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Demand Planning
&
Forecasting
Module 2, Section 1

Broad outline
• Overview on demand planning and forecasting
• Characteristics of forecasts
• Components of a forecast
• Forecasting methods: Qualitative
(i) Jury of executive opinion method
(ii) Delphi method
(iii) Market research
• Forecasting methods: Quantitative
• Estimating forecast errors

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Broad outline
• Time-series forecasting models:
(i) Moving average
(ii) Weighted moving average
(iii) Exponential smoothing
(iv) Naïve forecast
(v) Trend-corrected exponential smoothing
(vi) Seasonality-corrected exponential smoothing
(vii) Trend and seasonality corrected exponential
smoothing
• Selection of a particular forecasting tool

Demand planning and forecasting: An

overview
• The very first step in determining the long-term
capacity needs, yearly business plan, and supply
chain activities of an organization.
• Examples:
(i) Based on forecast demand of automobiles, capacity
requirement of automobile manufacturing plant, investment
requirement and manpower requirement of varied level of skills
are computed.
(ii) The same approach applies to FMCG and consumer durables
also for finding out capacity requirement and manpower
requirement .

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Demand planning and forecasting: An

overview
(iii) The capacity requirement of hotels, airlines and other service
organizations are also determined based on forecast demand.
• Different organizations utilize different types of
forecasting techniques depending on the problems
faced by them.
• Forecasted values can never be perfect because
forecasting itself is fraught with errors.
• Demand forecasting tries to capture the estimated
demand of a product or service for a future period.

Characteristics of forecasts

• Forecasts are almost always wrong.

• Long-term forecasts are usually less accurate than
short-term forecasts.
• Aggregate forecasts are usually more accurate than
disaggregate forecasts.
• In general, the farther up the supply chain a
company is, the greater is the distortion of
information it receives.

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Components of forecast
• Consists of two components: (a) Systematic
component & (b) random component.
• Systematic component consists of
(i) Level (current deseasonalized demand),
(ii) Trend (growth or decline in demand),
(iii) Seasonality (predictable seasonal fluctuation in demand)
• Random component is that part of the forecast that
cannot be explained by the historical demand
patterns.

Systematic components of forecast

(Source: Shah, 2009, Supply Chain Management, Pearson Education)

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Forecasting methods: Qualitative

(A) Jury of executive opinion method:

• Involves securing opinions from a group of experts on
expected future sales and combining them into the estimate
of future sales.
• Quick and relatively inexpensive method.
• Applicable for finding out the forecast demand of both new as
well as existing products.
• Based on subjective judgment of experts and hence suffers
from the biases of experts.

Forecasting methods: Qualitative

(B) Delphi method:
• Involves eliciting responses from a panel of experts and
proceeds through a series of rounds.
• The first round of Delphi method is, in general, unstructured
and exploratory in nature.
• Later rounds are structured and attempts to achieve a
reasonable degree of consensus amongst the experts without
disclosing the identity of the experts.
• Useful when a new product is launched in the market.
• Relevant when major technological changes are expected in
the market.
• It is a very time-consuming method.

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Forecasting methods: Qualitative

(C) Market survey:
• Involves eliciting opinions from the potential customers
through market survey for the purpose of estimating the
market size.
• Market survey may be carried out through focus group
interview, telephonic interview, direct interview or simple
questionnaire survey.
• Relevant when a new product is at the conception stage and
firms attempt to know the purchase preferences of potential
customers.
• Relevant when a firm does some innovations in its existing
products.
• Relatively expensive method of forecasting.

Forecasting methods: Quantitative

(A) Time series:
• Consists of observations arranged in a chronological order.
• Chronology of observations and the respective values are
utilized to forecast the demand.
• Based on the assumption that past demand history is a good
indicator of future demand.
• Most appropriate when the basic demand pattern does not
vary significantly from one year to the next.
• Tries to predict the systematic component of demand.

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Forecasting methods: Quantitative

(B) Causal methods:
• Based on the assumption that demand forecast is highly
correlated with certain factors prevailing in the
environment, e.g. GDP growth rate, interest rate,
promotional efforts by a firm etc.
• There could be single or multiple causal variables which
might influence the demand.
• Suitable for medium to long term forecasting.
• Tries to predict the systematic component of demand.

Estimating forecast error

• The forecast error for period t is the difference between the
actual demand and the forecast for that time period, i.e.
Forecast error (Et) = Actual demand (Dt) – Forecast (Ft)
• Four measures of forecast errors are mostly used in practice.
(i) Mean error (ME):

(ii) Mean absolute deviation (MAD):

(iii) Mean squared error (MSE):

(iv) Mean absolute percentage error (MAPE):

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Estimating forecast error

• ME simply calculates average error over n time periods.
• ME fails to capture the magnitude of error because positive
and negative error may cancel out each other.
• Closer to zero value of ME indicates that the forecasting
method is almost unbiased.
• MAD captures the magnitude of error by considering the
absolute difference between actual and forecast values.
• MSE method also captures the magnitude of forecast error
and attaches higher penalty to higher value of forecast error.
• MAPE considers the absolute deviations between actual
demand and its forecast as a percentage of actual demand
and finds out its mean over n time periods.

Time Series Forecasting Methods

Systematic component of demand is computed using the
following forms of the equations:

• Multiplicative: Systematic component = level X trend X

seasonal factor
• Additive: Systematic component = level + trend + seasonal
factor
• Mixed: Systematic component = (level + trend) X seasonal
factor
Mixed method seems to produce better forecasts than the other
two.

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Time Series Forecasting Methods

Static method:
• Based on the assumption that the estimates of level, trend and
seasonality within the systematic component do not vary as
new demand is observed.
• Uses the same parameters for all future forecasts.

• The forecast for period t+l in period t is as follows:

L = estimate of level, i.e. the deseasonalized demand during period

t=0
T = estimate of trend
St+l = estimate of seasonal factor for period t+l

Time Series Forecasting Methods

Adaptive method:

• Updates the estimates of level, trend and seasonality after

each demand observation.
• The forecast for period t+l in period t is given as:

Lt = estimate of level at the end of period t

Tt = estimate of trend at the end of period t
St+l = estimate of seasonal factor for period t+l

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Time Series Forecasting Methods

(i) Moving Average (MA) method:

• Used when the systematic component of demand consists of
only level and does not have trend or seasonality.
• The level in period t (Lt) is estimated as the average demand
over the most recent n periods.

Where Dt indicates the actual demand observed in period t

• Thus forecast for period (t+1) is the same as the level in
period t, i.e.
• Further forecast for future period n is also same as the level in
period t, i.e.

Time Series Forecasting Methods

• Attaches equal weight to all the periods of past demand.

• Accounts for the effects of random variations by averaging out
the demand data of the most recent periods.
• With more number of periods, MA method becomes less
sensitive to the actual changes in the data.
• Quite popular in practice and finds applications when demand
of a product does not show much variation from period to
period.

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Time Series Forecasting Methods

Example: Refer to example 1 of the main text.
Forecasting of mobile phone through 3-month moving average
Month Demand (D) Level (L) Forecast (F) Error Abs error Squared error

Jan, 10 200

Feb 190

Mar 180 190

April 210 193.33 190 20 20 400

May 195 195 193.33 1.67 1.67 2.78

June 175 193.33 195 -20 20 400

July 170 180 193.33 -23.33 23.33 544.44

August 172 172.33 180 -8 8 64

September 178 173.33 172.33 5.67 5.67 32.11

October 230 193.33 173.33 56.67 56.67 3211.11

November 225 211 193.33 31.67 31.67 1002.78

December 224 226.33 211 13 13 169

Jan, 11 226.33

Time Series Forecasting Methods

Mean error MAD MSE MAPE
8.59 20 647.35 9.76
• The forecast for the month of January, 2011 is 226.33.

