Supply Chain Management: Strategy,

Planning, and Operation

Seventh Edition

Chapter 6
Designing Global Supply
Chain Networks

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Learning Objectives
6.1 Identify factors that need to be included in total cost when
making global sourcing decisions.
6.2 Define relevant risks and explain different strategies that may
be used to mitigate risk in global supply chains.
6.3 Understand decision tree methodologies used to evaluate
supply chain design decisions under uncertainty.
6.4 Use decision tree methodologies to value flexibility and make
onshoring/offshoring decisions under uncertainty.

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Impact of Globalization on Supply Chain
Networks (1 of 2)
• Opportunities to simultaneously increase revenues and
decrease costs
• Accompanied by significant additional risk and uncertainty
• Difference between success and failure often the ability to
incorporate suitable risk mitigation into supply chain design
• Uncertainty of demand and price drives the value of building
flexible production capacity

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Impact of Globalization on Supply Chain
Networks (2 of 2)
Table 6-1 Results of Accenture Survey on Sources of Risk That Affect Global
Supply Chain Performance
Risk Factors Percentage of Supply Chains Affected
Natural disasters 35
Shortage of skilled resources 24
Geopolitical uncertainty 20
Terrorist infiltration of cargo 13
Volatility of fuel prices 37
Currency fluctuation 29
Port operations/custom delays 23
Customer/consumer preference shifts 23
Performance of supply chain partners 38
Logistics capacity/complexity 33
Forecasting/planning accuracy 30
Supplier planning/communication issues 27
Inflexible supply chain technology 21

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Importance of Total Cost (1 of 4)
• Comparative advantage in global supply chains
• Quantify the benefits of offshore production along with the
reasons
• Two reasons offshoring fails

1. Focusing exclusively on unit cost rather than total cost

2. Ignoring critical risk factors

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
The Offshoring Decision: Total Cost
• A global supply chain with offshoring increases the length and
duration of information, product, and cash flows
• The complexity and cost of managing the supply chain can be
significantly higher than anticipated
• Quantify factors and track them over time
• Big challenges with offshoring is increased risk and its
potential impact on cost

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Importance of Total Cost (2 of 4)
Table 6-2 Dimensions to Consider When Evaluating Total Cost from Offshoring

Performance Dimension Activity Affecting Performance Impact of Offshoring

Order communication Order placement More difficult communication
Supply chain visibility Scheduling and expediting Poorer visibility
Raw material costs Sourcing of raw material Could go either way
depending on raw material
sourcing
Unit cost Production, quality (production Labor/fixed costs decrease;
and transportation) quality may suffer
Freight costs Transportation modes and Higher freight costs
quantity
Taxes and tariffs Border crossing Could go either way
Supply lead time Order communication, supplier Lead time increase results in
production scheduling, production poorer forecasts and higher
time, customs, transportation, inventories
receiving

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Importance of Total Cost (3 of 4)
Table 6-2 [Continued]
Performance Dimension Activity Affecting Performance Impact of Offshoring
On-time delivery/lead time Production, quality, customs, Poorer on-time delivery and
uncertainty transportation, receiving increased uncertainty resulting
in higher inventory and lower
product availability
Minimum order quantity Production, transportation Larger minimum quantities
increase inventory
Product returns Quality Increased returns likely
Inventories Lead times, inventory in transit Increase
and production
Working capital Inventories and financial Increase
reconciliation
Hidden costs Order communication, invoicing Higher hidden costs
errors, managing exchange rate
risk
Stockouts Ordering, production, Increase
transportation with poorer visibility

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Importance of Total Cost (4 of 4)
• Key elements of total cost

1. Supplier price
2. Terms
3. Delivery costs
4. Inventory and warehousing
5. Cost of quality
6. Customer duties, value added-taxes, local tax incentives
7. Cost of risk, procurement staff, broker fees, infrastructure,
and tooling and mold costs
8. Exchange rate trends and their impact on cost

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Summary of Learning Objective 1
It is critical that global sourcing decisions be made while
accounting for total cost. Besides unit cost, total cost should
include the impact of global sourcing on freight, inventories, lead
time, quality, on-time delivery, minimum order quantity, working
capital, and stock- outs. Other factors to be considered include
the impact on supply chain visibility, order communication,
invoicing errors, and the need for currency hedging. Offshoring
typically lowers labor and fixed costs but increases risk, freight
costs, and working capital.

