ( y ), y )
dy g ( y)
∂y dy dy

In the case of the Newsvendor model, we wanted to find the minimum of:

Q ∞
g (Q) = E ( G (Q)) = ∫c
x=0
0 (Q − x) P( x) dx + ∫c
x =Q
u ( x − Q) P ( x) dx

For the first term, y à Q, g(y) = 0 (a constant), h(y) à Q, and f(x, y) à f( x, Q) = c0(Q-
x)P(x). Taking the derivative, we get:

∂ c 0 (Q − x ) P ( x ) ∂ c (Q − x ) P ( x ) ∂ c (Q − x) P( x)
Q Q Q Q
dQ
∫0 ∂Q
dx + f ( Q, Q )
dQ
=∫ 0
0
∂Q
dx = ∫ 0
0
∂Q
dx = ∫ c 0 P ( x) dx
0

The analysis for the second term is similar, in this case, y à Q, g(y) = Q, h(y) à 0, and
f(x, y) à f( x, Q) = cu(x-Q)P(x).
∞
Thus the derivative, following the same steps, is: ∫−c
Q
u P ( x) dx

In other words, the expected cost is minimum when:

Q ∞
c0 ∫ P( x) dx −
0
cu ∫ P( x) dx
Q
= 0.

Since P(x) is the probability density function, the integral in the first term is just the
cumulative probability function, represents the probability that demand is Q or less. We
denote this by F(Q). Similarly, the integral in the second term denotes the probability that
the demand is larger than Q, which is (1 – F(Q)), since the total of these two probabilities
must be 1. Therefore, at optimality,
c0 F(Q) – cu ( 1 – F(Q)) = 0
à c0 F(Q) = cu ( 1 – F(Q))
à (c0 + cu) F(Q) = c u
à F(Q) = cu/(co + c u) QED