(ii) Weighted MA method:

• Tends to put more weight on the most recent data and
relatively less weight to the data of the distant periods.
• The level in period t (Lt) is estimated as the weighted average
demand over the most recent n periods, i.e.

Where
• Thus forecast for period (t+1) is the same as the level in
period t, i.e.

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Time Series Forecasting Methods

Example: Refer to example 2 of the main text.
In this problem, the weights 0.25, 0.35 and 0.40 are placed on the demand of
period 1, period 2 and period 3 respectively in all the cases while computing
the forecast demand of the next period.
Forecasting through 3-month weighted moving average

Month Demand (D) Level (L) Forecast (F) Error Abs error Squared error

Jan, 10 200

Feb 190

Mar 180 188.5

April 210 194.5 188.5 21.5 21.5 462.25

May 195 196.5 194.5 0.5 0.5 0.25

June 175 190.75 196.5 -21.5 21.5 462.25

July 170 178 190.75 -20.75 20.75 430.5625

August 172 172.05 178 -6 6 36

September 178 173.9 172.05 5.95 5.95 35.4025

October 230 197.3 173.9 56.1 56.1 3147.21

November 225 215 197.3 27.7 27.7 767.29

December 224 225.85 215 9 9 81

Jan, 11 225.85

Time Series Forecasting Methods

Mean error MAD MSE MAPE
8.055 18.777 602.468 9.17
• The forecast for the month of January, 2011 is 225.85.

(iii) Simple exponential smoothing:

• Forecast demand of the next period is calculated as the weighted
average of the current period’s actual demand and forecast demand
through the following formula.

Ft+1: Forecast for time period (t+1)

Ft: Forecast for time period t
Dt: Actual demand for time period t
α: Smoothing constant used to weight Dt and Ft (0<=α<=1)

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Time Series Forecasting Methods

• Systematic component of demand does not have any
observable trend and seasonality and only contains Level (Lt).
• In exponential smoothing, the current forecast for all future
periods is equal to the current estimate of level and is given as
and
• The initial estimate of level (L0) is taken to be the average of
all historical data. Given demand data for periods 1 through n,
L0 is expressed as:

• Closer the value of α is to 1, the greater is the weight put on

the most recent actual demand and closer its value is to 0, the
more emphasis is put on the past forecasts.
• Value of α chosen through trial and error method

Time Series Forecasting Methods

Example: Refer to example 3 of the main text. Value of α = 0.2
Forecasting through simple exponential smoothing

Period Month Demand (D) Level Forecast Error Absolute error Squared error
0 195.36
1 Jan, 10 200 196.29 195.36 4.63 4.63 21.49
2 Feb 190 195.03 196.29 -6.29 6.29 39.57
3 Mar 180 192.03 195.03 -15.03 15.032 225.98
4 April 210 195.62 192.03 17.97 17.97 323.058
5 May 195 195.49 195.62 -0.62 0.62 0.385
6 June 175 191.39 195.49 -20.49 20.49 420.11
7 July 170 187.12 191.39 -21.39 21.39 457.85
8 August 172 184.09 187.12 -15.12 15.11 228.55
9 September 178 182.87 184.09 -6.094 6.094 37.140
10 October 230 192.30 182.87 47.12 47.124 2220.72
11 November 225 198.840 192.30 32.69 32.69 1069.265
12 December 224 203.87 198.84 25.16 25.16 633.010
13 Jan, 11 203.87

Mean error MAD MSE MAPE

3.545 17.72 473.09 8.80
• Forecast demand for the month of January, 2011 is 203.87

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Time Series Forecasting Methods

(iv) Naïve Forecast:

• Forecast for the next period is considered equal to the actual
demand of the current period.
• Thus current demand is the best estimator of the future
demand, i.e.
• Does not incorporate any element of systematic component,
i.e. level, trend or seasonality.
• Does not account for the random component into its forecast.
• Suitable for those products which exhibit stable demand
pattern, e.g. groceries, staple food items etc.
• Forecast demand of mobile phone for the month of January
2011 will be the same as the actual demand observed in
December, 2010.

Time Series Forecasting Methods

(v) Trend-corrected exponential smoothing:
• Applicable when demand consists of both level and trend in
the systematic component but no seasonality.
• In period t, given estimates of Lt and Tt, the forecast for future
periods is expressed as
and
• After observing demand for period t, the revised estimates of
level and trend are as follows:

• α is a smoothing constant for the level (0<=α<=1) and β is a

smoothing constant for the trend (0<=β<=1).

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Time Series Forecasting Methods

Example: Refer to example 4 of the main text. The value of α = 0.2 and β = 0.3.
The value of L0 and T0 are 179.95 and 2.43 respectively, which are determined
through running a linear regression between actual demand (Dt) and the periods
(t).
Forecasting through trend-corrected exponential smoothing
Forecast Absolute
Month Demand (D) Level (Lt) Trend (Tt) (Ft+1) Error error Squared error
179.95 2.43
Jan, 10 200 185.90 3.48 10.60 10.60 112.54
Feb 190 189.51 3.52 189.39 -3.03 3.03 9.22
Mar 180 190.43 2.74 193.036 -13.17 13.17 173.47
April 210 196.53 3.75 193.17 9.71 9.71 94.32
May 195 199.23 3.43 200.28 -7.66 7.66 58.74
June 175 197.13 1.77 202.66 -23.90 23.90 571.48
July 170 193.12 0.039 198.90 -23.16 23.16 536.59
August 172 188.93 -1.23 193.16 -15.70 15.70 246.53
Sept 178 185.76 -1.81 187.70 -5.95 5.95 35.39
Oct 230 193.16 0.95 183.95 35.88 35.88 1288.08
Nov 225 200.28 2.80 194.11 21.90 21.90 479.94
Dec 224 207.27 4.058 203.092 12.66 12.66 160.46
Jan, 11 211.33
Mean error MAD MSE MAPE
-0.15 15.28 313.9 7.794
• Forecast for the month of January, 2011 is 211.33.

Time Series Forecasting Methods

(vi) Seasonality-corrected exponential smoothing:
• Applicable when demand consists of level and seasonality in the
systematic component but no trend.
• Systematic component of demand = level X seasonal factor
• The seasonal factor is represented by periodicity (p). p is the
number of periods after which the seasonal cycle repeats itself.
• The forecast for future period is given by
and
• On observing demand for period (t+1), the estimates of level and
seasonal factors are computed as follows:

• α is a smoothing constant for level (0<=α<=1) and γ is a smoothing

constant for seasonality (0<=γ<=1).

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Time Series Forecasting Methods

Steps followed for finding out seasonal factors:
• Step 1: Observe the periodicity (p)of demand.
• Step 2: Obtain the deseasonalized demand.
• Step 3: Find out the seasonal factor (St) of each individual
period by dividing actual demand by the deseasonalized
demand of the corresponding period.
• Step 4: Estimate the average value of seasonal factor ( ) by
taking the average of individual seasonal factors (St) of the
same quarters over the seasonal cycles.