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk Management in Global Supply Chains (1 of 6)

• Risks include supply disruption, supply delays, demand

fluctuations, price fluctuations, and exchange-rate fluctuations
• Critical for global supply chains to be aware of the relevant
risk factors and build in suitable mitigation strategies

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk Management in Global Supply Chains (2 of 6)

Table 6-3 Supply Chain Risks to Be Considered During Network

Design

Category Risk Drivers

Disruptions Natural disaster, war, terrorism Labor disputes
Supplier bankruptcy

Delays High capacity utilization at supply source Inflexibility

of supply source Poor quality or yield at supply
source
Systems risk Information infrastructure breakdown System
integration or extent of systems being networked
Forecast risk Inaccurate forecasts due to long lead times,
seasonality, product variety, short life cycles, small
customer base Information distortion

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk Management in Global Supply Chains (3 of 6)

Table 6-3 [Continued]

Category Risk Drivers

Intellectual property risk Vertical integration of supply chain Global
outsourcing and markets
Procurement risk Exchange-rate risk Price of inputs Fraction
purchased from a single source Industry-wide
capacity utilization
Receivables risk Number of customers Financial strength of
customers
Inventory risk Rate of product obsolescence Inventory holding cost
Product value Demand and supply uncertainty
Capacity risk Cost of capacity Capacity flexibility

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk Management in Global Supply Chains (4 of 6)

• Good network design can play a significant role in mitigating

supply chain risk
• Every mitigation strategy comes at a price and may increase
other risks
• Global supply chains should generally use a combination of
rigorously evaluated mitigation strategies along with financial
strategies to hedge uncovered risks

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk Management in Global Supply Chains (5 of 6)

Table 6-4 Tailored Risk Mitigation Strategies During Network Design

Risk Mitigation Strategy Tailored Strategies

Increase capacity Focus on low-cost, decentralized capacity for
predictable demand. Build centralized capacity for
unpredictable demand. Increase decentralization as
cost of capacity drops.

Get redundant suppliers More redundant supply for high-volume products,

less redundancy for low-volume products. Centralize
redundancy for low-volume products in a few flexible
suppliers.

Increase responsiveness Favor cost over responsiveness for commodity

products. Favor responsiveness over cost for short–
life cycle products.

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk Management in Global Supply Chains (6 of 6)

Table 6-4 [Continued]

Risk Mitigation Strategy Tailored Strategies

Increase inventory Decentralize inventory of predictable, lower value
products. Centralize inventory of less predictable,
higher value products.
Increase flexibility Favor cost over flexibility for predictable, high-volume
products. Favor flexibility for unpredictable, low-
volume products. Centralize flexibility in a few
locations if it is expensive.
Pool or aggregate demand Increase aggregation as unpredictability grows.

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Flexibility, Chaining, and Containment (1 of 3)

• Three broad categories of flexibility

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Flexibility, Chaining, and Containment (2 of 3)

Figure 6-1 Different Flexibility Configurations in Network

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Flexibility, Chaining, and Containment (3 of 3)

• As flexibility is increased, the marginal benefit derived from

the increased flexibility decreases
– With demand uncertainty, longer chains pool available
capacity
– Long chains may have higher fixed cost than multiple
smaller chains
– Coordination more difficult across with a single long chain
• Flexibility and chaining are effective when dealing with
demand fluctuation but less effective when dealing with supply
disruption

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Summary of Learning Objective 2
The performance of a global supply chain is affected by risk and
uncertainty in a number of input factors such as supply, demand, price,
exchange rates, and other economic factors. These risks can be
mitigated by building suitable flexibility in the supply chain network.
Operational strategies that help mitigate risk in global supply chains
include carrying excess capacity and inventory, flexible capacity,
redundant suppliers, improved responsiveness, and aggregation of
demand. Hedging fuel costs and currencies are financial strategies that
can help mitigate risk. It is important to keep in mind that no risk
mitigation strategy will always pay off. These mitigation strategies are
designed to guard against certain extreme states of the world that may
arise in an uncertain global environment.

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Using Decision Trees (1 of 2)
• Several different decisions
– Should the firm sign a long-term contract for warehousing
space or get space from the spot market as needed?
– What should the firm’s mix of long-term and spot market
be in the portfolio of transportation capacity?
– How much capacity should various facilities have? What
fraction of this capacity should be flexible?

