EXAMPLE 4.5 42 Supply Chain Management Concepts 101 Orders Product Shipments Factory Retailer Figure 4.3 Basic Two Level Supply Chain ‘Table 4.1 Variance Propagation in a Two Level System ‘Week Starting retail inventory On order Order-up-to target Order quantity Demand 1 200 100 400 100 100 2 200 100 400 100 100 3 200 100 400 100 110 4 190 100 440 150 i00 5 190 150 400 60 100 6 240 60 400 100 100 7 200 100 400 100 100 8 200 100 400 100 100 placed before demand is realized and stay at 100 units. However, the next week we find that demand has jumped to 110 units, and inventory has dropped to 190, At this point, fear takes over. Instead of using the safety stock as the buffer it was intended to be, the typical reaction is to try to maintain the four-week “order-up-to” rule with weekly de- ‘mand now set to 110. With 190 units on-hand (after receiving the order placed in period ‘one) and 100 units on order, we conclude that an order for 4(110) ~ 190 ~ 100 = 150 units is needed. A demand increase of 10% suddenly translated into a 50% increase in or- ders at the plant. The plant shifts into high gear this period to increase production. In ac- tuality, we only needed to produce 10 extra units. This reality manifests itself in the next period when orders drop to 60 units as we correct for the excessive ordering of week four: Eventually, we settle down to our original pattern, but only after stressing the plant, prob- ably with expensive overtime, hiring, or subcontracting, followed by undertime or layoffs. ‘You probably feel it was foolish to have overcompensated, and indeed, with expo- ential smoothing of demand forecasts, it is questionable that the target order-up-to point would actually go to 440 in week four. However, the forecast would have been raised based on the 110-unit demand, and even if the forecasted demand increased to only 105, we would still have a target of 420-units and, therefore, have ordered 420 ~ 290 = 130 units. Thus, the variance acceleration effect exists; we are only quibbling about the mag- nitude. You may also think that over time, the plant would recognize this phenomenon and cease to over-react. That might be the case if demand was so well managed that these effects could be clearly witnessed. However, in practice, demand is constantly changing, and all the plant sees is variability in arriving orders. It is difficult for plant management to associate variability in orders with specific minor perturbations in customer demand, particularly when customer demand is not observed by plant personnel. As we see below, the problem worsens when the supply chain gets longer. ‘A supply chain consists of a raw material supplier, production facility, and retail outlet. The retailer places an order at the start of each week and receives the onder three weeks Tater. The retailer al- tempts to Keep its starting inventory level equal to 1.5 weeks of demand representing expected102 Chapter 4 Manufacturing Strategy and the Supply Chain SOLUTION Raw Materials Factory Retatier Figure 4.4 Three Stage Supply Chain weekly sales plus safety stock of one-half-weeks average demand. Actual demand for the week is not known until after the order is placed, The retailer uses a two-week moving average of demand to estimate expected weekly sales, When the production factory receives the order, it immediately places an order for raw materials and begins producing the number of units ordered by the retailer. ‘The raw materials arrive one week later. The factory also tres to Keep 1.5 weeks of materials on- hand atthe start of each period. Find the impact on the retailer if customer demand suddenly shifts from 100 to 110 units per week. Next, determine how this change in demand affects the factory. ‘The system is sketched in Figure 4.4 ‘The retailer sees a three-week lead time, Thus, following the model used in Eq, 4.10, its order-up- to mule is RE = E(Lead Time Demand) + Desired Starting Inventory = 3D + SBS = 45Df. ‘The order size placed at the stat of period 1 by the retailer will be Of = 458 — I~ OF - OR which corrects the order-up-to level for actual starting inventory and units on order. Average demand will be given by the moving average. Bho Past Ber ‘Assuming demand increases to 110 units per week starting in week 2, Table 4.2 shows the pro- gression of order and inventory quantities for the retailer. The table reflects status at the start of the week except for the final column that shows demand that is to occur during that week. The “on- order" column indicates the units ordered in the past two weeks, These have not yet arrived. As ex pected, the retailer over-reacts in week 3. However, order quantities stabilize in week $ at 110 units, and the starting inventory finds its new base level at 165 units (1.5 times average weekly demand) in week 7. The order-up-to quantity stabilizes at 4.5 times the new average demand. Table 4.2 Weekly Status Data for the Retailer Initial retail Quantity Average Order-up- Retailer order Period inventory onorder_—demand ~—to level guantity Demand 1 150 200 100 450 100 100 2 150 200 100 450 100 110 3 140 200 105 4725 132.5 110 4 130 232.5 110 495 1325 110 5 120 265 110 495 110 10 6 1425 292.5 10 495, 110 110 7 165 220 110 495 110 110 8 165 220 no 495 110 11042 Supply Chain Management Concepts 103 ‘Table 4.3 Weekly Status Data for the Factory Initial materials Average — Material Flow —> Figure 4.5. Hierarchical Supply System Without Integration house and raw materials to support production. Production takes one week after materi- als are released to the shop floot. Products are added to inventory at the end of the week in which they are released. It takes one week to obtain raw materials, As before, assume demand averages 100 units per week. The target safety stock inventory level is 100 units at each stage except 200 at the factory output point. This accounting detail simply feflects the fact that factory production is added to inventory before the end of the week, whereas shipments are all received at the start of the following week. Solid arrows show material ‘movement, and dotted arrows show order information. Let /? represent the end of period + inventory at location a. Locations are denoted “R” for retailer, “W” for the warehouse, “FI” for the factory input, and “FO” for finished goods at the factory. Likewise, let Q? represent orders placed by the facility a at the start of period t. Demand will be noted as D, and factory production as X,. Average values are indicated by a “bar” over the value and represent an average of historical data. We can quantify the status of each stage in the supply chain over time by the relations: I= 1h, + QF D, 4.12) OF = D+ Dr ~ HE + Des ~ OE] (4.13) = Diy + Dr ~ UE + OR) TY = 1, + OM, — OF 4.14) OP = OF) 42-08, UM, + OMI (41s) Hf? = 172, + x,— oi" (4.16) X= i +2 OF) — 41D = 1, + OF, ~ x, 4.18) OF = Xp $2 Key — WE + OF 4.19) ‘The inventory equations (4.12), (4.14), (4.16), and (4.18) have the general form that in- ventory available at the end of period r equals inventory leftover from period 1 ~ 1, plus receipts in period t minus shipments in period t. Consider Equation (4.12). The retailer’s inventory at the end of any period ¢ (/*) equals the retailers starting inventory left over ‘from the previous period (/# 1), plus the order that was placed last week and received this week (Qf ;), minus this week's customer demand (D,). These inventory balance equations will play a major role in subsequent chapters. The remaining ordering and production equations implement our replacement and inventory target goals. Storage locations place orders to replace units shipped out last week, plus an adjustment to bring the level of available inventory (inventory that is on-hand or on-order) equal to the average demand for two weeks. The two weeks represent our time exposure until we can next affect in- ventory levels. If we place an order at the start of week 1, then this order must meet re-4.2 Supply Chain Management Concepts 108 quirements for the next two periods because we cannot order again until period ¢ + 1, and then we must wait another week for receipt of goods. Equation (4.13) records the weekly order quantity expression for the retailer. First, we estimate demand for this coming week by using the goods sold last week (D,_,). Next, we try to correct for any deviation be- tween desired and actual safety stock. Desired safety stock is one week’s supply on-hand, plus one week in transit. Thus, we add a correction for the difference between average demand (D,—,) and on-hand inventory (J/,), plus a similar correction for the difference between average demand and quantity on order (OF ;). Now, suppose in week six, demand exhibits a one-time increase from 100 to 110 units per week, Without coordinated planning and data exchange, the dynamic activity of the system is surprising. Inventory levels are shown in Figure 4.6. In week 6 demand goes up 10 units, causing retail inventory to drop 10 units. Warehouse inventory then drops a little more in week 7, followed by an even larger drop in factory product inventory in week 8 and a large drop in raw material inventory in week 9. Each stage jumps into action and over-eacts the following week. Eventually the system settles down, Figure 4.7 shows the corresponding level of orders and production each week. Effects are minor at the upper level of the