Time Series Forecasting Methods

Example: Refer to example 5 of the main text. The value of α = 0.2 and γ = 0.4.
The value of initial level (L0) is the average of the actual demand observed in
12 quarters over 3 years. This turns out to be 195.75.
Forecasting through seasonality-corrected exponential smoothing
Deseasonalized Seasonality Average
Period Demand (Dt) Level (Lt) demand ( Dt ) (St) seasonality( St )
0 195.75
1 200 197.69 0.974
2 190 194.92 1.032
3 180 193.98 194.37 0.926 0.946
4 210 196.23 191.87 1.0944 1.023
5 195 196.40 188.75 1.033 0.989
6 175 191.79 182.75 0.957 1.009
7 170 189.65 175.87 0.966 0.938
8 172 184.73 180.62 0.952 1.042
9 178 183.71 194.37 0.915 0.990
10 230 194.36 207.75 1.107 0.970
11 225 204.30 0.921
12 224 208.34 0.997
13 0.982

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Time Series Forecasting Methods

Absolute
Period Forecast (F) Error error Squared error
0
1 190.745 9.254 9.254 85.646
2 204.042 -14.042 14.042 197.196
3 184.465 -4.465 4.465 19.938
4 198.515 11.484 11.484 131.884
5 194.153 0.846 0.846 0.717
6 198.226 -23.226 23.226 539.449
7 180.089 -10.09 10.09 101.807
8 197.630 -25.63 25.63 656.911
9 183.030 -5.030 5.030 25.302
10 178.303 51.696 51.696 2672.578
11 179.193 45.806 45.806 2098.229
12 203.832 20.167 20.167 406.742
13 204.605

Mean error MAD MSE MAPE

4.73 18.478 578.03 6.145

Forecast for the 1st quarter of the next year is 204.605

Time Series Forecasting Methods

(vii) Trend and Seasonality-corrected exponential smoothing:
• Applicable when demand consists of level, trend and
seasonality in the systematic component, i.e.
Systematic component = (level + trend) X seasonal factor
• The forecast for future period (t+1) is given by
and
• On observing demand for period (t+1), the estimates of level,
trend and seasonal factors are computed as follows:

• α is a smoothing constant for level (0<=α<=1), β is a

smoothing constant for trend and γ is the same for seasonality
(0<=γ<=1).

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Time Series Forecasting Methods

Example: Refer to example 6 of the main text. The value of α = 0.2, β = 0.3
and γ = 0.4. The initial estimates of level and trend are 183.73 and 0.8913
respectively.
Forecasting through trend & seasonality-corrected exponential smoothing
Initial deseasonalized Dt = L 0 + T 0 * t ( St )
Period Demand (D) demand (Dt) Deseasonalized Seasonality (St) Average seasonality

1 200 184.6213 1.083298623 1.015929515

2 190 185.5126 1.024189193 1.047884137

3 180 194.375 186.4039 0.965645032 1.007704009

4 210 191.875 187.2952 1.121224676 1.058172853

5 195 188.75 188.1865 1.036206104 1.037163397

6 175 182.75 189.0778 0.925544934 1.03464023

7 170 175.875 189.9691 0.894882378 0.990771668

8 172 180.625 190.8604 0.901182225 1.078571495

9 178 194.375 191.7517 0.928283817 1.032631307

10 230 207.75 192.643 1.193918284 0.995522002

11 225 193.5343 1.162584617 0.964848198

12 224 194.4256 1.152111656 1.033907944

13 1.026909978

Time Series Forecasting Methods

Period Level Trend Forecast Error Absolute error Squared error

0 183.753 0.891
1 187.088 1.6244 187.5856 12.4144 12.4144 154.11747
2 187.233 1.1807 197.7491 -7.7490 7.74908 60.048268
3 186.456 0.5933 189.8661 -9.8660 9.8660 97.339394
4 189.330 1.2776 197.931 12.0690 12.0690 145.66169
5 190.089 1.1219 197.6922 -2.6921 2.6921 7.2479091
6 186.797 -0.2022 197.8349 -22.8349 22.8349 521.43397
7 183.592 -1.1029 184.873 -14.873 14.873 221.20599
8 177.885 -2.4841 196.8282 -24.8282 24.8281 616.43740
9 174.796 -2.6657 181.1252 -3.1252 3.1252 9.766942
10 183.911 0.8685 171.3598 58.6402 58.6402 3438.67308
11 194.463 3.7735 178.2846 46.7154 46.7154 2182.3331
12 201.920 4.8785 204.9587 19.04127 19.0412 362.56984
13 212.3638

Mean error MAD MSE MAPE

5.2426 19.570 651.40 9.636
Forecast for the first quarter of the next year is 212.3638

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Selection of a particular forecasting tool

• The thumb rule indicates that the manager should choose that
particular method which would produce minimum forecast error.
• Availability of several measures of forecast errors which produce
different results of forecast error.
• Which measure should be given more importance is a matter of
judgment and discretion to be exercised by the manager.
Overall steps to be followed for choosing a particular forecasting tool:
(i) Short listing of a few forecasting methods based on the patterns
of demand observed in the recent past.
(ii) Prioritizing the measures of forecast error based on the
preferences of the manager.
(iii) Comparison of forecast error values on the prioritized measures of
forecast error.

Procurement Decision

Module 2, Section 2

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Broad outline
• Overview on procurement
• Procurement cycle
• Vendor evaluation and selection
• Case study on vendor evaluation

Overview on procurement
• Major proportion of working capital remains blocked in the
form of raw materials and other inputs while procuring the
same from different sources.
• The most important aspect of procurement is the quality and
the quantity of inputs.
• If the input items are procured in insufficient quantity, the firm
may fail to deliver the required quantity of finished goods to its
customers in time.
• If the same is procured in excess, the firm will have to bear
additional financial burden in terms of the opportunity cost of
funds tied in unused items, inventory carrying cost etc.

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Overview on procurement

• The capacity of the supplier in terms of infrastructural

facilities, financial resources, technological knowhow,
commitment towards quality, delivery schedule etc. need to
be properly ascertained.
• Procurement involves sourcing right material from right
supplier/s in right time with right quantity.

Procurement cycle

• Step 1: Identification of requirements of an item by User

Department in terms of type, quality and quantity etc.
• Step 2: Identification of the right sources of supply and
invitation of quotations.
• Step 3: Comparison of quotations, negotiation with the
vendors and placing of purchase order.
• Step 4: Keeping track of purchase order.
• Step 5: Inspection of quality, quantity etc. and receipt of
purchase order.

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Vendor evaluation
• Vendor evaluation, a strategic issue in view of its potential in
improving overall supply chain performance attempts to
(i) reduce the risk and uncertainty associated with procurement,
(ii) maximize overall value to the organization and
(iii) build long-term relationship with suppliers.

List of supplier evaluation criteria considered important from the

perspective of different researchers are as follows:
• Price
• Quality / Reliability of the product
• Technical support / After sales support
• Ability to meet delivery schedule / Delivery lead time

Vendor evaluation
• Quality system at suppliers’ place/ quality policy /quality philosophy
• Technological capability / Innovation capability / R & D capability
• Breadth of product line / Ability of a supplier to supply a number of items
• Sensitivity of suppliers to buyers’ requirements
• Willingness of suppliers to share information
• Existence of IT / Communication system
• Integrity of vendor/ Vendor’s image
• Financial capability of the supplier
• Business volume / Amount of past business
• Geographic proximity of suppliers
• Support in new product development

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Case study on vendor evaluation

• Study conducted in a large Engineering Organization

primarily engaged in manufacture of diesel locomotives.
• Large number of high value and critical (Strategic) items are
purchased from different suppliers.
• Stores and Purchase department professionals were
consulted about the practices being followed
• List of criteria was shown to the professionals.
• Finally list of criteria made relevant to the organization.

Objective
Identification of supplier evaluation criteria

Major
Criteria C1 C2 C3 C4

C11 C12 C13 C14 C15 C41 C42 C43

Sub- Criteria

C21 C22 C23 C24

C31 C32 C33 C34 C35

Major Criteria: C1: Technical factors; C2: Commercial factors; C3: Communication & miscellaneous support provided by
suppliers; C4: Financial performance of suppliers
Sub-Criteria: C11: Quality/Reliability; C12: Quality system at suppliers’ place;
C13: Technological capability and innovation of suppliers; C14: Breadth of product line;
C15: Technical support/After sales support
C21: Price; C22: Ability to meet delivery schedule; C23: Payment terms and conditions;
C24: Geographic proximity
C31: Service response time; C32: Sensitivity of suppliers to buyer’s requirement;
C33: Willingness of suppliers to share vital information; C34: Support in Value Engineering
C35: Support in developing new product specification
C41: Financial capability of suppliers;
C42: Supplier’s volume of business with the buyer with respect to supplier’s turnover;
C43: Supplier’s volume of business with respect to buyer’s total annual turnover

Figure 1: Hierarchy of supplier evaluation criteria

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Case Study on vendor evaluation

Eliciting opinions from the Experts:

• Three top-most Executives from Stores and Purchase
department identified as Experts.
• Explained the purpose of the study and pair-wise comparison of
AHP as explained by Saaty.
• The Experts show their preferences in terms of linguistic
variables suggested by Saaty, such as Very high, High etc.
Table 1 : Composite weights of supplier evaluation criteria
Sub-Criteria C11 C12 C13 C14 C15 C21 C22 C23 C24 C31 C32 C33 C34 C35 C41 C42 C43

Composite .239 .0245 .135 .045 .082 .153 .072 .032 .017 .051 .043 .021 .010 .0062 .015 .043 .005
Weights

Evaluation of suppliers

Evaluation Importance Performance rating of the suppliers Factor Scores of the suppliers
criteria weight S1 S2 S3 S4 S5
S1 S2 S3 S4 S5
C11 0.239 5 4 3 4 5 1.195 0.956 0.717 0.956 1.195

C12 0.0245 5 4 4 4 5 0.1225 0.098 0.098 0.098 0.1225

C13 0.135 5 4 4 5 4 0.675 0.540 0.540 0.675 0.540

C14 0.045 4 4 4 3 4 0.180 0.180 0.180 0.135 0.180

C15 0.082 5 4 4 3 4 0.410 0.328 0.328 0.246 0.328

C21 0.153 4 3 5 4 4 0.612 0.459 0.765 0.612 0.612

C22 0.072 4 5 5 4 5 0.288 0.360 0.360 0.288 0.360

C23 0.032 5 4 5 4 4 0.160 0.128 0.160 0.128 0.128

C24 0.017 3 4 5 4 4 0.051 0.068 0.085 0.068 0.068

C31 0.051 5 5 3 5 5 0.255 0.255 0.153 0.255 0.255

C32 0.043 5 3 2 4 5 0.215 0.129 0.086 0.172 0.215

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Evaluation of suppliers (Contd.)

Evaluation Importance Performance rating of the suppliers Factor Scores of the suppliers
criteria weight S1 S2 S3 S4 S5
S1 S2 S3 S4 S5

C33 0.021 4 4 3 5 4 0.084 0.084 0.063 0.105 0.084

C34 0.010 5 3 2 3 5 0.050 0.030 0.020 0.030 0.050

C35 0.0062 5 4 3 4 5 0.031 0.0248 0.0186 0.0248 0.031

C41 0.015 5 5 3 4 5 0.075 0.075 0.045 0.060 0.075

0.043 5 3 2 3 4 0.215 0.129 0.086 0.129 0.172

C42

C43 0.005 5 4 3 4 5 0.025 0.020 0.015 0.020 0.025

Total Factor scores secured by the suppliers 4.6435 3.8638 3.7196 4.0018 4.4405

Overall Rank of the suppliers 1 4 5 3 2

Managing inventory in a supply

chain
Module 2, Section 3

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Broad outline
• Meaning of inventory in the context of Operations &
Supply Chain
• Inventory types
• Inventory-related costs
• Basic EOQ model
• Capturing uncertainty: Safety stock
(i) Safety stock in case of Continuous review policy
(ii) Safety stock in case of Periodic review policy
(iii) Impact of service level on safety stock
(iv) Impact of demand and supply uncertainty on safety stock
• Managing inventory for short life-cycle products
• Selective inventory control
• Vendor managed inventory (VMI)

Inventory: An overview
• Vital element of any organization which enables it
- to run its operation in an uninterrupted manner and
- to provide a satisfactory level of service to its customers.
• The issue is – how much inventory should an organization
keep – too much or too little?
• Trade-off between providing good customer service versus
achieving operating efficiency.
• Performance measures of inventory management: inventory
turnover ratio.
• Generally higher the ratio, the better is the performance.
• Desirable number of turns depends on the type of industry
and the amount of profit margins.
• High-end retailers have a low turnover rate while
supermarkets have a fairly high turnover rate.

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Inventory types
• On the basis of physical characteristics (or accounting
classification), inventory is divided into three main types:
- Raw materials and purchased parts
- Work-in-process (WIP) goods
- Finished goods
• On the basis of functional classification
- Cycle inventory
- Safety inventory
- Pipeline inventory
- Anticipation inventory
- Decoupling inventory

Inventory related costs

• Ordering costs:
Costs associated with the preparation of purchase order, getting the
necessary approval for placing the purchase order, actual placing of
the order and follow-up of the same.
• Carrying costs:
Costs incurred in connection with the physical storage of items.
• Shortage costs:
Costs incurred by the firm when demand exceeds supply of inventory
on hand. There are two types of shortage costs:
(i) lost sales cost and
(ii) backorder cost.

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Basic EOQ model

• Assumptions of the basic EOQ model:
- Only one product is involved
- Annual demand requirements are known
- Demand is even throughout the year
- Lead time does not vary
- Each order is received in a single delivery
- There are no quantity discounts

The Inventory Cycle

Profile of Inventory Level Over Time

Q Usage
Quantity rate
on hand

Reorder
point

Time
Receive Place Receive Place Receive
order order order order order
Lead time

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Basic EOQ model

Notations:
• D: Annual demand
• A: Setup or Order Cost
• C: Cost per unit
• h: Holding cost per year as a percentage of unit product cost
• H: Inventory carrying costs per unit per year = h*C
• Q: Lot Size
• T: Reorder interval
• Number of orders per year = D/Q
• Annual material cost = C*D
• Annual order cost = (D/Q)*A
• Annual holding cost = (Q/2)*H
• Total annual variable cost (TC) = (D/Q)*A + (Q/2)*H

Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Q D
TC= H + A
2 Q
Annual Cost

Ordering Costs

Order Quantity (Q)

QO (optimal order quantity)

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Basic EOQ model

• The total cost curve reaches its minimum where the carrying
and ordering costs are equal, i.e.
Q/2 *(H) = (D/Q)*A
i.e.
Key insights:
• Total cost curve is relatively flat in the vicinity of EOQ. This indicates that
the total cost is not particularly sensitive to the optimal order quantity.
• In deciding the optimal lot size, the tradeoff is between order (set-up) cost
and holding cost.
• If demand increases by a factor of k, it is optimal to increase batch size by
a factor of Sqrt k.
• If lot size is to be reduced, one has to reduce fixed order cost.

Safety stock
• Takes care of variability in demand and supply lead time.
• Reduces the risk of stockout during lead time.
• The determinants of safety stock and reorder point are as
follows:
- The rate of demand
- The lead time
- The extent of demand variability
- The extent of lead time variability
- The degree of stockout risk acceptable to the management or the level
of service to be provided to customers.

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Safety stock

Safety stock: continuous review policy

• Popularly known as Q model or FOQ model or ROP model.

• Relevant policy is known as (s, S) or (s, Q) policy. ‘s’ and ‘S’
stand for reorder point (ROP) and order upto level (OUL)
respectively while Q indicates order quantity. The
relationship is as follows:
S=Q+s
ROP: Sum of the expected demand during lead time and safety
stock which is determined in case of ROP or FOQ model.
OUL: Expected demand during lead time and review period.

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Continuous review policy

Continuous review policy

Notations:
• = average daily/weekly demand
• sd = standard deviation of daily/weekly demand
• sdLT = standard deviation of demand during lead time
• LT = replenishment lead time in days/weeks
• =average replenishment lead time in days/weeks
• sLT = standard deviation of lead time
• h = holding cost of one unit per period
• A = fixed cost
• SL = Service level (for example, 95%). This implies that the probability of
stocking out is 5%
• SS = Safety inventory
• s = Reorder point (ROP)
• S = Order upto level
• z = standard normal variable corresponding to a particular service level
provided to customers

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Continuous review policy

• Normally utilized when the items purchased or handled are

expensive in nature and
• Management needs to closely monitor the level of its
inventory on a continuous basis.

Case 1: Only demand is variable

• Average demand during lead time =
• Safety stock (SS) =
• ROP (s) = +
• Order upto level (S) = Q + s

Continuous review policy

Case 2: Only lead time is variable

• Average demand during lead time =
• Safety stock (SS) =
• ROP (s) = +
• Order upto level (S) = Q + s

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Continuous review policy

Case 3: Both demand and lead time is variable

• Average demand during lead time =
• Safety stock (SS) =
• ROP (s) = +
• Order upto level (S) = Q + s

Periodic review policy

• Applicable for most of the retail stores handling FMCG or groceries.
• Also known as fixed order interval (FOI) model and the relevant
policy is known as periodic review policy or base stock policy.
• Orders for the items are placed at fixed intervals.
• Inventory level is also checked only in those intervals.
• Order upto level remains fixed.
• Order quantity computed on the basis of order upto level and
inventory level on hand at fixed intervals.
• The amount of safety inventory to be kept in this model is much
higher than that in case of FOQ model. Because the safety
inventory has to cover the period of lead time plus the fixed order
interval.

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Periodic review policy

Periodic review policy

The base-stock level includes two components:
• Average demand during (r+LT) period (the time until the next
order arrives): (r+LT)*d
• Safety stock during that time: z* sd * Ö(r+LT)
• Items from the same supplier may be clubbed together, which
yield savings in ordering costs, packaging costs, shipping costs,
handling costs and other related administrative costs.

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Impact of service level on safety stock

• Service level is the probability that all orders will be filled
from stock during the replenishment lead time or during the
reorder cycle.
• A retailer has specified a service level of 95 percent. This
implies that during 100 such reorder cycles, we can expect
stock out situation in about five cycles.
• A firm keeping a higher level of safety factor is in a position to
provide higher level of customer service.
• Service level increases as the level of safety inventory
increases.
• The marginal increase in service level in the initial period is
higher than that in the later period.

Impact of service level on safety stock

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Impact of demand and supply

uncertainty on safety stock
• Variability in demand and lead time has an important bearing
on the amount of safety stock to be kept by a firm.
• The absolute value of lead time also has an impact on the
amount of safety stock to be maintained.
• Reduction in variability of supplier lead time provides highest
benefits to the firm in terms of minimizing safety stock
requirement.
• Reduction in variability of demand is not a significant driver in
minimizing safety stock requirement.
• Reduction in average lead time does not have much impact in
minimizing safety stock requirement.

Impact of demand and supply

uncertainty on safety stock
Average S.D. of Average S.D. of Safety Safety stock Remarks
daily daily lead time lead time stock in days
demand demand (days)

500 100 20 6 4990 9.98 Base case

500 100 20 0 736 1.472 No supply

uncertainty

500 0 20 6 4935 9.87 No demand

uncertainty

500 50 20 6 4949 9.898 Reduce demand

uncertainty

500 100 20 3 2575 5.15 Reduce supply

uncertainty

500 100 10 6 4962 9.924 Reduction in lead

time

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Managing inventory for short life-cycle

products
• Special category of items for which demand occurs for
a very short period.
• The problem of managing inventory in a single period
with uncertain demand widely known as newsvendor
problem.
• Goods are to be kept ready before the selling season
starts in order to take care of the demand.
• Opportunity does not exist to place a second order
during the selling season.
• The issue is: how many items should the manager
order before the selling season starts?
• Examples: fashion products, high technology products,
perishable goods etc.

Managing inventory for short life-cycle

products
• Co = overage cost = (Cost – Salvage value)
increase in profit you would have enjoyed had you
ordered one fewer unit.
• Cu = underage cost = (Selling Price – Cost)
increase in profit you would have enjoyed had you ordered one
more unit.
• Critical ratio is Cu / (Co + Cu)
• This ratio implies the optimum level of service from
which the value of standard normal variable (z) is found
out.
• Optimum order size = Mean demand + z*standard
deviation of demand

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Selective inventory control

ABC classification:
• Items are classified into A, B and C category based on the
annual consumption value of items.
• ‘A’ category items: High value items and constitute roughly
10% of the whole items but account for approx. 70% of the
total annual consumption value.
• ‘B’ category items: Medium value items and account for
approx. 20% of the whole items and contribute towards 20%
of the annual consumption value.
• ‘C’ category items: Low value items and constitute roughly
70% of the items and account for only 10% of the annual
consumption value.

Selective inventory control

• ABC classification:

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Selective inventory control

VED classification:
• Items are segregated on the basis of criticality of the items
specified by the end users.
• ‘V’ indicates vital items without which the entire functioning
of the plant or the machine gets severely affected.
• ‘E’ indicates essential items required by the end users.
• ‘D’ denotes desirable items from the point of view of the end
users.
• This classification is quite popular in maintenance
management.

Selective inventory control

FSN classification:
• Items are classified based on the volume of consumption.
• ‘F’ indicates fast moving items
• ‘S’ indicates slow moving and
• ‘N’ indicates non-moving items.
• Fast moving items generally kept in all decentralized stores.
• Slow moving items generally stocked in a centralized store.
• Non-moving items need to be disposed off gradually.

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Selective inventory control

SDE classification:
• Items are classified based on their availability in the market.
• ‘S’ means ‘scarce to obtain’, which further implies that the items
are probably available in international market.
• D’ implies ‘difficult to obtain’, which indicates that the items are
probably available in the national market.
• E’ indicates ‘easy to obtain’, which implies that the items are
probably available in local markets.
• Helps in developing suitable sourcing strategies for different
category of items.

Vendor managed inventory (VMI)

• Inventory management jointly agreed upon by a retailer and a
supplier which ensures minimum mismatch between demand
and supply.
• Supplier takes the entire responsibility of determining when to
replenish and how much to replenish at the retail store.
• The supplier also decides about the right inventory policy.
• The retailer will have to share actual demand data with the
supplier through EDI, which helps improve the forecast.
• Supplier owns the inventory as long as the goods are lying in
the shelves of retailer.
• One of the shortcomings of VMI is the sale of substitute
products of the competing manufacturers by the retailers.

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Materials Requirements Planning

(MRP)

Module 2, Section 4

Broad outline
• An overview on MRP
• MRP inputs
• MRP processing
• MRP outputs
• MRP II

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An overview on MRP

• A computer based information system that converts a master

schedule of end products into time-phased requirements of
sub-assemblies, components and raw materials.
• Procurement lead time of input items and assembly time of
sub-assemblies are considered for timely completion of end
items.
• Also known as dependent demand estimation method.

An overview on MRP
An MRP system is designed to meet simultaneously three
objectives:

• Ensure inputs are available for production and end items are
manufactured for delivery to customers in time.
• Maintain the lowest possible level of inventory.
• Prepare delivery schedules and accordingly plan manufacturing and
purchasing activities.

It provides answers to the following three questions:

• WHAT is needed?
• HOW MANY/HOW MUCH is needed?
• WHEN is it needed?

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An overview on MRP

MRP inputs MRP processing MRP outputs

Master
schedule Order release
requirements (orders
to be released now)

MRP
Bill of
Materials Order rescheduling
computer (expedite,
deexpedite, cancel
open orders
Inventory
records Planned orders
(future)

MRP inputs

(i) a master production schedule, which provides the

details of how much end items are desired and when,
(ii) a bill-of-materials file, which tells the composition of a
finished item,
(iii) an inventory record file, which shows how much
inventory is on hand or on order.

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Master Production Schedule (MPS)

• Developed on the basis of aggregate production plan.
• Also gets inputs from specific customer orders
• Specifies which end items are to be produced, how many
quantities are needed and when the same is to be delivered.
• Divides the planning horizon into a series of time periods or
time buckets, which are often expressed in weeks.
Week number
Item: P 1 2 3 4 5 6 7

Quantity 50 90 80

• The schedule indicates that 50 units of P will be needed in

week 2, 90 units in week 4 and another 80 units in week 6.

Bill of Materials (BOM)

• Provides a clear idea about the composition of a product.
• The list of items in BOM is hierarchical.
• Shows the quantity of each item needed to complete one unit
of an item upstream.
• The diagram below shows an assembly diagram for a sofa and
its product structure tree.
Sofa

Leg assembly Seat Back assembly

Legs (4) Cross bar (2) Side rail (2) Cross bar (1) Back support (2)

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Inventory record file

• Refers to the information relating to the status of each item
by individual time period.
• Includes the quantity of the item available in the store, gross
requirements, scheduled receipts, projected available balance
etc.
• Also includes information on procurement lead time of the
item, setup time of each production run, run time for each
sub-assembly or assembly etc.
• Changes due to new orders, cancelled orders, stock receipt
and withdrawal etc. are to be recorded in the inventory record
file.

MRP Processing
• Main purpose of MRP processing is to determine the net
requirements of items in right time periods.
• Considers the requirements of end products specified by MPS
and explodes them into time-phased requirements of sub-
assemblies, components etc.
• Quantities estimated through exploding the BOM are gross
requirements.
• Net requirements are computed as
Net requirements in period t = Gross requirements in period t –
Projected on-hand inventory in period t + Safety stock

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MRP Processing
MRP processing takes place through the following list of items.
• Gross requirements: indicates the total expected demand for an
item during each time period regardless of the quantity available
on-hand.
• Scheduled receipts: indicates the open orders scheduled to arrive
from the vendors.
• Projected available balance: implies the expected amount of
inventory that will be on hand at the beginning of each time period.
• Net requirements: shows the actual amount needed in each time
period.
• Planned-order receipts: tells the quantity expected to be received at
the beginning of each period in which it is shown.
• Planned-order releases: indicates a planned amount to order in
each time period which equals the planned-order receipts offset by
lead time.

MRP Processing

Week number 0 1 2 3 4 5 6 7 8

Gross requirements

Scheduled receipts

Projected on hand

Net requirements

Planned order receipts

Planned order releases

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MRP Outputs
Primary reports: considered to be the main report

• Planned orders: a schedule indicating the amount and timing of future

orders
• Orders releases: authorization for the execution of planned orders
• Changes: Change in due dates or order quantities or cancellation of
orders.
Secondary reports: considered to be the optional outputs

• Performance-control reports: Evaluation of system by measuring the

deviations from plans.
• Planning reports: Useful for assessing future material requirements.
• Exception reports: Reports on major discrepancies such as late orders, late
delivery, excessive scrap rates etc.

Material requirements can be computed using both lot-for-lot ordering and

lot-size ordering.

Manufacturing Resources Planning

(MRP II)
• MRP does not include the feasibility of a plan.
• MRP II includes all essential elements of MRP. In addition, it
also incorporates the valuable inputs from other functional
areas like marketing, finance etc.
• Purpose is to devise a production plan which is practical,
feasible and implementable.
• MRP II enables managers to test ‘what-if’ scenarios by using
simulation.

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Logistics & Transportation

Management
Module 2, Section 5

Broad outline
• Logistics: A brief overview
• A brief concept of transportation
• Drivers of transportation decisions
• Impact of speed on transportation decisions
• Impact of demand uncertainty on transportation decisions
• Distribution network design
• Comparison of distribution network design options
• Other distribution networks in practice
• Warehousing & its different types

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Logistics: A brief overview

• Implies the movement of supplies of arms, ammunitions, food, medicines
and other essentials from one place to another in the context of military
operations.

• In the context of business operations, it implies the movement of raw

materials, components, semi-finished and finished goods from one region
to another within a country or from one country to another.

• Council of Supply Chain Management Professionals (CSCMP) has defined

logistics as
“The process of planning, implementing and controlling the efficient, cost
effective flow and storage of raw material, in-process inventory, finished
goods and related information from the point of origin to the point of
consumption for the purpose of conforming to customer requirements”.

Logistics: A brief overview

Components of logistics function are

• transportation,
• warehousing,
• packaging and material handling.

Logistics activities are divided into two broad functions

• inbound logistics or physical supply
concerned with bringing materials, components etc. from sources
of supply to the processing or the manufacturing plant and

• outbound logistics or physical distribution

concerned with the movement of finished goods from the
processing plant to the distribution centres and subsequently to the
retail stores.

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Logistics: A brief overview

• Logistics costs account for 13% of GDP in India
compared to 8-9% of GDP in the US.
• The inefficiencies in the logistics industry arise from
(i) a fragmented market,
(ii) multiple taxes,
(iii) physical infrastructure bottlenecks,
(iv) archaic labour laws, and
(v) state-centred policies.
The industry is growing at a rate of 8-10% per annum
and is expected to reach a size of $385 billion by 2015.

Transportation

• Transportation constitutes the largest element and accounts

for maximum cost of logistics.

• Transportation decision depends on the supply chain network

design of a firm.

• Transportation-related decisions have a direct impact on

supply chain efficiency and supply chain responsiveness of a
firm.

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Transportation
• A firm desirous of becoming responsive has to set up
warehouses and retail stores at many places which increases
operations and maintenance cost and inventory carrying cost
at the facilities. However, this reduces transportation cost.

• A firm emphasizing upon efficiency will need to set up few

distribution centres and warehouses. This will minimize
operations and maintenance cost and inventory carrying cost
at the facilities. However, transportation cost is likely to
increase.

Drivers of Transportation decisions

• Transportation cost
• Value density (weight, volume, chemical properties etc.)
• Patterns of demand (Volume of demand and the variability in
demand)
• Mode of transportation (in terms of cost, speed, capacity,
reliability etc.)