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Using Decision Trees (2 of 2)
• Executives need a methodology that allows them to estimate
global currency instability, unpredictable commodities costs,
uncertainty about customer demand, political or social unrest in
key markets, and potential changes in government regulations
the uncertainty in demand and price forecast

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Discounted Cash Flows
• Supply chain decisions should be evaluated as a sequence of
cash flows over time
• Discounted cash flow (DCF) analysis evaluates the present
value of any stream of future cash flows and allows managers
to compare different cash flow streams in terms of their
financial value
• Based on the time value of money – a dollar today is worth
more than a dollar tomorrow

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Discounted Cash Flow Analysis

1
discount factor 
1 k
t
 1 
T
NPV  C0     Ct
t 1  1  k 

Where

C0, C1,…,CT is stream of cash flows over T periods

NPV = net present value of this stream

K = rate of return

• Compare NPV of different supply chain design options

• The option with the highest NPV will provide the greatest financial return

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Trips Logistics Example (1 of 3)
• Demand = 100,000 units
• 1,000 sq. ft. of space for every 1,000 units of demand
• Revenue = $1.22 per unit of demand
• Sign a three-year lease or obtain warehousing space on the spot
market?
• Three-year lease cost = $1 per sq. ft.
• Spot market cost = $1.20 per sq. ft.
• k = 0.1

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Trips Logistics Example (2 of 3)

Expected annual profit if = (100,000 × $1.22)

Warehousing space is obtained − (100,000 × $1.20)
from spot market = $2,000

C1 C2
NPV(No lease)  C0  
1 k  1 k  2

2,000 2,000
 2,000   2
 $5,471
1.1 1.1

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Trips Logistics Example (3 of 3)

Expected annual profit with = (100,000 × $1.22)

Three year lease − (100,000 × $1.00)
Blank = $22,000

C1 C2
NPV(Lease)  C0  
1 k  1 k  2
22,000 22,000
 22,000   2
 $60,182
1.1 1.1
• NPV of signing lease is $60,182 − $5,471 = $54,711 higher
than spot market

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Basics of Decision Tree Analysis
• A decision tree is a graphic device used to evaluate decisions
under uncertainty
– Identify the number and duration of time periods that will
be considered (T)
– Identify factors that will affect the value of the decision
and are likely to fluctuate over the next T periods
– Evaluate decision using a decision tree

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Decision Tree Methodology
1. Identify the duration of each period (month, quarter, etc.) and the number
of periods T over which the decision is to be evaluated
2. Identify factors whose fluctuation will be considered
3. Identify representations of uncertainty for each factor
4. Identify the periodic discount rate k for each period
5. Represent the decision tree with defined states in each period as well as
the transition probabilities between states in successive periods
6. Starting at period T, work back to Period 0, identifying the optimal
decision and the expected cash flows at each step

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Decision Tree – Trips Logistics (1 of 3)
• Three warehouse lease options

1. Get all warehousing space from the spot market as

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Decision Tree – Trips Logistics (2 of 3)
• 1000 sq. ft. of warehouse space needed for 1000 units of demand
• Current demand = 100,000 units per year
• Binomial uncertainty: Demand can go up by 20% with
p = 0.5 or down by 20% with 1 − p = 0.5
• Lease price = $1.00 per sq. ft. per year
• Spot market price = $1.20 per sq. ft. per year
• Spot prices can go up by 10% with p = 0.5 or down by 10% with 1 − p =
0.5
• Revenue = $1.22 per unit of demand
• k = 0.1

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Decision Tree (1 of 2)

Figure 6-2 Decision Tree for Trips Logistics, Considering Demand

and Price Fluctuation
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (1 of 9)
• Analyze the option of not signing a lease and using the spot market
• Start with Period 2 and calculate the profit at each node

For D = 144, p = $1.45, in Period 2:

C(D = 144, p = 1.45,2) = 144,000 × 1.45
= $208,800
P(D = 144, p = 1.45,2) = 144,000 × 1.22
− C(D = 144, p = 1.45, 2)
= 175,680 − 208,800
= −$33,120
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (2 of 9)
Table 6-5 Period 2 Calculations for Spot Market Option