supply chain (the retailer), but the effects of the change are multiplied as they filter down the chain. In week 7 the retailer increases the order size to the warehouse to 125 units. In addition to the new perceived level of 110 units per week, extra units are or- dered to make up for the depleted inventory caused by the 10 additional units sold last week and to increase safety stock for the new perceived level of average demand. In our model, we use the average demand over the last four weeks as a measure of D,, thus Dy = (Dz + Dray + Dyna + Dya2)/4. A phenomenon similar in form, but with larger amplitude then happens in week 8 with the warehouse ordering 163 units from the factory. The multiplier is attributable to the warehouse now seeing a jump in orders of 25 units although demand actually increased by only 10 units per week. The factory, seeing a large jump in orders and worrying about its insufficient supply of goods, then produces 200 units in week 9, consuming all raw ‘Supply System Response to an Impulse ——2— Demand Rotaller Inventory Warehouse Inventory > = = Factory Output inventory om ~ — Factory Raw Material inventory 150 Inventory Demand Level 100 % 123.45 6 7 B 9 1011 1213141516 17 18 19 2021 2223 24 25 26 27 28.29 30 Time Figure 4.6 Inventory Levels without Coordination106 Chapter 4 Manufacturing Strategy and the Supply Chain Production and Replenishment Orders 350 : es ——+— Demand 300 . ae + + Retailer Orders: ~ tase —-~s--- Warehouse Orders 250 i [LIST Rear rl Oen I i ks = = Factory Production = 200 hae ! : 5 1 1 & 150 ' 100% 50 2 oe We a “ore aes678 8 1011 12191415 1617 18192021 2223.24.25 2627282030 Week Figure 4.7 Production Levels and Orders without Coordination materials. Imagine the disruption at the factory when it is suddenly asked to double pro- duction in one week. Of course, we do not really need 200 units every week, and the warehouse orders fower units in week 9, causing factory production to drop sharply in week 10. The system does not stabilize until week 13. In the meantime, production and inventory levels vary widely. Examine the graphs in Figures 4.6 and 4.7. Note that as we move from the retailer, to the warehouse, and to the factory, the curves become affected ‘one week later, and with a greater amplitude, The 10% increase in demand almost caused shortages at the factory despite having a full week’s supply of safety stock at every level of the supply chain! Now consider what happens with data exchange in an integrated, cooperative sup- ply chain. Complete information is available to all production stages as shown in Figure 4.8. Our strategy will be to maintain inventory only at the retail level. Orders placed at the retailer will be for raw materials to be shipped to the plant. The next week these fix production at the plant, followed by shipments to the warehouse the following week, and then shipments to the retailer to restock. Thus, customer demand in week 1 affects 1 Week Coordinator Figure 4.8 Supply Chain with Information Exchanige and Coordination4.2 Supply Chain Management Concepts 107 Inventory Effects with Coordination 140 —— Demand som + + Retail Inventory °0 123 4 5 6 7 8 9 101112131415 16 17 18 192021 22 23.24.2526 27 282930 Time Figure 4.9 Inventory Levels with Information Exchange and Coordination raw material orders for week 2, production in week 3, product arrivals at the warehouse at the end of week 4 (start of week 5), and product arrivals at the retailer at the start of week 6. The response to the same 110-unit demand in week 6 is shown for inventory levels in Figure 4.9 and orders/production in Figure 4.10. Note that the system still over- reacts at first because of the perception of the need for more inventory, but the overshoot is minor and dampens quickly. The ordering decisions for the coordinated system follow Replenishment Orders with Coordination 140 + Demand Retail Orders ---a=== Warehouse Orders = Production — Factory Material Orders °5 123.45 6 7 8 9 101112131415 1617 18 192021 22.23 24 26 26 27 28.2930 Time Figure 4.10 Order Levels with Information Exchange and Coordination108 Chapter 4 Manufacturing Strategy and the Supply Chain the simple rules: (4.20) (4.21) (4.22) OF = Duy + 9° Dia ~ UE + OR + OF + OF +X) (4.23) Equation (4.23) orders raw materials to replace most recent demand plus an adjustment to compare expected usage over the five-week lead time to the actual pipeline inventory. Comparing Figures 4.6 and 4.9, the reduction in inventory cost is obvious for the coordi nated strategy. Comparing Figures 4.7 and 4.10 shows the reduction in production volatil- ity obtained through coordination. The operational and cost differences between the two systems, differing solely by the decision to coordinate, are extreme and demonstrate the current widespread interest in the area of supply chain coordination. We have seen in this section how well-intentioned decisions can be misguided and lead to suboptimal, almost chaotic activity in the presence of uncertainty. Forecasting rules and safety stock policies tend to increase demand variability as we pass up through the supply chain. Other factors can cause similar reactions. For economic reasons, order quan- tities naturally tend to increase in size and decrease in frequency as we move from final products to raw materials. It almost never makes sense to order raw materials more fre~ quently than they will be put into production. However, it may seem economical to save ordering costs by ordering enough matetials to last through several production runs. If materials are cheap, we may reduce the risk of running out by ordering large quantities very infrequently, although the materials are used in smaller batches on a frequent basis. Thus, as we move from the final customer level toward raw materials, order quantities ‘will naturally either stay the same or increase at each stage, and order frequencies will decrease. This process is discussed at length in chapter 9. Occasional shortages of supplies present another source of variance acceleration. Material shortages, wherein customer orders temporarily exceed supply, lead to ra- tioning. Suppliers ship each customer only a portion of the items ordered. Customers, deprived of materials, quickly realize they are receiving only partial shipments. There- fore, the company orders extra units expecting to receive only a fraction of the amount ordered. This practice, again used as a tool to minimize risk caused by uncertainty (in material availability), causes orders to increase at each stage as we move upstream to~ ward the raw material. Once again, this activity accentuates itself. If all customers de- siring a commodity increase their orders in expectation of a shortage, then the percent of orders filled will drop. Seeing this drop in materials received compared with those ordered, the companies will exaggerate their order quantities even more the next time, and the process feeds on itself. Eventually, suppliers increase capacity and begin filling orders completely. This leads to an oversupply of the item. Customers then cut back ex- tensively on orders, and the supplier is stuck with excess capacity and no demand. A classic example of this phenomenon occurred with computer hard disk drives. In 1997, production capacity lagged demand and companies, such as Western Digital, put cus- tomers on an allocation system wherein orders were only partially filled. Consequently, computer manufacturers began to overorder. With a large backlog of orders, the com- pany invested in additional capacity. However, as soon as shipments could match or even exceed the real demand rate, orders were cancelled. An inventory glut resulted, and prices declined. Burdened with investment costs and falling incomes, the company’s stock price plummeted.42. Supply Chain Management Concepts 109 4.2.3, Product Design and Customization Product design can complement logistics strategy. Competition in delivery speed, local content laws, and cultural differences encourages distributing final assembly among mar- ket areas. This becomes possible when product design allows for simple final assembly using parts supplied locally. A generic product frame is designed that forms the basis for an entire family of products. Minor changes are made when finishing the product to adapt ito a specific customer or regional market. This may be as simple as supplying a differ- ent electrical connector or inserting product information in different languages. However, product differentiation may also be more substantial, including different options and power supplies using the same product backbone. Product assembly involves combining the cor- rect set of modules for the desited customer. The advantage comes from producing and storing a single generic base model that can be quickly customized to fit customer spec- ifications, Thus, if the demand for various options changes or if demand shifts from one regional market to another, the producer can rapidly adjust with minimal cost. Final as- sembly may even be geographically integrated with distribution warehouses. Orders are received at the warehouses, and products are assembled at that site using the stored mod- ules. This allows rapid delivery with minimal inventory. Billington [1994] describes an application of this strategy at the Hewlett-Packard Company. Deskjet Plus printers are