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Drivers of Transportation decisions

• Transportation cost: depends on
(i) the distance to be moved by the item from origin to
destination,
(ii) total quantity of the same item carried in the vehicle
etc.
- Marginal cost of transport decreases, as longer
distance is covered. This is technically known as
‘economies of distance’.
- Unit cost of transportation also decreases, if the
vehicle is moved in full truck load (FTL) mode rather
than in less-than truck load (LTL) mode, also known as
‘economies of scale’.

Drivers of Transportation decisions

• Value density
reveals the importance of transportation cost in the overall
product cost. It captures transportation-inventory trade-off.
(i) High value-density items
Examples: gold, diamond, high technology products etc.
- Transportation cost constitutes a small percentage of the
overall cost of the product.
- Firms can use faster and expensive mode of transportation.

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Drivers of Transportation decisions

(ii) Medium value-density items

Examples: FMCG, consumer durables etc.
- Transportation cost constitutes a moderate percentage of the
overall cost of the product.
- Firms use neither very fast nor very slow mode of transport
but attempt to choose between these mode two modes.
(iii) Low value density items
Examples: coal, iron ore, cement etc.
- Transportation cost accounts for a significant percentage of the
total product cost.
- Firms use slower mode of transportation.

Drivers of Transportation decisions

• Patterns of demand

(i) Volume of demand (cycle stock)

- FTL mode of transport for products with volume of demand.
- LTL mode of transport for products with low volume of demand.

(ii) Uncertainty associated with the product demand (safety

stock)
(iii) Long lead time (high safety stock)
- Faster mode of transport for products with high demand
uncertainty
- Slower mode of transport for products that have a stable demand

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Drivers of Transportation decisions

• Mode of transportation
- Rail
- Road
- Air
- Water
- Pipeline

Mode of transportation (Rail)

• Suitable for low value-density products

• Long and unreliable lead time
• Off-track delays (at pickup and delivery end)
• Indian railways is the second largest rail network in the world.
• Accounts 30% of freight movement in India
• Very high in-transit damages and losses
• 95% of the freight carried is in bulk goods and within that coal
accounts for 50% of the traffic.

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Mode of transportation (Road)

• India accounts for the second highest network of roads in

the world.
• National highways constitute only 2% of the total roads, but
carry almost 40% of the traffic.
• 80% of the roads considered as ‘village roads’.
• Trucks account for about 65% of freight movement in India.
• More expensive than rail, but offers the advantages of
door-to-door delivery and shorter delivery time
• Low freight rate and poor quality of service
• Unreliable transit time
• High in-transit damages.

Mode of transportation (Air)

• Expensive
• Rapid and reliable delivery
• Small, time-sensitive and high value-density goods
• Preferred mode for e-businesses (e.g., Amazon, Dell etc.)
• Consolidation of shipments (especially important for
package carriers that use air as a primary method of
transport)
• air transport contributes a very small percentage towards
freight movement in India but expected to play a
significant role in near future.

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Mode of transportation (Water)

• One of the cheapest modes of transport

• Very large loads at very low cost
• Slowest amongst all.
• Limited to certain geographic areas
• Ocean, inland waterway system, coastal waters
• Considerable delays at ports in loading and unloading
• Extensively used for international cargo.
• the amount of cargo handled by the Indian ports is very low
compared to the International standard.
• The amount of cargo handled by the Indian ports is very low
compared to the International standard.

Mode of transportation (Pipeline)

• High fixed cost

• Primarily used for transportation of crude petroleum,
refined petroleum products, natural gas etc. when the
point of origin and the point of destination remain same.
• Best for large and predictable demand
• Used for getting crude oil to a port or refinery, but not for
getting refined gasoline to a gasoline station.
• Losses and damages also remain at a very minimum level.
• Unit cost of transportation is also very low.
• In India, pipelines are being laid to transport gases and
petroleum products to different places.

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Comparison of transportation modes on SC

performance measures

• Freight cost
• Lot size
• Delivery time
• Delivery time variability
• Losses and damages

Relative ranking of modes of transportation

by performance measures

Mode of Cost (1 = Lot size (1= Delivery Delivery time Loss and
transportation least) smallest) time (1= variability (1= damage
fastest) least) (1=least)
Rail 2 3 3 3 4

Road 3 2 2 2 3

Water 1 4 4 4 1

Air 4 1 1 1 2

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Total cost approach to performance measures

Total cost =
Transportation cost + Cycle stock inventory
carrying cost + Pipeline inventory carrying cost
+ Safety stock inventory carrying cost + Cost of
losses and damages

Impact of speed on transportation

decision
Delivery time has a significant impact on the
choice of transportation mode.
• High-value products should be shipped by a faster
mode of transport.
• Low-value items should be shipped by a relatively
cheaper mode of transport.

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Cost comparisons of two modes of

transport under stable demand
An export-oriented garment manufacturing unit located in Ludhiana
manufactures two types of garments, viz. premium garment and low-
end garment and exports the same to European and American
markets. It considers two modes of transport, air and sea. It takes four
weeks to ship the goods to either Europe or America from Ludhiana, if
the same is sent by sea. However, shipping via air takes only one week.
If the firm decides to use air as the mode of transport, it can fly the
goods in smaller lots of 400 units, while shipping via sea requires a
minimum shipment size of 2000 units. The premium garment and low-
end garment cost Rs. 2000 and Rs. 500 per unit respectively. The
demand of premium garment and low-end garment is 100 units and
200 units per week respectively in the export market. Freight by air will
be Rs. 100 per unit while the same by sea will be Rs. 25 per unit. The
annual inventory carrying cost is 20% of the cost of the item. Consider
52 weeks in a year.

Cost comparisons for two modes of

transport under stable demand

Product Mode of Cycle Pipeline Average Inventory Transportation Total cost

transport stock stock inventory carrying cost cost in Rs. per annum
in Rs (annual) (annual) in Rs.
Premium Sea 1000 400 1400 560,000 130,000 690,000
garment
Air 200 100 300 120,000 520,000 640,000

Low end Sea 1000 800 1800 180,000 260,000 440,000

garment
Air 200 200 400 40,000 1040,000 1080,000

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Impact of demand uncertainty on

transportation decisions
Continue with the same example of premium and low-end
garments under stable demand. Assume that instead of the
weekly demand of the premium and low-end garments in
Europe and America being uniform, the same exhibits
randomness. Further assume that the weekly demand data
given in the previous example represent average demand of
premium and low-end garments. The standard deviation of
weekly demand of premium and low-end garments is 80
and 50 respectively. The firm is targeting a service level of
95%. (For 95% service level, consider the value of z = 1.645).

Cost comparison of two modes of

transport under uncertain demand

Product Mode of Safety stock Safety stock Total cost per annum Total cost
transport carrying cost under stable demand

Premium Sea 263.2 105,280 690,000 795,280

garment
Air 131.6 52,640 640,000 692,640

Low end Sea 164.5 16,450 440,000 456,450

garment
Air 82.25 8,225 1080,000 1088,225

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Distribution network design

• To decide how the items should be delivered to the

final customers.
• To find out how many distribution centres/
warehouses are to be set up and where the same
should be located.
• To ship the goods to the geographically dispersed
market areas in a cost-effective manner by evaluating
different distribution network options:
- Direct shipment network
- Direct shipping with milk-runs
- Shipment via Central Distribution Centre

Direct shipment network

• Stable demand with high volume
• High cycle inventory
• Goods are supplied in FTL mode in this network in order to
derive economies of scale in transportation.
Suppliers Demand centres

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Direct shipping with milk-runs

• Essentially a route on which a truck either delivers an item
from a single supplier to multiple retailers/distribution centres
or from multiple suppliers to a single retailer/ distribution
centre.
• Increase in frequency of visit
• Increase in transportation cost
• Low cycle stock because shipment size of an individual item
reduces due to the consolidation of several items in a single
truck.
• Low inventory carrying cost.

Direct shipping with milk-runs

Supply to multiple demand centres from a single supplier
Example: Delivery of milk by milk-delivery van to several outlets
of Mother-Dairy.
Suppliers Demand centres
A P

B Q

C R

D S

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Direct shipping with milk-runs

Supply from multiple suppliers to a single demand centre.
Example: Supply of auto-components from multiple suppliers to
the Toyota plant.
Suppliers Demand centres
A P

B Q

C R

D S

Shipment via Central Distribution Centre

• Suitable when the distance from the suppliers to the demand
centres is very high and at the same time replenishment to the
demand centres has to be made on a frequent basis.
• Provides the benefit of economies of scale in inbound
transportation because supply is made to the central
distribution centre on FTL mode.
• During outbound transportation, shipment size of an individual
item becomes smaller because a single truck is loaded with all
the items received from all suppliers in FTL mode.
• Cycle stock almost similar to Milk Run option.
• Transportation cost generally higher than Direct shipping, but
lower than Milk Run option.
• Setting up of an additional facility at DC.
• Additional loading and unloading costs at DC.

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Shipment via Central Distribution Centre

Shipping via central distribution centre

Suppliers Demand centres

A P

B Q
DC

C R

D S

Comparison of distribution network design

options
XYZ Company is having its manufacturing facilities of three different cars
namely hatchback, entry level sedan and high level sedan cars at three
different places namely Faridabad, Manesar and Gurgaon respectively. It
serves primarily three markets, Delhi, Noida and Greater Noida and
accordingly sends finished cars to the three depots located at Delhi, Noida
and Greater Noida. Weekly demand at each of these depots is 20 units of
hatchback cars, 10 units of entry level sedan cars and 5 units of high level
sedan cars. The distance of Delhi, Noida and Greater Noida depot from
Faridabad plant is 45 kms, 50 kms and 55 kms respectively. And the distance
of Delhi, Noida and Greater Noida depot from Gurgaon plant is 50 kms, 55
kms and 60 kms respectively. Further the distance of Delhi, Noida and Greater
Noida depot from Manesar plant is 80 kms, 85 kms and 90 kms respectively.
The distance between Delhi and Noida depot is 25 kms and that between
Noida and Greater Noida is 15 kms. The company is contemplating to set up a
distribution centre (DC) somewhere in the mid-point between the plants and
the depots. The distance of this DC from Faridabad, Gurgaon and Manesar
plant is expected to be 25 kms, 28 kms and 40 kms respectively. Further the
distance of Delhi, Noida and Greater Noida depots from the DC is expected to
be 25 kms, 30 kms and 35 kms respectively.

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Comparison of distribution network design

options
The company is considering three strategies for shipping the finished
cars from its plants to the depots, viz. (i) Direct shipping, (ii) Shipping
through milk run and (iii) Shipping through a distribution centre.
Imagine that a very big truck can carry 60 units of hatchback cars or 30
units of entry level sedan cars or 15 units of high level sedan cars in
FTL shipment or it can bundle 20 units of hatchback cars, 10 units of
entry level sedan cars and 5 units of high level sedan cars in FTL
shipment. The transportation cost is Rs.10 per km for FTL shipments.
To obtain economies of scale, the company has decided to work with
FTL shipments. The inventory carrying cost of hatchback, entry level
sedan and high level sedan cars is Rs. 5000, Rs. 10,000 and Rs. 15,000
per unit per year. If the company decides to ship through distribution
centre, then it will have to set up a cross-docking centre for which
facility cost of Rs. 50,000 will be incurred every year. Consider 52
weeks in a year.

Comparison of distribution network design

options
Option Distance Frequency of Annual Annual Annual Annual
traveled transport transport facility Inv. cost Total cost
in one cycle cost (Rs.) cost
cycle
(kms)
Direct 1140 Once in three 197,600 0 1237,500 1435,100
shipping weeks

Milk Run 500 Once a week 260,000 0 412,500 672,500

Shipping 366 Once a week 190,320 50,000 412,500 652,820

via DC

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Other distribution networks

Cross docking:
• Popularized by Wal-Mart and now currently it is being utilized
by a number of organizations worldwide.
• Appropriate for products with high, predictable and stable
demand.
• Used for facilitating the movement of goods from a set of
suppliers to the set of buyers.
• Inbound truck carries a product from a supplier to the cross-
docking centre in FTL mode.

Cross docking (Contd.)

• Outbound truck loaded with different products of different

suppliers in FTL mode at cross-docking point.
• Provides the benefit of economies of scale in both inbound
and outbound transportation.
• Product flows faster from supply sources to the demand
centres and inventory is held at the cross-docking centre for
12-14 hours only.
• It requires a significant degree of coordination and
synchronization between incoming and outgoing trucks.

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Hub & Spoke Model

• Suitable for airlines and postal services.
• Hub is considered to be the centralized point wherein all
operations like sorting of parcels, segregation of passengers
etc. are carried out.
• Spokes indicate different routes to be followed for shipping
products to different locations.
• One of the disadvantages of this network is that all parcels or
passengers will have to come to the hub first irrespective of
the locations of the originating station.
• To overcome this limitation, sometimes firms may attempt to
create regional hubs at different regions.

Warehousing

• An operation that receives, sorts, stores, or centralizes goods

for the purpose of storage or for facilitating the movement of
goods from sources to final destinations.
• Warehouses are used to reduce transportation costs, improve
operational flexibility, shorten customer lead time and lower
inventory carrying costs.
Warehouse types:
• Finished goods warehouse
• Consolidation warehouse
• Break-bulk warehouse
• Cross-docking warehouse

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Finished goods warehouse

• Responsible for the storage of finished goods.
• Continuous inflow and outflow of goods.
• Goods getting in and out of the warehouse are to be properly
recorded.
• Products are to be kept in designated places depending on
physical characteristics, chemical properties, arrival date,
demand pattern, expiry dates etc.

Finished goods Customer

Manufacturing
warehouse
plant

Consolidation warehouse
• Suitable, when supplies come from various sources in small
quantities while the need of the customers happens to be
very high.
• Small shipments from all suppliers are combined into a large
shipment in the warehouse.
• A single manufacturer may use a consolidation warehouse to
bring together the outputs from several plants.
Vendor 1 Buyer 1

Consolidation
Vendor 2 Buyer 2
Warehouse

Vendor 3 Buyer 3

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Break-bulk warehouse
• The reverse of the consolidation warehouse.
• The bulk incoming shipment from a single supplier is divided
into small shipments for the purpose of delivery to the final
customers.
• The bulk cargo of oil, gas, fertilizers etc. coming from a single
source is broken down into small consignments.

Customer 1

Manufacturing Break-bulk Customer 2

/Processing Warehouse
Plant

Customer 3

Cross-docking warehouse

• Similar to break-bulk warehouse except that it involves

multiple suppliers.
• Different items arriving in bulk from different suppliers in FTL
mode are broken down into smaller shipments in the cross-
docking warehouse.
• Smaller shipment of each item is loaded into the outbound
truck in FTL mode.
• Most commonly used in retail chains.

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