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (3 of 9)
• Expected profit at each node in Period 1 is the profit
during Period 1 plus the present value of the expected
profit in Period 2
• Expected profit EP(D =, p =, 1) at a node is the expected
profit over all four nodes in Period 2 that may result from
this node
• PVEP(D =, p =, 1) is the present value of this expected
profit and P(D =, p =, 1), and the total expected profit, is
the sum of the profit in Period 1 and the present value of
the expected profit in Period 2

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (4 of 9)
• From node D = 120, p = $1.32 in Period 1, there are four possible
states in Period 2
• Evaluate the expected profit in Period 2 over all four states possible
from node D = 120, p = $1.32 in Period 1 to be

EP(D = 120, p = 1.32,1) = 0.2 × [P(D = 144, p = 1.45,2)

+ P(D = 144, p = 1.19,2)
+ P(D = 96, p = 1.45,2)
+ P(D = 96, p = 1.19,2)
= 0.25 × [−33,120 + 4,320
− 22,080 + 2,880]
= −$12,000
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (5 of 9)
• The present value of this expected value in Period 1 is

EP (D  120, p  1.32,1)
 PVEP D  120, p  1.32,1 
(1  k )
$12, 000

 1.1
 $10, 909

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (6 of 9)
• The total expected profit P(D = 120, p = 1.32,1) at node D =
120, p = 1.32 in Period 1 is the sum of the profit in Period 1 at
this node, plus the present value of future expected profits
possible from this node

P (D = 120, p  1.32,1)   120,000  1.22  –  120,000  1.32 

PVEP (D  120, p  1.32,1)
 –$12,000 – $10,909  – $22, 909

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (7 of 9)
Table 6-6 Period 1 Calculations for Spot Market Option

P(D =, p =, 1)
= D × 1.22 – D x p + start fraction E P at left parenthesis D =, p =,
1 right parenthesis over left parenthesis 1 + k right parenthesis end fraction

EP (D  , p  ,1)
Node EP(D =, p =, 1)  1 k 
D = 120, p = 1.32 −$12,000 −$22,909

D = 120, p = 1.08 $16,000 $32,073

D = 80, p = 1.32 −$8,000 −$15,273

D = 80, p = 1.08 $11,000 $21,382

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (8 of 9)
• For Period 0, the total profit P(D = 100, p = 120,0) is the sum
of the profit in Period 0 and the present value of the expected
profit over the four nodes in Period 1

EP(D = 100, p = 1.20,0) = 0.25 × [P(D = 120, p = 1.32,1)

+ P(D = 120, p = 1.08,1)
+ P(D = 96, p = 1.32,1)
+ P(D = 96, p = 1.08,1)]
= 0.25 × [−22,909 + 32,073
− 15,273) + 21,382]
= $3,818
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Spot Market Option (9 of 9)

EP  D  100, p  1.20,0 
PVEP (D  100, p  1.20,1) 
 1 k 
$3,818
  $3,471
 1.1

P(D = 100, p = 1.20,0) = (100,000 × 1.22) − (100,000 × 1.20)+ P V E

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Fixed Lease Option (1 of 5)
Table 6-7 Period 2 Profit Calculations at Trips Logistics for Fixed Lease Option

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Fixed Lease Option (2 of 5)
Table 6-8 Period 1 Profit Calculations at Trips Logistics for Fixed Lease Option

Warehouse P(D =, p =, 1)
Space = D x 1.22−(100,000 x 1 +
at Spot Price S x p) + EP(D =, p = ,1)(1
Node EP(D =, p =, 1) (S) + k)
D = 120, p = 1.32 0.25 × [P(D = 144, p = 1.45,2) + 20,000 $35,782
P(D = 144, p = 1.19,2) + P(D = 96,
p = 1.45,2) + P(D = 96, p = 1.19,2)]
= 0.25 × (11,880 + 23,320 + 17,120
+ 17,120) = $17,360

D = 120, p = 1.08 0.25 × (23,320 + 33,000 + 17,120 + 20,000 $45,382

17,120) = $22,640

D = 80, p = 1.32 0.25 × (17,120 + 17,120−21,920 − 0 −$4,582

21,920) = −$2,400

D = 80, p = 1.08 0.25 × (17,120 + 17,120 − 21,920 0 −$4,582

−21,920) = −$2,400

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Fixed Lease Option (3 of 5)
• Using the same approach for the lease option, NPV (Lease) =
$38,364