maintained in a generic configuration at regional distribution centers. On order receipt, the center “localizes” the printer by adding the appropriate power supply, Lee and Tang [1997] further describe the general benefits of using standardized parts, modular product designs, and process plans that delay product differentiation, 4.24 Vendor Selection, Certification, and Contracting A central component of supply-chain management involves managing relationships with suppliers. One approach, vertical integration, was discussed earlier in this chapter. How- ever, many companies have found that it is better to concentrate on focused core compe- tencies for intemal production and to outsource materials and logistics. Parts vendors are available for selection from around the world. The chosen vendor(s) must be able to meet customer needs across the global manufacturing system. The choice of vendors must be based on a complete picture of the relationship. Table 4.4 lists the key factors to be con- sidered. It lists cost as only one factor and often not the most impostant. The availability of rapid delivery of the desired quantity of items is essential, as is conformance to spec- ifications, Factors such as the unit-load form or the package in which the product arrives can determine its compatibility with the receiving and material control systems. ‘The key is to develop a cost-effective system that guarantees delivery of materials as needed, Sole-sourcing offers one option. Instead of dealing with a large number of sup- pliers for a product and seeking the low-cost bidder each time a part is to be purchased, long-term contracts are negotiated with a single (or few) supplier(s) for each part. This symbiotic relationship allows the supplier and customer to communicate in greater detail to ensure that the material being supplied meets actual specifications. Employees often visit each other's plants, and it is not uncommon to see large manufacturers station em- ployees at the supplier's plants to certify processes and help troubleshoot problems. The supplier, knowing that a long-term contract exists, is motivated to work closely with the customer. With sole-sourcing and long-term relationships, it becomes important to see that both companies survive, Thus, price negotiations tend to be designed to ensure that both companies make a fair profit. Contract negotiations cover a variety of factors. Essential the supplier and customer decide how to split profit and risk. The contract may specify110° Chapter 4 Manufactaing Strategy and the Supply Chain ‘Table 4.4 Criteria for Vendor Selection Category ‘Measures Product Cost Purchase Price Breaks Delivery Charges ‘aris and Import Duties Local Content RequirementsPenaties Delivery Delivery Frequency Minimum Batch Size Maximum Available Rate Package Form Communication Speed, Base, and Accuracy Quality Completeness of Features Quality Level (Defect Rate) Reliability - Service Warranty Liability Coverage Repair Organization Financial Stability Eagemess for Business and Leverage Labor Relations price as a function of the quantity purchased or the price may be based on the customer's agreement to purchase at least a minimum quantity of units each period or over some specified time horizon. A return policy for units the customer does not consume (or sell) will typically be included in the contract. The specification of this policy indicates who will absorb the risk of demand variability. In the case that the parts are being purchased by a retailer for sale, the supplier may place limits on the selling price to protect other re- tailers and its own sales or demand for substitute items. Finally, the contract may stipu- late an allocation rule detailing how the supplier’s stock of items will be distributed among its retailers when shortages exist. Higher-paying retailers may receive preference. As dis- cussed earlier in the chapter, proportional allocation rules lead to inflated orders being placed in times of shortage, which in turn can wreak havoc with production schedules and raw material orders, Whereas long-term contracts have advantages for both partners (namely, secure sup- ply and revenue) the growth of product data interchange, e-commerce, and automated quo- tation systems supports short-term, even one-time supply relationships. Only the future can tell which approach will dominate, but it is clear that suppliers will be required to provide continuously improving service in the areas of price, speed of delivery, flexibil- ity of terms, and quality of goods. 4.2.5 Operational Decisions in Distribution Systems Distribution of finished goods can account for a significant proportion of logistics costs. ‘After production, parts are often sent to regional distribution centers and stored until needed by local wholesalers or retailers. These distribution centers can be very large, housing mil- lions of square feet of floor space and servicing tens of thousands of customer orders or tens of trucks per day. Goods can be shipped by train, boat, truck, air, or pipeline. Many items today are shipped by intermodal transit. Products may be loaded into a container4.2 Supply Chain Management Concepts ULL that can be handled by several means of transport, from the back of a truck to riding on a rail car. Starting at the factory, the filled container is driven or sent by rail to the near- ‘est port. From there, it is automatically loaded onto a ship. After it arrives at the destina- tion port, the container load is placed on the back of a cab and driven to the customer. Rail transport is very inexpensive, at least in the United States, but it can be rather slow, and delays can occur. Rail transport is commonly used for shipping heavy and cheap commodities such as coal or grain. Trucks represent a good alternative for shorter trans- port of smaller loads. Trucks provide point-to-point service compared to the central de- pot constraints of trains and ships. Air transport is reserved for small, light items, gener- ally with high cost, short life spans, or high urgency that are either traveling in small quantities or covering a distance that makes trucking impractical. Examples are mail, crit- ical repair parts, medical supplies, and perishable items. Pipelines are inexpensive but nor- mally only useful for special products such as crushed ore, oil, and gas. Key decisions affecting distribution include the scheduling of production at each facil- ity and the setting of inventory levels at each point, Scheduling decisions are driven by de~ ‘mand forecasts, production lead times, and facility capacities. Inventories are kept to smooth production during demand cycles, to guard against interruptions caused by breakdowns and strikes, and to reduce delivery times to customers by shipping from nearby warehouses. However, storing inventory is costly (this subject is explored in later chapters) and runs the risk of product deterioration and obsolescence. (It is not uncommon for a warehouse to con- tain large quantities of products not in demand while being void of those in demand.) Cross-docking has become a major strategy for rapidly meeting demand with minimal inventory. In cross-docking, goods are never put into storage at distribution centers. Instead, _goods are received from suppliers and manufacturing plants and immediately routed to the shipping bay for loading onto trucks. This process reduces handling and storage costs sig- nificantly but assumes that product acquisition and shipping can be closely coordinated. A shipment of products may arrive each day from several manufacturing plants, These prod- ucts are unloaded and immediately allocated to customer orders, each order potentially 1e- quiring a small number of units from each truck that has arrived over the past day of two. ‘The products arriving from the various suppliers are combined to meet individual customer orders, loaded on the truck, and shipped. Wal-Mart has become widely recognized for this practice. Wal-Mart collects point-of-sale data on customer demand and compiles the infor- mation into replenishment orders, which are electronically transmitted back to one of their approximately twenty distribution centers around the country, These centers then ship re- plenishment orders to stores twice a week. By restocking shelves more frequently than com- petitors, customers can be assured of availability of high-demand items while the company avoids the cost of centralized inventory and the wasted shelf space allocated to slow-mov- ing items. Toyota uses cross-docking at its distribution center in Ontario, CA. This central location serves eleven regional distribution centers, which, in tum, serve 1,400 dealers. Where possible, arriving cases are bar coded with their destination and automatically sorted to the destination dock. When arriving cases must be broken down for shipment, receiving cases are scanned and placed on a sortation line. As the case passes the sorting station for specific distribution ceaters, an electronic message informs the worker of how many parts are to be removed from the case and repacked for shipment to that distribution center. 4.2.6 Locating Inventory ‘The location of component and finished-product inventories largely determine system cost and delivery time. The key issue, then, becomes where to store inventory in the system. The rule of thumb is to first try to eliminate the need for inventory. Adding capacity, en- hancing communication, improving process and supplier quality, and improving forecast-112 Chapter 4 Manufacturing Strategy and the Supply Chain ing models can alll aid in this endeavor. When this fails, maintain inventory at the cheap- est level that allows meeting demand on time. Itis usually cheaper to store items upstream than downstream in the supply chain. If deliveries from suppliers are uncertain, raw ma- terial stocks are maintained. If plant capacity is unreliable, finished goods (from that fa- cility) are stocked. Both unit cost and the amount of inventory needed to achieve a spe- cific service level depend on the stage of the supply chain. This phenomenon is examined in the next section. 42.61 Basic Trade-Off: Centralization versus Responsiveness Suppose we have defined our multistage supply chain, We have one or more manufac- turing plants. Each plant serves several distribution centers, (Bight to ten of these spread throughout the United States can put us within a day's truck delivery of most domestic locations.) We may add a few more for our European and Asian markets. Each distribu- tion center supplies a delivery warehouse in each of the major local markets in its region. Local markets may be defined as standard metropolitan areas of over 100,000 people or regions meeting specified sales volume. These local warehouses distribute frequently to the individual retail outlets in their immediate area. How do we determine the ordering policies and target safety stock levels at each location? The basic trade-off is between the added safety from pooling demand variability and storing inventory centrally versus the faster delivery available from local storage at the warehouses. First, note that the distribution centers are the customers of the manufacturing plants, the local warehouses are the customers of the distribution centers, and the retail outlets are the customers of the Jocal warehouses. Assuming that demands of the various cus- tomers are independent, we can provide the same service level of stock availability with less inventory if we keep the safety stock closer to the manufacturing plant, Safety stocks are typically set as some multiple of the standard deviation of demand. Suppose retailer ihas weekly demand being independent between weeks and retailers. Denote standard de- viations® of retail demands by o;, i = 1, ..., N. The safety factor is k, chosen to provide some desired level of service such as guaranteeing that 98% of demand can be filled from. on-hand stock. If each retail outlet carries its own safety stock, the required amount of system safety stock is x SSp=k > 07 Suppose, instead, we keep all the safety stock at the warehouse. If demand exceeds ex- pectations, then either the retail outlet places a special order to receive an extra shipment of the customer must wait while demand is backlogged until the next scheduled delivery. Each of these has a cost. However, if we centralize risk at the warehouse, we need only guard against the cumulative demand variability. The required centralized safety stock is: a Nie SSw= & “) . Since, for x x Mia N>LSo>( 07). a a 519 practice, the standard deviation is often a multiple ofthe mean demand rate. We will assume the demand is stationary so that we can ase the constant factor o-EXAMPLE 46 SOLUTION 42 Supply Chain Management Concepts 113 we know SS\y 128) [+ (646) Planned Shipments 327 | ca28) | G46) Factory On-Hand Inventory 158 Planned Production 950 950 950 Planned Shipment 158 + 950 950 950 includes anticipated receipt of 56 units ( ather allocation of initial factory inventory and period I production batch42 Supply Chain Management Concepts 117 they can cover 72/(100 + 70), or 42%, of these needs. Thus, we add 0.42(100) = 42 units to re- tailer A's shipment and 0.42(70) = 30 units to retailer B’s shipment. This makes a shipment of 125 + 42 = 167 units to retailer A and 130 + 30 = 160 units to retailer B, as shown in Table 4.6. Other warehouse and factory allocations are made in the same manner as soon as product becomes available, Disbursement of the initial units and period 1 production from the factory to the ware hhouse and retailer C are shown in ( ) in the table. The warehouse would then immediately ship these to A and B. 4.2.6.3 Echelon versus Installation Accounting The concept of item inventory becomes more complex for multistage systems. Consider the product structure shown in Figure 4.11. Each circle in the Figure represents a differ- ent part of set of operations in the production of a part, We will refer to these as produc tion stages. For each stage j we have a quantity of J, units of inventory on-hand. However, is [5 really the number of units of stage 3 product available? Each unit of stage 1 inven- tory also contains a stage 3 product (plus a stage 2 part, and possibly additional work). Thus, we could claim that the stage 3 inventory is f; + J. This defines the difference be~ tween stage 3 installation stock, Js, and echelon stock, I + J. Installation stock at stage J equals only those units residing at stage j. Echelon stock includes installation stock, plus all those units residing in higher-level assemblies and products. We will denote the ech- elon stock as E, and, in this case, Ey =, +h As with our definition of inventory, we can differentiate between installation and ech- elon holding cost. The installation holding cost rate fits our traditional view of hy = iC, at stage j, where hy represents the accumulation of holding cost per unit of average inven- tory per time, ‘is the inventory cost rate, and C; is the value of a stage j item. Part of this G;cost results from the incorporation of lower-level items in stage j product. For instance, stage 3 in Figure 4.11 includes a stage 4 and a stage 5 part. We define the echelon hold ing cost of an item at a stage to be the value added at that stage over and beyond its con- stituent components, We could represent the value of a stage j item as Gad Cty sth where [P()) is the set of immediate predecessors (components) of j, and v; is the positive value added at stage j. For instance, as shown in Figure 4.12, Cc: Cyt Cs + vs. This value added results in incremental cost of holding a stage 3 product in inventory over and above the cost of storing one each of the stage 4 and stage 5 component items. Thus, E38 Components Figure 4.11 Sample Three Level, Five Stage Product Structure118 Chapter ¢ Manufacturing Strategy and the Supply Chain EXAMPLE 4.9 GB C1 =v 4 Cy +05 we Figure 4.12 Item Echelon and Installation Cost Structure (Excluding Holding Cost Rate) if our choice is whether to store a stage 3 item or keep the components in stock ready for assembly, the relevant incremental cost of assembling the product is attributable to This leads to the concept of echelon holding cost, ¢), as the holding cost resulting from the value added at a stage. Thus, . es = by, important result comes from the fact that total inventory cost can be computed on the basis of installation stock and costs or echelon stock and costs. Thus, for a product hierarchy of W stages, % x Installation Holding Cost = Echelon Holding Cost, ic, Yhj-5= >, eB. (4.24) A formal proof of this result is presented in Chapter 9 where we elaborate on multiech- clon planning models. Recognizing the incremental impact of echelon costs for storing inventory in a mul- tistage system allows us to justify keeping inventory close to the customer. This can be shown with the standard BOQ inventory model. Recall that the order size is given by 2 h where A is the cost to place an order, D is the demand rate, and h is the relevant holding cost per period. Demand and ordering costs are unchanged by the echelon perspective. At the lowest level of the factory, holding and echelon costs are the same. The production batch size is the same for either model. However, as we move higher in the supply chain, to the distribution centers, warehouses, and retailers, echelon costs, which are determined by incremental costs, will be Jess than the full installation costs. If we use the smaller ech- clon holding cost for a stage in the EOQ expression, we will obtain a larger batch size. Because average inventory is equal to half the batch size, echelon costs will lead to higher inventory levels as we get closer to the final customer. From our conservation property of installation and echelon cost approaches, we can infer that the system-oriented echelon costing approach justifies holding inventory closer to the final customer. Consider a two-stage system composed of a distribution center and local retailer system, Demand is 100 units per period, and ordering cost is $400 for the distribution center and $100 for the re- tailer, Installation holding costs are $1 and $1.25 per unit per period, respectively, for the centerSOLUTION 42 Supply Chain Management Concepts 119 and retailer. Find the order sizes and average inventory levels for the installation and echelon cost approaches. ‘Using the BOQ expression, order size for the distribution center for both echelon and installation costs is ~ /2AD 2(400)(100) Ove = | AP = J 2gnoure Now, consider the retailer. With echelon costs of ¢ = 1.25 ~ 1.00 = 0.25, the onder size is n= [42 = [2t0ma00 * é 0.25 ‘The order sizes are the same. Because Onc = Qg, the distribution center will not hold inventory but immediately pass it onto the retailer as shown in Figure 4.13a, Average inventory levels for the ech- ‘elon model are 283, 83. 283 Tye = 0 and Ig = > = 142, where “e” implies an echelon cost basis. With installation costs, fram, [2.00 x00) n= J BP = POO = 106 In practice, we would probably increase this slightly to 142 units so that the retailer orders twice as often as the distribution center. The timing of these orders would be synchronized such that as soon as the DC receives an order, it passes half that order onto the retailer. Average inventory lev- als are Pye = Th = 71, where “h” indicates an installation cost basis. The corresponding inventory levels are shown in Figure 4.13b. Figures 4.13¢ and 4.13d provide the echelon inventory pictures relating to Figures 4.13a and 4.13b, respectively. Retailer inventories ase the same. The echelon in- ventory at the DC is the sum of the installation inventories forthe retailer and DC. ‘The natural question now arises: Which is better? Let’s examine the actual costs. Tota system costs include setup, plus holding costs for both sites. The costs are given by: System Cost = [Pater + hye ioe| + [Patt hig in| (4.25) For the echelon cost solution: = | 00400 100)(100) _ {283 syn coe [LIMA oy] [HOLA + 125-28] w ssiat esaaal = 5s For the installation cost solution: syaom can =[ MEH. 9975] »| SRD « 250020] = $212.09 + $159.11 = $371.20. From the system perspective, echelon based allocation is preferred. However, ifthe DC and retailer are different profit centers, they may not agree to work for the common good. The retailer, esam- ining hishher own cost structure, realizes that it is best to order smaller batches if they are charged the $1.25 holding cost. The organizational structure, evaluation, and accounting system will ulti- mately determine the policy adopted.120 Chapter 4 Manufacturing Strategy and the Supply Chain DC Echelon Inventory 4. Echelon Inventory with Smaller Retaler Order Size Figure 4.13 Mlustrtion of Echelon and Installation Inventory4.3. Multifacility Location-Allocation Models: Designing the Logistics Network 121. 4.3. MULTIFACILITY LOCATION-ALLOCATION MODELS: DESIGNING THE LOGISTICS NETWORK Strategic planning includes the sizing and location of production facilities and the allo- cation of product family production responsibility to those facilities. The objective is to minimize cost while meeting customer service objectives in all markets. A market refers to a combination of product and geographical region. A region could be a country or lo- cal region within a country (such as the southwestern United States). Typically, produe- tion responsibility will be assigned at the level of product families. A family may be a line of toasters, or motherboards for a line of PCs, Each family is assigned to one or more production facilities. Each facility must be allocated the necessary labor, tooling, and sup- porting resources to produce its assigned product families. This allocation problem has become more important in recent years as we have witnessed the globalization of manu- facturing. It is not uncommon to have parts being assembled in one country that were fab- ricated on other continents. The finished product may then be shipped worldwide. Pro- duction and logistics costs can vary considerably based on whether we decide to produce ‘our products in’ Europe, North America, the Far East, or in several of these locales. Tax rates, exchange rate uncertainties, and local content requirements can play a major role {in such decisions as well. Cohen and Lee [1989] summarized a number of strategies that organizations may adopt for plant location and logistics. When markets ate spread out, production capacity is flexible, distribution costs are high, and tax structures favor local production, a regional strategy may be used. A production facility is located in each ge~ ographical region to produce a wide variety of products that are then distributed locally. With less flexible capacity and strong economies of scale, the organization may adopt product focus. In this case, plants ate built in different regions, but each produces a lim- ited line of products. Products are then distributed internationally, possibly globally, from the distribution center colocated at each production plant. Typically, raw materials will be obtained locally, and the availability of material suppliers may contribute to the decision of where to locate each produet’s facility. When economies of scale, market demand, and international cost structures warrant, a consolidation strategy may be adopted, whereby large-scale production occurs at a single plant. Usually, product development and a large distribution center are colocated at the site. We will present a mathematical programming model, adapted from Munson and Rosenblatt {1997}, for aiding in the facility location and distribution decision. To keep the ‘model simple, we assume that production can be aggregated into a single product that is assembled from a set of components. We further assume that product demand in each mar- ket region is known and constant over time, Product will be shipped directly from pro- duction plants to the regional markets. We let the index j indicate the set of possible man- ufacturing (assembly) plant locations. Locations may indicate countries where we could build a plant, or they may represent one or mote specific Jocations within each country; potential locations have been identified by considering labor supply, utility rates, trans- portation network, local environment, and related factors. A known set of possible sup- pliers exists for each component. This set may include the options of building our own component plants in some of the countries served. The decision variables for the model are: Decision Variables: Y= 1 if we utilize an existing facility or open a new production facility at location jand 0 otherwise;122 Chapter 4 Manufacturing Strategy and the Supply Chain mount of product assembled at location j for shipment to customer [5 Xx = amount of component i purchased from supplier k and used for production in location j;, ‘To choose our production system rationally, we need the following parameter data: Technological Coefficients: ‘unit cost to purchase and deliver component i from supplier k to production location js ‘D, = demand per time period for customer location [; F, = fixed cost per period to open a production facility in location K) = capacity per petiod of the facility being considered at location js L, = minimum local content of value added required by customer region [; _ ‘Pr = sale price (or value) of item sold in customer region {; ‘r= amount of component i needed to produce a unit of produét; 4 ~ unit shipment plus import cost fo serve customer I from a production plant iti location j; vy = value added (variable production cost) at plant location j for a product designed for market J Con (Note that the finished product may be customized for each market and, therefore, production cost may depend on the customer market 1); V{1} = set of suppliers and sites in the same country as market area /. Minimize SF; ¥;+ SD cy Xe t+ SS t dS 4.26) 7 ar 4 subject to: > (33, a Xi) FS vy 52 De pal — 42 shy Sho TS. set Su SY Kp Vil (4.28) Ss KW (4.29) DX Do Se Ve (4.30) ¢ 0 > Si ¥; E{0,1}; Xge = 0; Sy =O (4.32) ‘The objective function (4.26) mifimizes the sum of fixed costs to use production facili- ties, the cost to obtain components, the cost to produce at the plant, and the cost to ship product to the final market destination, To introduce the basic model and keep it relatively simple, our objective function minimizes cost. Because tax rates vary by country, it would be preferable to track profits by country and to maximize total after tax profits. The reader is asked to make this extension in the end-of-chapter exercises. The constraints (4.27) enforce the local content regulations, The left hand side of the equation computes the value of components purchased in the country, plus valued added by production in the Dy WL (4.31)43. Multifaclity Location-Allocation Models: Designing the Logistics Network 123 country. Total internal expenditures are proportioned, based on the percentage of produe- tion that is sold within the country. The right hand side determines the required local con- tent value based on regulations and total local sales. We assume that markets share a one~ to-one correspondence to governmental jurisdictions; otherwise, we may need to aggregate markets in these constraints. The precise form of this equation may vary depending on the specific form of the local regulations. Value, for instance, may be measured in terms ‘of number of parts, vali aiided, or selling price.° Equation (4.28) performs accounting functions for the model. ‘The Equation set forbids production at a plant unless the fixed cost to build the facility is incurred, Plant capacity is enforced in Equation (4.29) by re- stricting total shipments from each production facility to be no more than the capacity of that facility. The necessity of acquiring a sufficient number of components of each type to allow production at the assembly plants is assured in Equation set (4.30). The 7; factor allows for differences in units between components and products. For example, there may be 10 square fect of sheet metal required to make a microwave oven or 10 transistors of a particular specification on each circuit card. Equation (4.31) ensures that demand will ‘be met in each customer market. The left hand side of the equation sums up deliveries from all production plants to a single customer. Finally, the integer nature of plant construction and the non-negativity restrictions on production and shipments are satisfied by Equation (4.32) ‘The binary facility variables and nonlinear nature of the content restrictions (4.27) make the problem difficult to solve. Fortunately, the system design problem does not re- quire real-time decisions, The analyst may specify a limited set of scenarios for the set of manufacturing plants to use and then solve the model for each scenario. For an existing network, the analyst may periodically consider the possibility of adding or deleting sev- eral new plant locations or suppliers. By assuming that plants will produce to near ca- pacity and always serve the local market, we can remove the nonlinearity by replacing the Su D, St py Be x5. in Equation (4.27). ‘The model may be extended to include a variety of factors, As noted previously, the “product” could be divided into multiple product families. If demand and supply options vary over time, we could model time as a sequence of annual periods. A different strat- egy might be used for each year, and we might even consider storing inventory in peri- ods of slack demand. The set of potential facilities indexed by j implies we have already specified the capacity for each site. However, we could include several different facility sizes in each country simply by including these as options with different fixed costs and capacities. Other types of local content rules could also be modeled. In the next chapter we describe dynamic system-wide production and distribution models in greater detail ‘Our objective here was primarily to present the issues involved in designing global lo- gistics networks and to demonstrate the possibility of using mathematical models to aid in network design. as stated, this equation is nonlinear in the Sy variables. We can linearize the model at the expense of defin- ing more variables. The Xy, variables could be expanded to X,y to include an indication of where the compo- rent will ultimately be used.124 Chapter 4 Manufacturing Strategy and the Supply Chain 4.4 SYNTHESIZING THE CONCEPTS ‘As noted by Tompkins [1998], the secret to success lies in leadership that synthesizes the core supply chain competencies. We must understand and build effective product design processes, operating systems, and distribution systems. This includes capturing the voice of the customer, catering to the whims of the best customers, and, where profitable, sat- isfying the needs of the smaller customers. We must select the proper combination of push and pull production and distribution systems’ to meet delivery requirements with mini- ‘mal inventory cost. This requires effective maintenance and quality assurance procedures and intelligent warehousing and distribution control plans to allow dependable and effi- cient product delivery. We must develop long-term partnerships with suppliers and cus- tomers with a willingness to share information, risks, and rewards. Then we must reap the benefits of these conditions by exchanging information and coordinating plans. Finally, effectively applying today's supply chain concepts will not suffice to ensure continued success in the future. The company must understand the process of change and hamess its potential. If we don’t improve, the competition will, and we will be left behind. In- stead of moving from peak to valley, as the competition exceeds our improvements, we should anticipate technological and organizational breakthroughs and push the frontier forward, or at least be agile enough to follow closely behind. 4.5 SUMMARY Markets today tend to be global, raising the opportunity for tremendous growth but, atthe same time, inereasing competition. Global competition requires establishment of an effective supply chain that spans the spectrum from materials purchases to prod- uct delivery, including the functions of manufacturing and cus- tomer service. The supply chain design must consider material availabilty, logistics costs, and local cultures, as well as market ‘opportunities. Attention should be given to building mutually ben- cfcial relationships with partners in the supply chain. ‘Manufacturing strategy plays an important role in decid- ing how a firm wil position itself in the supply chain, Setting the strategy requires an understanding of the company’s mai- kets and competitive advantage opportunities. The core com= potencies vital for success are defined and protected to maxi- mize competitiveness. The degree of vertical integration is selected, and necessary linkages with suppliers are formed, The company must decide how it can most efficiently add value. ‘This typically includes choices concerning which products to ‘make, where to make them, where to acquire the required ma- terials, and where to distribute the finished products. As part of this process, the company decides the degree of flexibility to {incorporate into operations, how to take advantage of informa- tion technologies most effectively, and where to stock inven tory. Inventory may be pushed or pulled through the supply chain, and safety stock can be aggregated at distribution cen- ters of distributed to retail sites. Mathematical programming models can assist in defining the network of suppliers, produc tion facilities, and distribution facilities that minimizes total costs, Ultimately, the strategic plan must consider plants, processes, people, and products in forming the purchasing, ‘manufacturing, distribation, and service plan Information exchange becomes critical for effective opera- tion to minimize inventory and respond rapidly to customers. Without the free flow of information to all partners in the sup- ply chain, random fluctuations in demand tend to accelerate up the supply chain, causing large fluctuations in oxders and pro- duction levels Itis typically best to coordinate decisions at each level of the supply chain with a planning horizon at least as long as the cumulative lead time through the system. Distribu- tion requirements planning and allocation schemes are used to pull or push inventory through the multiple stages of the sup- ply chain, ‘Some inventory storage will always be necessary to guard against random events. The preferred location for safety stock depends heavily on the eustomer’s expectation for delivery time, product cost sircture, degree of randomness, and number of sites involved. Safety stock should be aggregated at the high- ‘est level ofthe hierarchy that still permits delivery to customers as,needed without excessive cost or delay. An echelon cost ‘model can help determine the optimal inventory strategy for the integrated supply system. "Push and pull systems are addressed in Chapters 7 and 8,4.6 REFERENCES Aner, B.C., BRown, G.G. Haneson, TR, & Trarvow, LiL. Global supply chain management at digital equipment corporation. Jer faces, 1995, 25(1), 69-98. Bano, LR, & Feo, TA. An algorithm forthe manufacturing equipment selection problem, IZE Transactions, 1991, 23(2), 83-92. ‘Browne, J Dywois, D. Rathuit, K, Sev, SP. &eSrecke, KB. Clas sification of flexible manufacturing systems. The FMS Magazine, 1984, 2, 114-117 CCaNaba, LR., & SuLLivaN, W.G. Economic and muliatribute evalua- tion of advanced manufacturing technologies. Englewood Clits, NI: Prentice-Hall, 1989 Cowen, MA, & Let, HLL, Resource deployment analysis of global manufacturing and distibution networks. Journal of manufacturing «and operations management, 1989, 2, 81-104 Danae. 1G, & Askin, RGA multiple objective decision model for the evaluation of advanced manufacturing. system technologies. Journal of Manufacturing Systems, 1992, 11@), 179-195. Dornier, P, Beast, R. Penba, M. & Kouveus, P°Giobal operations ‘and logistics, New York: John Wiley & Sons, 1998 Gowen, BL, Was, EA. & Levy, DE. The analytic hierarchy process: Applications and studies, Springer-Verlag, Berlin, 1989. Kanan, RS. Must CIM be justified by feith alone? Harvard Business Review, 1986, 642), 87-95, Kuouis, RA. Customer-centered supply chain management. New York: ‘American Management Association, 1998, Lae, HLL, & BILLNOTON, C. The evolution of supply chain manage~ tment models and prtctice at Howle-Packard. Interfaces, 1995, 25(5), 42-63. 4.7 PROBLEMS 41, What is the difforence between a technology-push and rmarke-pull product? How should this impact the company’s product design and marketing efforts? 42. Define the term core competency and explain ts ole in manufacturing strategy. 4.3, What are the competitive advantages of vertical integra- tion? 44, List the different strategies available for achieving flexi- bility in manufactaring operations. 45. Describe the different strategies for organizing produc- tion facilities across « geographically dispersed supply chain ‘and indicate the conditions under which each is appropriate. 4.6. A company can purchase a component for $0.35, How- ‘ver, the Facility has extra capacity, and if they invest $5,000 in new tooling, the item can be made for an estimated $0.23 per anit, Find the break-even point for determining whether the component should be made or bought. 4.7. A common bracket can be purchased in large quantities for $0.67. The company can make the bracket ata variable cost of $0.41 by buying a machine for $33,000, Demand over the next two years (the anticipated life ofthe product and machine) Problems 125 Let, HLL, PaDMaNabian, V, & Wan, S. The bullwhip effect in sup- ply chains. Sloan Management Review, 1997, 38(3), 93-102. Le, HLL, & Tana, C.S. “Modelling the costs and benefits of delayed product differentiation” Management Science, 1977, 43(1), 40-53. Maciazras J. Fas, global and entrepceneuiat: supply chain management, Hong Kong style. Harvard Business Review, 1998, 76(5), 102-114, Munsox, C., & Rosanna, MI. The impact of local content rales on global sourcing decisions, Production and Operations Management, 1997, 6), 277-290, Nanasinitas, 8, McLeavey, DLW, & BILLINGTON, P. Production plan- ning and inventory control, Englewood Cliffs, NJ: Prentice-Hall, 1995, ‘Saary, TL. The analytic hierarchy process: planning, priority setting, resource allocation. McGraw-Hill, New York, 1980, Sumi, AK, & Serut, SP Flexibility in manufacturing: a survey. Ine ternational Journal of Flexible Manufacturing Systems, 1980, 23). 289-329, ‘Tavur,S., Ganestan, R, & Macazose, M. Quantitative models for sup~ ply chain management. Boston: Kluwer Academic Publishers, 1999, ‘Tompuans, JA., Time to rise above supply chain management. Mater lal Handling Engineering, October 1998, SCFI6~SCF 18. Viost Cl, & GosTscHa.cix, M. Suategie production distribution mod ‘ls: a critical review with emphasis on global supply chain models. European Journal of Operational Research, 1997, 98, 1-18. Warr, CE., Crossdocking, Material Handling Engineering, July 1998, 44-49, Zapent, F The analytic hierarchy process—a survey of the method and. its applications, erfaces, 1986, 16(4), 96-108. is estimated to be normally distributed with mean 100,000 units and a standard deviation of 10,000 units. Would you recom- ‘mend making or buying this bracket? 48. The purchasing manager for a job shop must decide ‘whether to stock a particular material or just order it as needed for custom jobs. To stock the item, the inventory status would hhave to be checked once a week at a cost of $500 annually. The cost to place an order is estimated at $125. Imegular orders placed for specific jobs would require an additional $85 deliv- ‘ery charge. The company would have to place approximately twenty such orders per year, Demand for the $8 item is 2,300 ‘units per year. The annual holding cost rate is 40%, Should the manager decide to stock the item? 4.9. A plant is being built to manufacture two product fami- lies—A and B. The facility must produce 100,000 units of each family per year. Three technologies are available, Technology ‘one costs $125,000 per system per year, and a system can pro- ‘duce 50,000 units of product A, or 25,000 Bs (or any propor tional combination) annually. Technology two costs $65,000 per Year and can produce 45,000 of either product per year A third ‘technology exists that can only produce product B. The system could produce all 100,000 units for a cost of $180,000 per year.126 Chapter 4 Manufacturing Strategy and the Supply Chain a. Develop a mathematical programming formulation for the problem of selecting technologies. b. Find a good heuristic solution to the problem by first re- laxing the integer restriction on purchasing processes and then rounding up the resultant acquisition variables, . In addition to expected cost, what other factors should be considered? 4.10, An industrial engineer believes @ new data collection and scheduling system will improve shop performance. The sys- tem will cost $150,000 to purchase, and will require a class TI ‘employee to operate. Class Il employees have @ compensation package of $46,000 per year. The current scheduling system is ‘operated by two employees costing $31,000 each per year. The benefits of an improved schedule are dificult to estimate, but the engineer is confident that work-in-process inventory hold ing cost will be reduced atleast 33% from the current cost of {$80,000 per year. The reduction in inventory will also reduce ‘congestion and response time to meet customer orders. Current delivery times are ten weeks, The plant manager has agreed that 12 50% reduction in production flow time would be as impor- tant as incurring the cost of the system. System life is estimated at three years. The company uses @ minimum attractive rate of retum of 17%, Should the engineer recommend purchasing the system? 4.11, FACE Co, distributes cosmetics to department stores. FACE recognizes that fast delivery of a full range of cosmetic products accounts for its success. Currently, products are bought in large quantities and stored in regional warehouses. The an- nual cost of carrying inventory, including losses for unsold items, is $12,000,000. As an alternative, the company could pur- chase a manufacturing system for $3,000,000 and operate the system for $1,500,000 per year: Inventory costs would be elin- inated and delivery time would be unaffected, However, the va- riety of products offered would be reduced by 50%. Assuming product variety is twice as important as cost and delivery time for the range of values that would result from these two alter- natives, construct an AHP decision hierarchy to decide whether the system should be purchased. The company requires a pay- back period of two years, at most, for investments, The annual discount rate for the company is 20%. 4.12, A US. company has a network of manufacturing facil- ites around the world. How should changes in exchange rates, affect its decisions about where to purchase raw materials and where to produce products? 4.13. A US. company that makes sheet rock enters into a Jong-range contract to buy 1,000,000 Ibs. of gypsum each month, from a mine in Mexico. Suppose the exchange rate forthe Mex- ican peso changes from 10.20 pesos per dollar to 10.85 pesos per dollar, What effect will this have on the profits of the U.S. company? 4.14, Consider a two-stage plant-retaler supply chain. Lead time for the plant to fill retail orders is one week. The plant produces exactly to demand and does not keep inventory. De- sited safety stock at the retailer is equal to half-week demand, and furure demand is estimated by the average of the past two weeks. Find the impact on plant production (customer orders) if demand permanently increases from 100 to 110 units per period, 4.18. Suppose in the previous problem that the plant main- tains a finished goods inventory with a target safety stock level cof one week's demand based on a three-week moving average. Shipments are made from the plant’s inventory to the retaler and take one week in transit. It also takes one week to produce items; therefore, whatever the plant produces this week is not available for shipping until next week. aL State the order-up-to rule used by the retailer. 1b, State the rule used by the plant to determine the produc- tion quantity each period. | & Find the impact on plant production and inventory levels, if demand permanently increases from 100 to 110 units per period. 4.16. Consider a two-stage plant-reailer supply chain, Lead time for orders is three weeks. Safety stock is equal to one week's demand, and fature demand is estimated by the average ‘of the past two weeks, Find the impact on plant production (cus~ tomer orders) if demand increases from 100 units to 120 units for a single period and then retums to 100 units. 4.17. Consider a two-stage plant-retailer supply chain. Lead time for orders is two weeks. Safety stock is equal to one week's demand, and future demand is estimated by the average of the past two weeks. Find the impact on plant production (customer orders) if demand changes from 100 units a week to cycling between 90 units and 110 units per week. 4.18, Repeat the variance accelerations example in Section 4.2.2.1, assuming demand increases to 110 units in period six and then returns to 100 units per week in week 7 and thereafter. Use a spread sheet to track the effect on inventory levels and factory production. 4.19. A retailer places an onder at the start of each week and receives the order two weeks lier. The retailer attempts to keep its starting inventory level equal to 1.5 weeks of demand rep- resenting expected sales for that week, plus, hal-werk safety stock. (Actual demand is not known until after the order is placed.) The retailer uses a three-week moving average of de- ‘mand to estimate mean demand. When the factory receives the order it immediately places an order for raw materials. The fac- tofy also immediately starts producing the number of units or dered by the retailer. Lead time in the factory i two weeks once production begins. The raw materials arrive one week after the order is placed, The factory tries to Keep 1.5 weeks of raw ma- terials in stock atthe start of each week. Mean demand is based ‘on a two-week moving average of retail orders. a, Diagram the supply chain and state the order-up-to rule cused by the retailer.b, State the orderup-to rule used by the factory in ordering raw materials, . Using a spread sheet format, track performance of this sys- tem for eight weeks if demand suddenly shifts from 100 units per week to 110 units per week starting in period 3. ‘4, Suppose that, instead of placing an order for raw materi- als each week and then using the existing raw material inven- tory, the factory decided to eliminate the raw material safety stock, Each week an order would be placed for enough mate- salto fill the retailer's order. When those materials arrived one week later, the factory would stat its iwo-week production ey- cle, What effect would this strtegy have on delivery lead time to the customer, and how would it affect inventory swings in reaction to demand changes? 4.20. Describe the key factors in selecting and certifying a vendor. 421, Describe the impact of cross-docking on inventory cost ‘and delivery lead time in a multistage supply chain, 4.22, A distribution center serves twenty local outlets. De- ‘mand at the outlets is normally distributed with a total mean of 24,000 units per month, Individual outlet demands are in- dependent and all have a standard deviation equal to 0.15 ‘mean demand. The company has a target of filling 98% of demand from stock. What is the difference in required safety stock if this is kept at the distribution center instead of the outlets? 4.23, Repeat Example 4.7, assuming the production plan calls for producing 500 units of the product every other week, start- ing in week 1. Determine the shipping plan for the next ten ‘weeks using distribution requirements planning 4.24, Repeat the previous problem using a runout based allo cation scheme. Fully allocate all factory shipments 4.28. A final product is composed of two part AS, one part B, and one part C, Each part C requires one part D and two part Es, Let 1 be the installation inventory level of item i, Using Ey for echelon stock, give the expression for each item’s echelon stock in terms of installation inventory values, 4.26. Weber Manufacturing is trying to define its supply cchain to serve demand in an area encompassing three coun tries. A production plant can be built in any one or more of the three countries, Monthly demands by customers in the three countries are 10,000 units in country A, 25,000 in coun- ty B, and 30,000 in country C. A plant with capacity 40,000 units per month (the optimal plant size for this product) can be built in any one of the three countries for an amortized rionthly fixed cost of $20,000, Unit variable production costs in the three countries will be $1.25, $1.10, and $1.40, re- spectively, Potential raw material suppliers already exist in 47 Problems 127 countries A and B. The product sells for $4.50. Country A does not have a content law. Country B imposes a 50% tariff if less than 50% of the product’s value is produced in coun- tuy B. Country C imposes a 75% tariff if less than 25% of the product's value is produced in country C, The raw material is ‘abasic commodity costing $1 per unit. Shipping costs per unit are as follows: Raw Material Shipping Costs/Unit To country From country A B c A 80 sos $0.15 B $0.15, $0 $0.20 Finished Product Shipping costs/Unit ‘To country From country A B c A $0 $0.25 $030 B $0.25 $0 $0.35 c 0.40 $035 $0 ‘a. Formulate this supply chain design problem as a mathe- matical program, Define all decision variables. Bb. Solve the formulation to determine the optimal supply sys- ‘tem decisions. 427. Expand the formulation in patt A of the previous prob- Jem to allow for the possibility of also constructing a raw ma- terial plant in country C. Define any necessary notation. 4.28. Suppose that in Problem 4.26, smaller plants could also ‘be built with capacity of 20,000 units for an amortized monthly ‘cost of $15,000 and a 10% increase in variable costs. How would this change your formulation? 429. Modify the formulation in Section 4.3 to track profits by country and to maximize total after-tax profits. In doing so, define notation for matecial purchase costs, tax rates, exchange, rates, variable production costs, and selling price for each prod- uct. Note that transportation costs for materials and distribution costs for products must be charged to either the shipping plant or the reesiving location. Discuss how varying tax rates between countries should affect the decision of how to charge these costs and set transfer prices between international facilities128 Chapter 4 Manufacturing Strategy and the Supply Chain CASE STUDY 4.8 Elba Electronics John James, vice president for Manufacturing of Elba Elec- tronics, stared out the window past the autumn leaves floating down the Elba River. He was lost in thought and didn’t notice the refleetion ofthe setting sun as it glistened off the lake, nor the reddish-orange wash it painted over the surrounding moun- tains. He had just finished reading Rick Armstrong's recom- ‘mendation to close part of the Elba facility and move all pro- duction of low-end components and circuit card manufacturing offshore. Rick was the chief financial officer of Elba, and made a strong case for significant cost saving from the move, OF ‘course, Rick wasn’t a native of Elba; he hadn't worked at the plant along with his childhood buddies for the past twenty-five ‘years, and he wasn’t on a fist-name basis with virtually every ‘worker in the plant. John, troubled by his conflicting emotions and loyalties, could not help bat wonder whether the decision ‘was truly 50 straightforward. Elba Electronics opencd its plant along the river banks in 1955. Three friends retuming to the small town from the Korean War recognized the potential for supplying basic clec- trical components used in the production of radios. The town ‘of 15,000 offered limited opportunities. The three friends de- cided to make use of the GI Bill. After earning degrees at the public university located outside the state capital forty miles away, they retumed to Elba and opened the plant with sup- port from the entire population. Early on, their catalog of parts expanded to serve the rapidly growing television in- dustry, Except for a few lean years in the mid-1970s and 19803, the company had prospered and grown steadily through the years, until recently. John’s uncle Bill and his ‘two cofounders had retited about ten years ago and sold the ‘company t0 @ large conglomerate, Elba’s business was ust- ally dominated by high-volume production of basic com- ‘modity electrical components. However, the founders had twice fed the company out of recessions by investing their re- tained earnings in new production equipment and exclusive rights to revolutionary new product technologies. These high- tech components carried higher profit margins. Unfortunately, those businesses required constant investment to remain com- petitive. In the past ten years, the company’s core business hhad retuned to producing basic axial and radial components and the production of printed circuit boards. These businesses were more labor-intensive, but Elba Electronics had devel- ‘oped a strong reputation for high-quality and dependable de- Jivery. Consequently, they were a preferred vendor for many of their customers, In recent years, however, profits were ropping. Overseas competitors, with lower labor costs, were. cutting prices. Elba’s customers were slowly migrating, and now most of their product was shipped to Mexico, Ireland, Korea, and Singapore. Elba was forced to absorb the in- creased shipping cost and to incur increased inventory cost by warehousing components overseas fo ensue timely deliv- ery. John felt trapped between his loyalty to the employees and the new company owners, He was hoping he could dis- cemn some weakness in the CFO's analysis. His thoughts fo- cused on two questions: 1, What noneconomic factors deserve consideration, and how should they be measured and weighted? 2. Are there rational alternatives to the options of status quo and closing the Elba site? John turned back to his desk and picked up the memo to give it a second look. To: BR. Pullman, President, Etba Blectionics From: Rick Armstrong, chief financial officer RE: Comporate Financial Planning Committee Viability Investi- ‘gation The FPC has completed its study of the Tong-term viability of Eba’s current operating plan. It is our eorihusion that contin- ued operation ofthe Elba facility plant is unwarranted. Let me emphasize that the corporate members ofthe committee were ‘most steadfast in this view and are inthe process of drafing a ‘memo to the corporate executive council recommending that the facility be closed by the end of the year with the operation being moved to Southeast Asia ‘The committee’s decision came down to one of eeonom ics, We curently employ 265 workers here in Elba, and recorded $37.6M in revenues last year. Revenues have been growing at the rate of 3% annually in recent years, The com> riltee focused on the rapidly increasing distribution and ware- housing costs that have led to erosion in our profit margin. A summary of current cash flows and the three-year trend appears as Cost category ‘Annual cost 3yr growth rate Labor $11.8Mi 3% Marketing $2.0M 2% Depreciation and Utilities. $3.3M 4% Distribution SLIM 12% Finance (Inventory) $4.6M 10% Materials S46M 3% Net Earnings 0.2M ~5% "Labor cost is 35% administrative, SO% direct and 15% indirect. shop labor. A preliminary study indicated that a move to Southeast Asia could probably be completed with a star-up cost of $6 nillion after accounting for the sale of local facilities and ex- pected tax breaks. This includes transferring the production equipment, We currently have on the books a plant value of $12