EP(D = 100, p = 1.20,0) = 0.25 × [P(D = 120, p = 1.32,1) + P(D

= 120, p = 1.08,1) + P(D = 80, p =
1.32,1) + P(D = 80, p = 1.08,1)]
= 0.25 × [35,782 + 45,382 − 4,582 −
4,582]
= $18,000

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Fixed Lease Option (4 of 5)

EP  D  100, p  1.20,1
PVEP (D  100, p  1.20,1) 
 1 k 
$18,000
  $16,364
 1.1

P(D = 100, p = 1.20,0) = (100,000 × 1.22) − (100,000 × 1)

+ PVEP(D = 100, p = 1.20,0)
= $22,000 + $16,364 = $38,364

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Fixed Lease Option (5 of 5)
• Recall that when uncertainty was ignored, the NPV for the
lease option was $60,182
• However, the manager would probably still prefer to sign the
three-year lease for 100,000 sq. ft. because this option has the
higher expected profit

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Flexible Lease Option (1 of 2)
Table 6-9 Period 2 Profit Calculations at Trips Logistics with Flexible
Lease Contract

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Evaluating the Flexible Lease Option (2 of 2)
Table 6-10 Period 1 Profit Calculations at Trips Logistics with Flexible
Lease Contract
Warehouse P(D =, p =, 1)
Warehouse Space = D × 1.22 (W x 1 + S
Space at $1 at Spot Price x p) + EP(D =,
Node EP(D =, p =, 1) (W) (S) p = ,1)(1 + k)
D = 120, 0.25 × (11,880 + 23,320 + 100,000 20,000 $37,600
p = 1.32 21,120 + 21,120) =
$19,360
D = 120, 0.25 × (23,320 + 33,000 + 100,000 20,000 $47,200
p = 1.08 21,120 + 21,120) =
$24,640
D = 80, 0.25 × (21,120 + 21,120 + 80,000 0 $33,600
p = 1.32 14,080 + 14,080) =
$17,600
D = 80, 0.25 × (21,920 + 21,920 + 80,000 0 $33,600
p = 1.08 14,080 + 14,080) =
$17,600

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Decision Tree – Trips Logistics (3 of 3)
Table 6-11 Comparison of Different Lease Options for Trips Logistics

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Summary of Learning Objective 3
Uncertainty in demand and economic factors should be included
in the financial evaluation of supply chain design decisions.
Decision trees can be used to evaluate supply chain decisions
under uncertainty. Uncertainty along different dimensions over
the evaluation period is represented as a tree with each node
corresponding to a possible scenario. Starting at the last period of
the evaluation interval, the decision tree analysis works back to
Period 0, identifying the optimal decision and the expected cash
flows at each step. The inclusion of uncertainty typically
decreases the value of rigidity and increases the value of
flexibility.

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Onshore or Offshore
• The value of flexibility under uncertainty
– D-Solar demand in Europe = 100,000 panels per year
– Each panel sells for €70
– Annual demand may increase by 20 percent with
probability 0.8 or decrease by 20 percent with probability
0.2
– Build a plant in Europe or China with a rated capacity of
120,000 panels

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (1 of 21)
Table 6-12 Fixed and Variable Production Costs for D-Solar

European Plant European Plant Chinese Plant Chinese Plant

Fixed Cost Variable Cost Fixed Cost Variable Cost

(euro) (euro) (yuan) (yuan)
1 million/year 40/panel 8 million/year 340/panel

Table 6-13 Expected Future Demand and Exchange Rate

Period 1 Period 1 Period 2 Period 2

Demand Exchange Rate Demand Exchange Rate

112,000 8.64 yuan/euro 125,440 8.2944 yuan/euro

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (2 of 21)
• European plant has greater volume flexibility
• Increase or decrease production between 60,000 to 150,000 panels
• Chinese plant has limited volume flexibility
• Can produce between 100,000 and 130,000 panels
• Chinese plant will have a variable cost for 100,000 panels and will lose
sales if demand increases above 130,000 panels
• Yuan, currently 9 yuan/euro, expected to rise 10%, probability of 0.7 or
drop 10%, probability of 0.3
• Sourcing decision over the next three years
• Discount rate k = 0.1

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (3 of 21)

Period 0 profits = (100,000 × 70) – 1,000,000 − (100,000 × 40) = €2,000,000

Period 1 profits = (112,000 × 70) − 1,000,000 − (112,000 × 40) = €2,360,000

Period 2 profits = (125,440 × 70) − 1,000,000 − (125,440 × 40) = €2,763,200

 2,000,000  2,360,000
Expected profit from onshoring 
1.1
2,763,200

1.21
 €6,429,091

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
 D-Solar Decision (4 of 21)

 8,000,000   100,000  340 

Period 0 profits   100,000  70       €2,333,333
 9   9 
 8,000,000   112,000  340 
Period 1 profits   112,000  70        €2,506,667
 8.64   8.64 
 8,000,000   125,440  340 
Period 2 profits   125,440  70       €2,674,319
 7.9524   7.9524 
2,506,667 2,674,319
Expected profit from off  shoring  2,333,333    €6,822,302
1.1 1.21

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Decision Tree (2 of 2)

Figure 6-3 Decision Tree for D-Solar

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (5 of 21)
• Period 2 evaluation – onshore

Revenue from the manufacture and sale of 144,000 panels

= 144,000 × 70 = €10,080,000
Fixed + variable cost of onshore plant
= 1,000,000 + (144,000 × 40)
= €6,760,000
P(D = 144, E = 10.89,2)
= 10,080,000 − 6,760,000
= €3,320,000
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (6 of 21)
Table 6-14 Period 2 Profits for Onshore Option

Production
Cost Revenue
D E Sales Quantity (euro) Cost (euro) Profit (euro)
144 10.89 144,000 144,000 10,080,000 6,760,000 3,320,000
144 8.91 144,000 144,000 10,080,000 6,760,000 3,320,000
96 10.89 96,000 96,000 6,720,000 4,840,000 1,880,000
96 8.91 96,000 96,000 6,720,000 4,840,000 1,880,000
144 7.29 144,000 144,000 10,080,000 6,760,000 3,320,000
96 7.29 96,000 96,000 6,720,000 4,840,000 1,880,000
64 10.89 64,000 64,000 4,480,000 3,560,000 920,000
64 8.91 64,000 64,000 4,480,000 3,560,000 920,000
64 7.29 64,000 64,000 4,480,000 3,560,000 920,000

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (7 of 21)
• Period 1 evaluation – onshore

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

0.56 × P( D = 144, E = 8.91, 2)+ 0.06
× P( D = 96, E = 10.89, 2)+ 0.14 × P(
D = 96, E = 8.91, 2)
= (0.24 × 3,320,000) + (0.56 ×
3,320,000)+ (0.06 × 1,880,000)
+ (0.14 × 1,880,000)
= €3,032,000

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (8 of 21)

EP  D  120, E  9.90,1
PVEP (D  120, E  9.90,1) 
 1 k 
3,032,000
  €2,756,364
1.1

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (9 of 21)
• Period 1 evaluation – onshore

Revenue from manufacture and sale of 120,000 panels

= 120,000 × 70 = €8,400,000
Fixed + variable cost of onshore plant
= 1,000,000 + (120,000 × 40)
= €5,800,000
P(D = 120, E = 9.90, 1) = 8,400,000 − 5,800,000
+ PVEP(D = 120, E = 9.90, 1)
= 2,600,000 + 2,756,364
= €5,356,364
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (10 of 21)
Table 6-15 Period 1 Profits for Onshore Option

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (11 of 21)
• Period 0 evaluation – onshore

EP(D = 100, E = 9.00, 1) = 0.24 × P(D = 120, E = 9.90, 1)+ 0.56 × P(D =
120, E = 8.10, 1)+ 0.06 × P(D = 80, E = 9.90,
1)+ 0.14 × P(D = 80, E = 8.10, 1)

= (0.24 × 5,356,364) + (0.56 × 5,5356,364)

+ (0.06 × 2,934,545) + (0.14 × 2,934,545)

= € 4,872,000

EP  D  100, E  9.00,1
PVEP (D  100, E  9.00,1) 
 1 k 
4,872,000
  €4,429,091
1.1
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (12 of 21)
• Period 0 evaluation – onshore
Revenue from manufacture and sale of 100,000 panels
= 100,000 × 70 = €7,000,000
Fixed + variable cost of onshore plant
= 1,000,000 + (100,000 × 40)
= €5,000,000
P(D = 100, E = 9.00, 1) = 8,400,000 − 5,800,000
+ PVEP(D = 100, E = 9.00, 1)
= 2,000,000 + 4,429,091
= €6,429,091
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (13 of 21)
• Period 2 evaluation – offshore

Revenue from the manufacture and sale of 130,000 panels

= 130,000 × 70
= €9,100,000
Fixed + variable cost of offshore plant
= 8,000,000 + (130,000 × 340)
= 52,200,000 yuan

 52,200,000 
P (D  144, E  10.89,2)  9,100,000   
 10.89 
 €4,306,612
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (14 of 21)
Table 6-16 Period 2 Profits for Offshore Option

Production
Cost Revenue
D E Sales Quantity (euro) Cost (yuan) Profit (euro)
144 10.89 130,000 130,000 9,100,000 52,200,000 4,306,612
144 8.91 130,000 130,000 9,100,000 52,200,000 3,241,414
96 10.89 96,000 100,000 6,720,000 42,000,000 2,863,251
96 8.91 96,000 100,000 6,720,000 42,000,000 2,006,195
144 7.29 130,000 130,000 9,100,000 52,200,000 1,939,506
96 7.29 96,000 100,000 6,720,000 42,000,000 958,683
64 10.89 64,000 100,000 4,480,000 42,000,000 623,251
64 8.91 64,000 100,000 4,480,000 42,000,000 −233,805
64 7.29 64,000 10,000 4,480,000 3,560,000 −1,281,317

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (15 of 21)
• Period 1 evaluation – offshore

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

+ 0.56 × P(D = 144, E = 8.91, 2)
+ 0.06 × P(D = 96, E = 10.89, 2)
+ 0.14 × P(D = 96, E = 8.91, 2)
= (0.24 × 4,306,612) + (0.56 × 3,241,414)
+ (0.06 × 2,863,251) + (0.14 × 2,006,195)
= € 3,301,441

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (16 of 21)

EP  D  120, E  9.90,1
PVEP (D  120, E  9.90,1) 
 1 k 
3,301,441
  €3,001,310
1.1

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (17 of 21)
• Period 1 evaluation – offshore

Revenue from manufacture and sale of 120,000 panels

= 120,000 × 70 = €8,400,000

Fixed + variable cost of offshore plant

= 8,000,000 + (120,000 × 340)

= 48,800,000 yuan

 48,800,000 
P (D  120, E  9.90,1)  8,400,000   
 9.90 
 PVEP (D  120, E  9.90, 1)
 3,470,707  3,001,310
 €6,472,017
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (18 of 21)
Table 6-17 Period 1 Profits for Offshore Option

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

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (19 of 21)
• Period 0 evaluation – offshore

E P(D = 100, E = 9.00, 1) = 0.24 × P(D = 120, E = 9.90, 1)

+ 0.56 × P(D = 120, E = 8.10, 1)

+ 0.06 × P(D = 80, E = 9.90, 1)

+ 0.14 × P(D = 80, E = 8.10, 1)

= (0.24 × 6,472,017) + (0.56 × 4,301,354)

+ (0.06 × 3,007,859) + (0.14 × 1,164,757)

= € 4,305,580

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (20 of 21)

EP  D  100, E  9.00,1
PVEP (D  100, E  9.00,1) 
 1 k 
4,305,580
  €3,914,164
1. 1

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
D-Solar Decision (21 of 21)
• Period 0 evaluation – offshore

Revenue from manufacture and sale of 100,000 panels

= 100,000 × 70 = €7,000,000

Fixed + variable cost of onshore plant

= 8,000,000 + (100,000 × 340)

= €42,000,000 yuan

 42,000,000 
P (D  100, E  9.00, 1)  7,000,000   
 9.00 
 PVEP (D  100, E  9.00, 1)
 2,333,333  3,914,164
 €6,247,497
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Summary of Learning Objective 4
Relying solely on expected trends can lead to flawed decisions when
designing global sup- ply chains under uncertainty. It is important to
use an approach such as decision trees that accounts for future
uncertainty. In the presence of uncertainty, flexibility can be valued as a
real option using decision trees. Decision trees allow the valuation of
different flexibility alternatives for each potential outcome of an
uncertain future. This provides an accurate value of flexibility and other
real options such as onshoring. In general, the value of real options
such as flexibility and onshoring increases with an increase in
uncertainty, while the value of inflexible choices decreases with an
increase in uncertainty.

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Copyright

Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved