OCM - Material Adicional de Consulta - Fundamentos - v1.1

Operaciones de Clase Mundial
Fundamentos de Operaciones y
Supply Chain Management
Material Adicional de Consulta
Prof. Luigi Laporte

llaporte@utdt.edu
Fundamentals of Operations and Supply Chain Management
Introduction Economics of Inventory and SCM
1. Definitions and overview 7. Economics of SCM
8. Inventory Management
Procurement Fundamentals a) Single period models: Newsvendor
b) Multiperiod models: Continuous and Periodic

review
2. The importance of procurement for the firm:
procurement as strategy
3. Fundamental processes and concepts in

procurement Wrap-up
4. Segmenting procurement operations

9. Wrap-up of the fundamentals
Logistics & SCM Fundamentals
5. The importance of logistics and SCM for the firm:

SCM as strategy
6. Fundamental processes and concepts in Logistics

and SCM
2
1. Definitions and overview
▪ What are the contents of this course on Operations and Supply Chain Management?
▪ Topics will be in…
▪ the scope of functions such as Procurement, Manufacturing, and Logistics
▪ the interfaces among them,
▪ and the interfaces with other functions in the firm, such as Finance, HR,
Marketing, Sales, and Technology
▪ … but with a focus on the strategic decisions (which sometimes will force us to delve
into the math and the fundamentals)
▪ We are interested in what the General Manager must know
1. to define a solid firm’s strategy based on an end-to-end perspective about Operations

and its most important issues
2. to be able to interact with functional managers with the necessary expertise to build
alignment
3
Purchasing, Procurement, or Sourcing?
▪ There is no clear agreement on the definition and differences. Alternatives include:
1. a broadly indiscriminate use: Purchase = Procure = Source
2. “Procurement is the business management function that ensures identification, sourcing,

access and management of the external resources that an organization needs or may
need to fulfil its strategic objectives.” Chartered Institute of Procurement and Supply
(CIPS) Australia, cited in Lysons & Farrington (2020, p. 4).
3. “The new strategic function will probably not be called purchasing – that is much too
limited a word. The connotations of purse strings and spending money have no relevance to
the setting up and management of strategic interfirm relationships. This task is concerned
with ensuring the correct external resources are in place to complement the internal
resources. Perhaps ‘external resource managers’ is a term that future purchasing
managers will adopt.” Lamming (1985)
Lysons, K., & Farrington, B. (2020). Procurement and Supply Chain Management (10th ed.). Pearson UK.
Lamming, R., ‘The future of purchasing: developing lean supply’, in Lamming, R. and Cox, A. (eds), Strategic Procurement Management in the 1990s , Earlsgate Press,
UK, 1985, p. 40. 4
▪ There is no clear agreement on the definition and differences. Alternatives include:
4. Procurement = Purchasing + Supplier Management (Lysons & Farrington, 2020)
5. Sourcing includes tasks and operations needed to obtain external resources, as

defined in the Supply Chain Operations Reference Model - SCOR (ASCM, 2021):
Source: Association for Supply Chain Management (ASCM), Supply Chain Operations Reference Model (SCOR). More information on https://scor.ascm.org 5
▪ We will embrace all these definitions in this course and will focus on the processes
that enable organizations to identify and obtain external resources to support
the firm’s strategy and achieve its goals in costs, quality, flexibility, risk,
sustainability, and innovation
▪ We might use the terms indiscriminately, although we will give preference to the
following perspective:
Procurement Manufacturing Logistics
Sourcing Purchasing
1. Procurement is the function that executes purchasing activities, which include supplier
management
2. Sourcing includes deciding to make or buy, therefore a component can be ‘sourced internally’
instead of purchased
3. Sourcing materials is inscribed in a broader supply chain management perspective
Source: own elaboration. 6

Logistics, Supply Chain Management (SCM), or both?
▪ Professional associations and international programs have rebranded, signaling a trend:
▪ The Council of Logistics Management (CLM) rebranded as the Council of Supply Chain
Management Professionals (CSCMP) in 2004
▪ The Association for Production and Inventory Control (APICS) merged with the Supply-
Chain Council in 2014, and with the American Society for Transportation and Logistics
(AST&L) in 2015; it finally rebranded as Association for Supply Chain Management (ASCM)
in 2018
▪ The MIT Center for Transportation and Logistics (CTL) offered its renowned Masters of
Engineering in Logistics but, before 2012, changed the program’s name to Masters of
Engineering in Supply Chain Management
▪ The trend signaled an increasing recognition of the importance of cross-firm collaboration

and interactions, for which logistics was essential – but a name considered to be not broad
enough to convey the desired meaning
7
▪ Some alternative definitions include:
1. Supply chain management ”encompasses the planning and management of all activities
involved in sourcing, procurement, conversion, and logistics management. It also includes
the crucial components of coordination and collaboration with channel partners,
which can be suppliers, intermediaries, third-party service providers, and customers.” “[It]
includes all of the logistics management activities noted above, as well as manufacturing
operations, and it drives coordination of processes and activities with and across marketing,
sales, product design, finance and information technology.” (CSCMP, 2004)
2. “The key components of logistics are transport, inventory, and warehousing”. “Logistics =
Materials Management + Distribution”, and “Supply Chain = Suppliers + Logistics +
Customers”. (Rushton, Croucher, and Baker, 2014, p. 3-4)
3. “Logistics is... the positioning of resource at the right time, in the right place, at the
right cost, at the right quality.” (CILT, 2012, as cited in Rushton et. al, 2014, p. 6)
Source: Council of Supply Chain Management Professionals (CSCMP) (2014). Retrieved from www.cscmp.org.
Rushton, A., Croucher, P. and Baker, P. (2014). The Handbook of Logistics and Distribution Management (5th ed.). Kogan Page Limited. 8
▪ Some alternative definitions include:
4. The Supply Chain Operations Reference Model - SCOR (ASCM, 2021) approaches the
topic through a broad supply chain perspective that includes logistics as part of
source, delivery and return processes:
Source: Association for Supply Chain Management (ASCM) (2021), Supply Chain Operations Reference Model (SCOR). Retrieved from https://scor.ascm.org 9
▪ We will take the broader view and will discuss both in this course – we will focus on the
processes required to match supply with demand, including the collaboration
across the value chain with clients and suppliers
▪ We will give preference to the following perspective:
Supply Chain Management (SCM)
Procurement Manufacturing Logistics
Warehousing
Transportation
Inventory Management
1. SCM includes logistics activities, which include warehousing and transportation
2. Inventory Management crosses procurement, manufacturing, and logistics, and is a

fundamental part of SCM

Putting it all together: Operations and Supply Chain Management
▪ The course will focus on the processes required to match supply with demand,
including the collaboration across the value chain with clients and suppliers to
enable organizations to identify and obtain the required external resources
Operations and Supply Chain Management (SCM)
Suppliers Procurement Manufacturing Logistics Marketing Clients

& Sales
Warehousing
Transportation
Inventory Management
Sourcing
Other functions
Finance HR Technology Legal
A. Superior results require cross-functional collaboration and strategic alignment based on a

holistic, end-to-end perspective
B. The General Manager plays a central role in establishing this integrated perspective and
setting objectives that avoid local functional maximization


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SCM as strategy

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2. The importance of procurement for the firm: procurement as
strategy
▪ The dynamics of the definitions of purchasing, procurement, and sourcing signal a path of
evolution: an increasing recognition of the procurement function as strategic
▪ Procurement is the biggest single cost for most businesses: 60% of the average company’s
total cost; 75% for steelmakers; 90% for petrochemical (Degraeve and Roodhooft, 2001)
▪ Procurement can both create value – through collaboration and coordination with suppliers
– and capture value, through negotiation, in six dimensions (Schnellbächer & Weise, 2020):
Sources: Degraeve, Z., & Roodhooft, F. (2001) A Smarter Way to Buy. Harvard Business Review.
Schnellbächer, W., & Weise, D. (2020). Jumpstart to Digital Procurement. Cham: Springer International Publishing. 13
2. The importance of procurement for the firm: procurement as
strategy
▪ Examples of value creation or capturing in these dimensions include:
▪ Savings: collaboration in planning and forecasting to reduce supplier inventories and splitting the
benefits through purchase price reduction
▪ Innovation: development and launch of a product based on integrating a new technology developed
by a supplier
▪ Quality: reduction of the % of defective units sourced from a supplier after increasing quality audits
frequency and providing quality management training
▪ Sustainability: collaborating with a supplier to reduce or replace packaging materials with a more
sustainable alternative
▪ Speed: selecting a supplier geographically close to ensure quicker replenishment and faster response
to demand fluctuations
▪ Risk: developing alternative sources of supply for a critical component to avoid supply chain
disruptions
▪ Procurement must evaluate these dimensions combined in their sourcing decisions!
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3. Fundamental processes and concepts in procurement
Enablers: procurement
External context: the must act on the levers
procurement strategy that enable and support
must align the entire the execution of the
procurement procurement strategy
organization to the
external context and to
the firm’s business
2. Category
strategy management
1. Strategic 3. Source to
sourcing contract
Procurement
Strategy
6. Supplier 4. Procure to
management pay
Fundamental 5. Contract
management
processes:
mature procurement
includes several
processes properly tied
to one another and
directed by the
procurement strategy
Source: adapted from (i) CIPS Procurement and Supply Management Model, cited in Lysons, K., & Farrington, B. (2020). Procurement and Supply Chain
Management (10th ed.). Pearson UK. and (ii) Belotserkovskiy, Drentin, Spiller, & Mercker. (2019). The next-generation procurement model. Supply Management. 16
In strategic sourcing, procurement:
• engages with the other business functions

to understand their strategy and have clarity
on its role in enabling the business plan
• assesses the ‘as-is’ regarding competences,

2. Category
management
spending, and supply base
1. Strategic
sourcing
3. Source to
contract
• generates options to improve competences
Procurement
and expand the supply base for the strategic
Strategy
items or services
management pay
• collaborates with other functions to decide
5. Contract
management
on make vs. buy
• considers outsourcing, offshoring,

vertical integration, risks, and long-term
impacts
• monitors the strategic fit of the sourcing

alternatives to the current context and
business plan in the six dimensions of value
In category management, procurement:
• groups products and services in

categories to foster the development and
2. Category
management
retention of category specific knowledge in
1. Strategic 3. Source to the procurement team
sourcing contract
Procurement • defines targets for savings and

Strategy
improvements in speed, risk, quality,
innovation, and sustainability for each

management pay
5. Contract
management category
• monitors the execution and evolution

towards the defined targets
Some proposed categories (CIPS Australia, 2011):
• Information & • Other Indirects

Communications (multiple unrelated or
Technology unspecified indirect
• Maintenance, Repairs categories)
& Overhaul • Facilities
2. Category • Professional Services Management
management
• Raw Material & • Capex
sourcing contract Ingredients • Equipment
Procurement • Packaging • Medical
Strategy
• Specific Directs • Print

management pay (discreet category or • Energy
5. Contract related direct spend
management • Recruitment & Labor
categories)
Hire
• Other Directs
• Marketing Services
(multiple or unrelated
direct categories)
• Logistics & Transport
• Fleet Services
• Travel
Source: CIPS Australia (2011) The state of the art of category management. 19
In source to contract, procurement:
• identifies potential suppliers for the

requested services or products
• gathers market information through a

2. Category
management
request for information (RFI)
sourcing contract
• unifies requirements and specifications
Procurement
Strategy and requests a proposal (RFP) or quotation
6. Supplier
management
4. Procure to
pay
(RFQ)
5. Contract • evaluates proposals, negotiates a

management
contract, and selects a winner to provide

the products or services
• creates and signs the contract
In procure to pay, procurement executes the

most operational procurement tasks – those
often supported by the firm’s ERP:
• a purchase starts with a purchase

requisition from the area that needs the
2. Category
management
service or product
1. Strategic
sourcing
3. Source to
contract
• after internal approval and supplier
Procurement selection, procurement issues a purchase

Strategy
order
management pay
• goods or services are received, and quality
5. Contract
management
control inspections are performed
• receipt confirmation is issued to the

supplier
• procurement approves the supplier’s

invoice for payment
In contract management, procurement:
• monitors the execution of the existing

contracts, the delivery of the products or
2. Category
management
services, and the authorization of the
1. Strategic 3. Source to payment to suppliers
sourcing contract
Procurement • collaborates with suppliers on continuous

Strategy
improvement activities related to the
contracts
management pay
5. Contract
management
• formalizes contract completion or
resolves disputes to achieve exit and
termination
In supplier management, procurement:
• onboards new suppliers
• monitors supplier performance and

metrics related to costs, delivery timeliness,
quality, financial health, risk, innovation, and
2. Category
management
sustainability
sourcing contract
• audits suppliers to ensure compliance with
Procurement
Strategy norms and standards
6. Supplier
management
4. Procure to
pay • communicates, meets with, and
5. Contract strengthens the relationship with
management
suppliers
• invests on and develops suppliers as part

of continuous improvement activities
• resolves issues and decides on

relationship termination

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▪ A typical procurement organization must source thousands of different types of items and
services from an overwhelmingly high number of suppliers
▪ Thus, fulfilling its mission with limited resources requires segmentation and prioritization
▪ We will cover three important segmentation frameworks:
▪ segment items and adopt the procurement processes and procurement organization
based on item importance
▪ segment supply risks to choose adequate mitigation strategies based on risk

predictability and impact
▪ segment supplier collaborative forecasting based on items’ demand and demand

volatility
25
The Kraljic matrix: sourcing strategy
High Leverage items Strategic items

Focus: competitive bidding Focus: performance-based partnerships
• Employ competition and purchasing • Centralize and adopt global sourcing
power to obtain the best short-term
• Seek long-term partnering agreement
deal and maximize cost savings
with built-in arrangements for continuous
• Keep contract terms relatively short improvement and performance
measurement
• Negotiate value-added agreements: VMI,
Importance of JIT, storage • Consider joint-venture with selected
purchasing suppliers and customers
Criteria: profit impact, Non-critical (routine) items Bottleneck items

cost of materials as %
Focus: standardization and outsourcing Focus: cost control
of total costs, volume
purchased • Buy at the best price • Contract to secure short- and long-
term supply and reduce risks
• Reduce administrative procedures and
costs – employ e-procurement • Consolidate purchases to increase
leverage
• Simplify requisitioning, buying, and
payment • Search for alternative products/suppliers
• Consolidate and buy from consortia • Adopt centrally coordinated but
Low decentralized decision authority
Low Complexity of Criteria: supply risk, short and High

(e.g. many suppliers) long-term availability, number (e.g. one or few
supply market of potential suppliers, structure suppliers)
of supply market (monopoly,
oligopoly, etc)
Source: adapted from Peter Kraljic. (1983) Purchasing Must Become Supply Management. Harvard Business Review. and Lysons, K., & Farrington, B. (2020, p. 55).
Procurement and Supply Chain Management (10th ed.). Pearson UK. 26
Supply risk assessment framework
High Operational Risk 2 3 High Risk 1 2 3

Detectable risk E.g.: Late shipments, customs issues E.g.: Key supplier bankruptcy
Occurrence can be
predicted or forecasted • Optimize mitigation efforts based on • Monitor closely and prepare for fast
based on past frequency of occurrence response; preventively mitigate when
observations appropriate
Risk predictability Limited Risk Disruptive Risk 2 3

Black swan
E.g.: minor supplier is acquired E.g.: rare natural disasters, unexpected political
Unforeseen events not
detectable through past
shifts
• Monitor development and early warning
observations signs of changes to the risk impact • Hedge sensitivity to disruptions based on
risk appetite
Low
Low Non-critical Impact Critical High

Slightly deteriorating Significantly impairing
company performance or jeopardizing the
company’s existence
Risk mitigation
1 Transparency 2 Preventive mitigation 3 Reactive mitigation
• Visit supplier plants and embed • Increase buffer inventory • Delay noncritical deliveries
to assess likelihood of
• Reengineer product • Deploy operations experts at
disruption
supplier
• Employ dual sourcing
• Purchase remaining stock in
• Integrate vertically
market
• Buy insurance to reduce impact
• Subsidize or buy out supplier
Source: adapted from Schnellbächer, W., & Weise, D. (2020). Jumpstart to Digital Procurement. Cham: Springer International Publishing. 27
Demand forecasting collaboration
High Power items Problem items

High volume/importance and stable demand High volume/importance and volatile demand
• Provide suppliers with data on item • Periodically share updated forecasts
usage and current inventory data and production plans with suppliers
• Periodically share updated forecasts • Consider Collaborative Planning,
and production plans with suppliers Forecasting and Replenishment (CPFR)
to reduce supplier’s costs and improve
• Consider value-added agreements such
the supply chain’s profits
Importance of as JIT
purchasing • Consider VMI or consignment inventory
Criteria: profit impact, Low items

annual volume,
Low volume/importance
annual spend
• Simplify sourcing: adopt min/max or reorder point, order quantity model
• Review and update parameters annually
• Revisit and negotiate suppliers’ minimum order quantity
• Monitor inventory levels with leading alarms to avoid stockouts
• Evaluate possibility of standardizing to eliminate some items from the product design
Low
Low Demand variability High

(stable demand) (volatile demand)
Coefficient of variation of demand
(CV = std. dev/mean)


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5. The importance of logistics and SCM for the firm: SCM as strategy
▪ 2020 was the year in which supply chains made the headlines: the COVID-19 pandemic
disrupted many of them, and it took weeks until supermarket shelves were back into their
usual stocking levels
▪ A complex network with thousands of firms – that were working behind the scenes to
allow consumers to do their groceries in their favorite supermarket store – was suddenly
unable to match supply with demand
▪ One of Kellogg’s executives in Australia summarized it remarkably:
“There was one day in March (2020) when our third-party warehouse had to do the equivalent
to a week’s worth of dispatching, and then we worked at that level for three weeks. (…) We
are used to big surges during promotions, but this was unprecedented.”
Shanaka Wijesuriya, CFO for Kellogg’s in Australia and New Zealand,

who also heads up planning and end-to-end logistics
Source: Sara Silver (2021). How Kellogg's, Nike, and HP handled 2020 supply chain disruptions. Financial Management Magazine. Retrieved from https://www.fm-
magazine.com/news/2021/jan/coronavirus-supply-chain-disruptions-kelloggs-nike-hp.html 30
▪ Inventories are a massively important asset: the total inventory in US firms1 summed up to
1.9 trillion dollars in 2020
▪ approximately the GDP2 of Brazil (8th) or Italy (9th economy in the world)
▪ roughly 1.5 GDPs of Spain and 3 GDPs of Argentina
▪ Strategically managing inventories in the supply chain is necessary because of its central
role in making businesses profitable:
▪ too little inventory: firms lose sales – and goodwill, reputation, and customers
▪ too much inventory: several costs associated with…
▪ the goods themselves: spoilage, breakage, theft, insurance, and obsolescence
▪ logistics: unnecessary storage and transportation
▪ opportunity cost of capital: gains the company could be making from the money
invested in the excess inventory or, alternatively, unnecessary interests paid
Source: [1] Manufacturing and Trade Inventories and Sales (2020), US Census Bureau. https://www.census.gov/mtis/www/data/pdf/mtis_current.pdf
[2] World Bank (2017) 31
▪ SCM is about strategically balancing a triangle in which the challenge is to improve all three
dimensions simultaneously:
Service Level
What percentage of the demand1 do we
aim to fulfill?
Costs Inventory
How much does it cost in logistics and How much inventory do we need to fulfill the
manufacturing to fulfill the demand at demand at the desired service level? Where do we
the target level? need it?
Improvements require strategy: thinking the supply chain end-to-end
[1] Percentage of demand fulfilled is only one out of the three main measures of service level. We will dive into this point further in this presentation. 32
▪ Some firms have made their supply chain strategy a source of competitive advantage:
▪ Toyota: just-in-time production to coordinate the supply chain and reduce inventory
▪ HP: postponement – the delayed product differentiation to reduce inventory of

finished goods (e.g., power cables and power adapters)
▪ Walmart: cross-docking to reduce unnecessary storage in warehouses, and everyday

low price (EDLP) to avoid creating fluctuations in end-customer demand
▪ Dell: direct-to-consumer (DTC) operations – eliminating the distribution network and

selling online directly to end-customers
▪ Zara (Inditex): quick response and inventory deployment – high manufacturing capacity
to respond fast to demand, instead of marking down remaining inventory in the end of
the season
▪ Amazon: pure online retailer with centralized inventory – no costs in maintaining retail
stores plus the advantage of demand risk pooling in centralized inventory
33
▪ Not coincidently, many of these names are frequently on Gartner’s annual ranks of
supply chain performance – industry references in logistics and SCM, capable of providing
great service with highly competitive inventory and costs:
The Gartner Supply Chain Masters The Gartner Supply Chain Top 25
Source: Gartner (2021). The Gartner Supply Chain Top 25 for 2021.
Retrieved from https://www.gartner.com/smarterwithgartner/the-gartner-supply-chain-top-25-for-2021/ 34
▪ Inventory and logistics have a direct impact in one of the main metrics of firm operating
performance: RONA – the return on net assets
Inventory-driven costs
Price Product Component
Obsolescence
Protection return devaluation
Traditional
Revenues – Expenses
inventory costs
(cost of capital,
Return On spoilage, theft
Net Assets = breakage,
insurance)
(RONA)
Working Capital
Requirements + Fixed Assets
Days of Days of Days of

Receivables Inventory Payables
Outstanding Outstanding Outstanding
Source: adapted from Callioni, Montgros, Slagmulder, Van Wassenhove, and Wright (2005). Inventory-Driven Costs, Harvard Business Review. 35
▪ Inventory and logistics have a direct impact in one of the main metrics of firm operating
performance: RONA – the return on net assets
Logistics related costs

Freight
Warehouses Distribution
(inbound)
Fulfillment
Revenues – Expenses Product return

Return On
Net Assets =
(RONA)
Working Capital
Requirements + Fixed Assets
Days of Days of Days of

Receivables Inventory Payables
Outstanding Outstanding Outstanding
Source: adapted from Callioni, Montgros, Slagmulder, Van Wassenhove, and Wright (2005). Inventory-Driven Costs, Harvard Business Review. 36
There is another cost: excessive inventory hides inefficiencies!

The underlying causes must be addressed before reducing inventories
Rocks = Potential
Boat = Company Problems
Water = Inventory
Large inventory
levels can hide
problems in a
Defects Forecast supply chain
Supply error Equipment
Damage Issues breakdowns
If inventory levels
are reduced
without addressing
the underlying
Defects Forecast problems, the
Supply error Equipment entire operation
Damage Issues breakdowns can take damage
Hence, inventory
reductions often
need to be
accompanied by
improvements in
Supply Forecast Equipment operations
Damage Defects error
Issues breakdowns
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6. Fundamental processes and concepts in Logistics and SCM
▪ Having adequate inventory levels of finished goods at the right place depend on several
strategic and tactical processes that must work in conjunction and alignment
Sales &
Procurement Production Logistics
Marketing
Long-term Supply chain strategy, Segmentation and Network Design

Demand
Supply Planning (inside Sales & Operations Planning - S&OP) Planning
Mid-term (inside S&OP)
Material Net demand planning /
Production Planning
Requirements inventory
(MPS)
Planning (MRP) replenishment (DRP) Demand
Short-term Supplier
fulfillment &
Customer
collaboration Supplier call off / Production Transport. Warehouse Available to collaboration
purchasing scheduling planning ops planning. Promise (ATP)
Execution Supply Chain Control Tower/Sales & Operations Execution (S&OE)
Purchas Plant
Manufacturing Transport. Warehouse Sales order
e Order material
execution mgmt. mgmt. management
mgmt s mgmt
Enablers
Performance management
Information Technology Organization & Culture People (capability building)
(metrics, reports, & analytics)
Other domains (e.g., Finance, HR, Asset Management, Product Life Cycle Management)
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Demand Planning (part of Sales & Operations Process

Planning – S&OP)
Forecast short, medium and long-term demand. Process is
composed of Statistical Forecast and Collaborative Forecast:
• Statistical: for long-term, typically employ econometric

models (e.g., regressions) and, for short-term, time series
methods (e.g., moving average, exponential smoothing,
ARIMA)
• Collaborative: teams provide changes to the statistical

forecast to incorporate knowledge from the field and
Main inputs
events that could drive demand up or down such as
• Demand history • Market research
• Customer collaboration • Competitors’ investments planned promotions, opening/closing of stores, new
(customer’s demand in capacity
forecast translated into
clients, disruptions, concerts, new product launches, and
• Competitors’ promotions
firm demand) product discontinuation
Main outputs
Define actions to shape demand (e.g., promotions,
Forecast Aggregation level* Horizon*
discounts, new client visits, events to increase awareness)
Long-term Family vs. region vs. year 5+ years
Mid-term Family vs. location vs. month 1 to 2 years
Short-term SKU vs. location vs. 8 to 12 weeks

week/day
* Typical values. Aggregation level and horizon are industry-specific.
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Supply chain Strategy, Segmentation and Process

Network design
Segmentation: customers and products are not the same
• set service level targets accordingly and align the whole

chain to the segment: forecasting strategy,
manufacturing policy (MTS, MTO, MTF, ETO, ATO),
postponement, and suppliers
• split products according to ABC (from higher to lower

total contribution margin) and cascade the segmentation
to short-term processes
Main inputs
• Long-term demand • Long-term cost estimates:
Network design: define the location and capacity of plants,
forecast production costs, warehouses and transportation means to satisfy forecasted
transportation costs,
• Macro-economic
forecasts: exchange rates,
warehousing costs, demand
inventory holding costs
taxes, base interest rate
• Scenario based: given the uncertainty, analyses are
Main outputs often based on several scenarios for multiple input
• Planned network • Assignment of product
configuration and capacity families to plants variables
investment plan for
plants, warehouses and • Optimization based: methods often include
transportation
• Long term transportation
optimization techniques and employ thousands of
and logistics strategy: own statistical simulations that identify how often each
fleet and facilities, 2PL,
3PL, 4PL network configuration is the optimal
41
Segmentation is the first step when creating strategies for many types of supply chain issues
Potential decisions by segment

Production, distribution, sourcing locations
Network design Transportation routes and modes
Make vs buy by segment
Service levels and supported order lead times

Inventory
Stocking points (postponement strategies) by
management
segment
Forecasting approach – statistical forecasting,

Segmentation Forecasting
customer collaboration, no forecasting
Production frequency based on segment

Manufacturing
Single v. multi-supplier, make vs buy, near shoring vs

Sourcing off shoring sourcing by segment
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The winning supply chain strategy depends on the products’ characteristics
High-volume standard product, Customized product Novelty product

commodity
Flour, salt Customized kitchen Cell phone

▪ Low price ▪ High margins ▪ High margins
▪ Medium margins ▪ Unpredictable demand ▪ Unknown initial demand
▪ Smooth demand ▪ Service availability and due date ▪ Fast reaction to customer
performance are distinct factors demand required
▪ Known seasonality
▪ Minimize cost ▪ Optimize lead time ▪ Manage life cycle

▪ Minimize inventory (good ▪ Design to order from standard ▪ Sufficient initial inventory
forecasting & real-time POS components
▪ Advanced forecast model
data)
▪ Electronic link to get order in considering life cycle
▪ Smooth production to real time
▪ Fast supply after initial demand
optimize manufacturing cost
▪ Direct delivery to store or is known
▪ Minimize transport cost (FTL) customer as special shipment
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The network must be designed based on the selected main drivers
Example: Zara’s manufacturing and sourcing network for the European market
Fast-fashion segment Basic segment

▪ Lead time-driven network ▪ Cost driven network
▪ Manufacturing network owned by Zara ▪ Outsourced manufacturing in east Asia
▪ Main plants in Spain, Portugal, Morocco and ▪ e.g.: Bangladesh, Malaysia, Indonesia, India,
Turkey China, Vietnam
▪ High obsolescence → low inventory levels ▪ Orders placed 6+ months in advance
▪ Excess capacity and fast response ▪ Low obsolescence → higher inventory levels
▪ Fast shipments: air freight ▪ Cheap shipments: ocean freight
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… although governmental incentives packages are, sometimes, the main drivers of the
decision – offsetting logistics inefficiencies
1997: Ford announced an US$ 1 billion investment in a

new plant in Gravataí (RS) - as usual the company and
the state firmed an incentive package
1998: When Ford’s site earthwork had already been

started and the state government had transferred part of
the loan to the company, the newly elected RS Governor
decided to renegotiate the incentives package
previously offered to Ford
Camaçari,
Bahia 1999, S1: Ford stopped the building of its plant, as no
deal between the company and the State was achieved
1999, S1: Almost all Brazilian states made offers to

Region with the
highest GDP attract Ford’s new plant
concentration
1999, S2: In August 1999, Bahia was selected to host
Gravataí,
Rio Grande do Sul Ford’s new plant in Camaçari. The investment (R$ 3.5 bn)
represented 8.4% of the state GDP in 1999. Seventeen first
tier suppliers followed the assembler to Bahia.
45
Given an established network, choose the proper decoupling point (push-pull boundary) per
client and/or product segment
Segment
(lead time) SC Strategy
Platinum Make-to-stock Deliver-to-order

(1 day) MTS
(forecast-driven) (order driven)
Gold Make-to-stock Assemble-to-order or Configure-to-order

(2 days) ATO/CTO
(forecast-driven) (order driven)
Silver Source-to-stock Make-to-order

(16 days) (forecast-driven) MTO
(order driven)
Bronze Make-to-order
(21-46d) MTO
(order driven)
Stage Supplier Plant Central WH Regional WH Customer
Lead
time 5 - 30 d 12 d 1d 1d
46
And segment operations based on products’ demand characteristics
ABC - Distribution by value, volume or contribution margin1 ABC/XYZ – Segment also by demand volatility2
K210 J666
A
Power SKUs:
Problem SKUs:
MTS
MTF
B Dedicated
Intense forecast
production lines
collaboration
Cats and Dogs:

Evaluate adopting MTO
C J003
Consider SKU K102
K081
rationalization
Low X Y Z High
Demand volatility
• More managerial attention (CV3)
• More frequent reviews of inventory policy
parameters
• Closer supplier collaboration
1 When segmentation is applied to raw materials, use value (forecasted annual demand * unit cost); when applied to finished goods, use total product contribution margin (not unitary
contribution margin). Keep in mind how the segmentation will affect operations and allow for some ad hoc classification: despite not fitting a segment mathematically, some products
should be treated as A items based on other criteria (e.g., strategic importance, risk).
2 Often applied to finished goods only. Simplified versions with 2x2 instead of 3x3 segments are very common.
3 CV: coefficient of variation = std. dev/mean.
47
Supply Planning (part of Sales & Operations Process

Planning - S&OP)
Converge on a unified plan upon which Marketing, Sales,
Production, Logistics, Purchasing and Finance agree: what
demand to satisfy and how to satisfy it
• Iterative process of Supply and Demand Planning:

start with planning supply from the forecast from
demand planning and iterate to create several feasible
scenarios
• Executive approval: the S&OP team presents the

scenarios in the S&OP Executive Meeting for decision and
Main inputs approval
• Mid-term and short-term • Previous plans
Cascade plan into mid-term plans: Distribution
demand forecasts
• Forecast accuracy and
• Existing and planned bias
Requirements Planning (DRP), Master Production Schedule
capacity (MPS), and Material Requirements Planning (MRP)
• Supplier
capacity/restrictions Update segmentation and inventory parameters:
Main outputs periodically review assignment of products to segments and
• Distribution and inventory • Purchasing Plan/Material update corresponding inventory parameters per SKU
replenishment plan (net Requirements: months or (reorder points, safety stocks, base stock levels, seasonal
demand) weeks into which raw
materials are expected stocks, etc). Update A SKUs more frequently than B or C.
• Production Plan: capacity
and in what quantities
adjustments: shifts, extra-
hours, vacations, flexible
workers, etc.
[1] Net demand = demand - current inventories

48
Plans are always wrong, but planning is fundamental: the recommended approach is a cascaded plan, in
which each planning process centers on different levels of constraints and horizons. (1) The S&OP focuses on
the more restrictive and long-term decisions, such as capacity investments and rough-cut capacity planning.
(2) The MPS will focus on a more detailed plan, considering restrictions that are at plant level, such as shifts,
extra-hours, raw material availability, and line availability and efficiency. (3) The Production Schedule will focus
on sequencing production orders into machines subject to the most recent restrictions.
Demand Supply Inventory

Comments
0-13 weeks 3-24 months Typically, 3 to 24-month

S&OP focus: 80
3-months to 60 periods are where most
2-years 40 changes are allowed (i.e.,
horizon 20 “liquid”)
0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
0-13 weeks
20
In mid/short term planning,
MPS focus: 10
more level of detail is
1 or 2 to 13-
weeks
0
needed
horizon
W0 W1 W2 W3 W4 W5 W6 W7 W8 W9 W10 W11 W12 W13
Reallocated demand System orders
Weekly demand is reallocated
6 6 forward and back to level
Production 2 2 2 2
Schedule focus: 14 14 14 14 14 14 12 14 14
4
10 12 12 14 12 production.
next 1 or 2- Supply planners have less
weeks horizon
W0 W1 W2 W3 W4 W5 W6 W7 W8 W9 W10 W11 W12 W13 freedom the closer they are to
present time (i.e., “frozen” and
Frozen Slushy “slushy” periods)
based on
Production
Schedule 49
Transportation planning and Process

Warehouse operations planning
Plan how to employ transportation, storage, and
warehouse operations capacity to meet the inventory
replenishment plan
• Transportation plan: determine the need for extra

resources based on the transportation modes (train, road
vehicle, aircraft, ship, or pipeline), and contract with
carriers (transportation service providers) to establish the
shipping plan
Main inputs • Routing: if transportation is performed with firm assets,

• Inventory replenishment • Available spot carriers
plan
shipments must be grouped in reasonable routes to avoid
• Current warehouse
• Current transportation resources and assets unnecessary costs
plan and assets
• Currently contracted • Warehouse ops. plan: determine the need for extra
carriers
resources – such as personnel, storage (racks),
Main outputs equipment (scales, forklifts, pallet jacks, conveyor belts),
• Shipping plan, with • Warehouse resources plan
corresponding contracted and technology (automation and IT) – and plan
• Warehouse personnel job
carriers or internal assets
schedule operations (receiving, put-away, picking, packing,
assigned
dispatching, and returns) to support the shipping plan
50
Supply Chain Control Tower/ Process

Sales & Operations Execution - S&OE
Monitor and react quickly to satisfy demand
• Multifunctional teams with decision power: the

control tower team includes representatives from all
functional areas with power to make the required
decisions
• Leading indicators and alarms: have inventory levels

dropped below critical? Is a provider delivery delayed?
Has manufacturing equipment failed? Are sales for a
Main inputs product above the forecast? Is product sell-out above the
• Raw materials and • Sales alarms
supplier alarms and
forecast? Employ alarms in advance so you still have time
• Manufacturing events
events to react.
• Warehousing and
• Raw materials alarms
distribution events
• Supplier related events • Decision making: based on the alarms, the team
• Supply chain disruptions
• Finished products alarms decides on what urgent actions to make (e.g., change
Main outputs
production schedule, buy from another supplier,
• Short-term action plan • Suggested review points manufacture in another plant, fulfill from another
involving people for the continuous
accountable in all the improvement process warehouse, send by airplane, supply a substitute product
company areas (since the Control Tower
to the client)
does not search for root
causes)
51
Since deviations will occur, monitor leading indicators and react quickly
Warning sensors
Control
Tower Actions
Control Panel
Re-allocate/prioritize customer orders Reportes BW OTC
1 On Time % Cajas Total
1-10 S
98.0%
11-16 S 17-24 S 24-30 S 1-10 O 11-17 O 18-24 O 25-31 O 02-08 N
92.4% 92.8% 82.3% 97.8% 93.1% 95.0% 90.5% 99.1%
09-15 N 16-22 N
95.2% 95.1%
23-30 N
95.2%
TARGET
90%
Anticipated delay in product delivery
Custo 2 In Full % Cajas Total 97.3% 97.2% 97.0% 96.7% 92.9% 98.4% 99.1% 96.7% 95.2% 92.8% 94.7% 94.6% 97%
mer 3 OTIF % Ordenes Total 80.0% 73.6% 79.6% 72.6% 74.2% 84.9% 82.7% 80.1% 59.9% 59.7% 71.6% 66.2% 70%
Mgt
4 Cumplimiento politica % Clientes KA 71.4% 71.4% 85.7% 42.9% 85.7% 85.7% 71.4% 28.6% 29% 20% 50% 29% 85%
Orders > Customer allocated forecast

5 % Clientes 10-70 75.9% 77.8% 64.8% 61.5% 74.1% 85.1% 90.1% 58.7% 36% 46% 52% 38% 85%
6 % Clientes Resto 71.2% 76.4% 76.5% 63.2% 74.7% 81.0% 87.2% 66.9% 67% 71% 77% 65% 80%
Expedite order; alert client of delay

7 Local 76% 83% 82% 85% 81% 80% 83% 85% 78% 78% 78% 83% 70%
Distri 8 Pallets 42% 34% 43% 37% 37% 34% 31% 37% 42% 34% 36% 32% 40%
Transportation
bution % M3
9 Utilization Deployment 89% 92% 94% 98% 92% 91% 91% 91% 94% 96% 94% 95%
Mgt 96%
10 Total 84% 89% 89% 85% 87% 84% 83% 85% 78% 78% 78% 83% 70%
11 Tocancipá 97.1% 96.2% 96.3% 88.1% 95.6% 96.8% 95.4% 95.1% 86.9% 74.9% 79.0% 62.0% 95%
12 Production volume PDC 87.4% 95.3% 98.3% 96.3% 98.2% 98.4% 99.5% 64.5% 68.4% 90.9% 68.0% 81.0% 95%
% Volume
13 compliance Barbosa 86.3% 78.1% 84.8% 82.7% 51.9% 83.9% 92.6% 77.6% 98.7% 96.8% 98.0% 98.0% 95%
14 KCAG 83.1% 73.9% 71.5% 87.1% 78.6% 85.5% 82.6% 91.4% 93.4% 97.3% 86.0% 95.0% 95%
Dema 15 Forecast error/ sales % Forecast Total n.a. n.a. n.a. n.a. 32% 30% 29% 28% 28% 30% 29% 31% tbd
nd 16 Forecast hit rate % SKUs Total n.a. n.a. n.a. n.a. 42% 45% 41% 45% 46% 39% 41% 44% tbd
mgt 17 Net demand variation % Forecast Total n.a. n.a. n.a. n.a. 23% 11% 15% 13% 6% 23% 12% 21% tbd
Custo 18 Sales % 1st week % Cases n.a. n.a. n.a. n.a. 11% 12% 7% 9% 8% 10% 11% 8% 25%
mer 19 Sales % last week % Cases n.a. n.a. n.a. n.a. 66% 54% 65% 64% 64% 63% 59% 65% 25%
Expedite; increase;
20 FG 20 17 16 16 16 15 16 16 20 20 18 tbd
21 WIP 5 5 4 4 5 4 4 4 5 4 5 tbd
22 Total inventory $ $ Million RM 29 23 20 18 17 17 20 18 17 17 16 tbd
23 Supplies 6 5 5 6 6 6 6 6 7 7 7 tbd
24 Total 60 50 45 45 44 42 47 44 48 48 46 tbd
find alternate supplier

Invent 25 FG 34 26 23 24 23 21 22 22 27 26 23 tbd
ory 26 WIP 8 7 6 6 6 6 6 6 6 5 6 tbd
Inventory days
Over and under-coverage on

mgt 27 Days RM 48 35 30 27 23 23 27 24 23 22 21 tbd
(sales)
28 Supplies 9 8 8 8 8 8 8 9 9 9 9 tbd
Adjust FG
29 Total 99 76 67 65 60 58 63 60 66 62 59 58
30 FG inventory hit rate % SKUs Total 22% 23% 31% tbd
31 RM inventory compl. % SKUs Total 75% 61% tbd
Supplier order due date portfolio
Over and under-coverage on

performance
Adjust RM portfolio
production issues
critical FGs
Slow or stopped
Address line
production
1 2 3 critical RMs 4 5 6
Customer Raw Finished Customer
forecast / Supplier Materials Manufacturing goods (FG) receipt
demand (RM)
Orders > Customer allocated Supplier RM Coverage Production FG Coverage Customer

forecast OTIF1 OTIF OTIF
[1] OTIF = On-Time In Full. OTIF measures service level more strictly than Fill Rate because it penalizes both quantity deviations and delays. 52
In short, these processes cascade information and restrictions from the strategic levels
down to the more operational processes to enable the firm to better match supply and demand
Sales &
Procurement Production Logistics
Marketing
Long-term Supply chain strategy, Segmentation and Network Design

Demand
Supply Planning (inside Sales & Operations Planning - S&OP) Planning
Mid-term (inside S&OP)
Material Net demand planning /
Production Planning
Requirements inventory
(MPS)
Planning (MRP) replenishment (DRP) Demand
Short-term Supplier
fulfillment &
Customer
collaboration Supplier call off / Production Transport. Warehouse Available to collaboration
purchasing scheduling planning ops planning. Promise (ATP)
Execution Supply Chain Control Tower/Sales & Operations Execution (S&OE)
Purchas Plant
Manufacturing Transport. Warehouse Sales order
e Order material
execution mgmt. mgmt. management
mgmt s mgmt
Enablers
Performance management
Information Technology Organization & Culture People (capability building)
(metrics, reports, & analytics)
Other domains (e.g., Finance, HR, Asset Management, Product Life Cycle Management)
53

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SCM as strategy

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54
7. Economics of SCM
NON-EXHAUSTIVE
Procurement decisions drive several costs – and some are frequently hidden:
Speed & Supply

Scale Quality Sustainability Supplier base
Risk
Item price
Item price (supplier Item price (supplier Item price (supplier Item price (supplier
Price (competition and
costs) costs) costs) costs)
cost)
Transportation cost Transportation cost Transportation cost Transportation cost

Logistics
(consolidation) (mode, distance) (distance, mode) (consolidation)
Safety stock +
Cycle stock holding
Inventory Pipeline stock
cost
holding costs
Production delay Image and goodwill Supplier selection &

Ordering cost Quality control costs
costs damage costs onboarding costs
Production failure Waste collection and System adaptation

Receiving costs SC disruption costs
costs disposal costs costs
Operations
Supplier training
Product failure costs Environmental costs
costs
Contract
administration &
litigation costs
Source: adapted from Degraeve, Z., & Roodhooft, F. (2001) A Smarter Way to Buy. Harvard Business Review. 55
7. Economics of SCM
Scale is an especially important factor
▪ The more a client buys in each order (i.e., the higher Q, the order quantity), the…
▪ lower the supplier’s unit cost: benefits from larger batches and lower total setup costs
without having to maintain inventory
▪ lower the transportation cost per unit: benefits from load consolidation
▪ lower the client’s internal ordering costs and receiving costs per unit: benefits
from non-proportional work in performing these tasks
▪ higher the client’s leverage in the negotiation: benefits from discounts
▪ but the…
▪ higher the client’s cycle stock1 holding costs: average inventory = Q/2, so higher Q
leads to higher avg. inventory and higher inventory holding costs – those costs
associated with holding inventory, which include the opportunity cost of capital plus
storage, insurance, spoilage, and obsolescence
1 Cycle stock: the inventory needed to fulfill demand between consecutive replenishments 56
7. Economics of SCM
Scale is also related to the size of the supplier base, or the number of suppliers active:
▪ The more a client buys from a single supplier, the…
▪ lower the supplier’s unit cost: benefits from scale to spread fixed costs and overhead
▪ lower the transportation cost per unit: benefits from load consolidation or logistics
scale
▪ lower the internal operating costs: benefits from avoiding costs related to maintaining
more suppliers active
▪ but the…
▪ higher the supplier’s leverage in negotiating prices: lower competition!
▪ higher the disruption risks: potentially a single source of supply
57
7. Economics of SCM
Quality is also involved in a widely recognized trade-off
▪ The lower the quality the client demands from the supplier, the…
▪ lower the supplier’s unit cost: benefits from not investing in reducing process
variability, eliminating causes of defects, and maintaining quality assurance and quality
control processes
▪ but the…
▪ higher the client’s internal operating costs associated with quality control: more
effort dedicated to identifying defective items and avoiding they enter the production
line
▪ higher the operating costs associated to poor quality in the process or in the
finished product: the longer it takes to identify a defective part, the higher the costs
associated with the poor quality
58
7. Economics of SCM
Speed or lead time1 affects costs in several ways:
▪ The lower the lead time the client demands from the supplier, the…
▪ lower the client’s safety stock holding costs: benefit from a reduced period of
exposure to demand uncertainty, what leads to a lower needed safety stock and,
consequently, lower associated holding costs
▪ lower the client’s pipeline stock holding costs: inventory in-transit (or pipeline stock)
depends on transit time; either the client or the supplier incurs in the opportunity cost
of capital and the insurance associated with that stock (depending on the transaction
INCOTERMS), but the client pays directly or indirectly for those costs
▪ but the…
▪ higher the transportation costs: faster delivery is more expensive
▪ higher the supplier’s costs: the supplier has less time to make and deliver, what
requires it to (i) maintain inventories or (ii) maintain excess capacity to respond quickly
1 Lead time: the time between the moment a client places an order to a supplier and the moment the items are available for use by the client 59
7. Economics of SCM
Supply risk, the risk associated with a delays or disruptions, is also part of a trade-off:
▪ The lower the supply risk the client accepts from the supplier, the…
▪ lower the client’s safety stock holding costs: benefit from a reduced lead time
variability, what leads to a lower needed safety stock and, consequently, lower
associated holding costs
▪ lower the client’s operating costs: less production delays and less supply chain
disruptions lead to less fire-fighting, more efficient production schedules, less extra-
hours or extra-shifts, lower expediting costs or excessive logistics costs to fulfill the
demand
▪ but the…
▪ higher the supplier’s costs: the supplier must ensure enough safety stock available in
more than one geographical region or have more flexible plants so an item can be
manufactured in more than one plant, reducing supply risk
60
7. Economics of SCM
Sustainability is part of Corporate Social Responsibility and, therefore, less of a trade-off than
an obligation demanded by customers → increasing adoption of sustainable sourcing practices
▪ Sustainability has three dimensions:
▪ Economic sustainability: ensuring the business will be able to run in the long-term
because of the value the business creates
▪ Environmental sustainability: sourcing materials from renewable sources or reusing

materials in closed loop supply chains
▪ Social sustainability: employing procurement practices that foster supplier diversity,

sourcing locally, and enforcing suppliers adopt socially responsible practices
▪ Increasing sustainability can be strictly economical (e.g., employing more efficient and
sustainable materials) or require significant investment (e.g., supplier training and certification)
▪ But not doing it exposes firms to costly risks of image and goodwill
Source: Schnellbächer, W., & Weise, D. (2020, p. 44). Jumpstart to Digital Procurement. Cham: Springer International Publishing. 61
7. Economics of SCM
▪ In logistics, economies of scale are ubiquitous
▪ The general rule is that more consolidated loads are cheaper to transport than less
consolidated ones: when you order something online from a pure online retailer, the last
mile is the most expensive because it implies the transportation of one small package to your
house, instead of the transportation of a container from Shanghai to Barcelona
▪ Logistics costs vary with several factors:
▪ distance: costs increase with distance – variable costs (fuel, labor, maintenance costs)
▪ load weight: costs per pound/kg decrease with weight due to spreading fixed
transportation costs among more weight to be transported
▪ density: costs per pound/kg decrease with density [kg/m3] because vehicles have both
weight and cubic capacity limitations and often cube out before they weight out
▪ mode of transportation: generally, costs per pound/kg or per m3 are such that
air shipping > road shipping > railway shipping > ocean shipping
Source: Myerson, P. A. (2015). Supply Chain and Logistics Management Made Easy. Pearson Education. 62
7. Economics of SCM
▪ The design of the logistics network also affects inventory and transportation costs:
▪ The more warehouses in the network, the closer to clients and the lower the lead
time observed by clients or customers – potentially more revenue or competitive
advantage from better service!
▪ However, the more warehouses in the network, the more inventory in the whole
network and the lower the potential economies derived from (i) scale in ordering and
transportation and (ii) risk pooling
▪ Risk pooling example: suppose two adjacent cities have an independent and
identically distributed demand ~ N(𝜇, 𝜎). If each city is served by its own DC, each
DC observes a demand equal to ~ N(𝜇, 𝜎) with a CV1 = 𝜎/𝜇
▪ On the other hand, if the two cities are served from the same DC, the aggregated
2⋅𝜎
demand observed by the DC1 is given by ~ N(2𝜇, 2 ⋅ 𝜎). Notice that CV2 = ≅
2𝜇
0.71 ⋅ CV1 : the aggregated demand has less variability! The risk associated to the
demand variability is reduced by pooling demand on one DC.
1. If demand is not independent then you must account for the covariance of demand of the two sources. The new demand ~ N(𝜇1 + 𝜇2 , 𝜎12 + 𝜎22 + 2𝜌𝜎1 𝜎2 ). 63
7. Economics of SCM
In summary, trade-offs exist between several costs in SCM:
Replenishment Fulfillment
Inventory
location
𝑇𝐶 = 𝑃𝐶 + 𝑂𝐶 + 𝐻𝐶 + 𝐹𝐶 + 𝑆𝑜𝐶
Total Costs Purchase Ordering Holding Fulfillment Stockout
Costs Costs Costs Costs Costs
• The total amount you pay • Incremental costs1 related • Incremental costs1 • Transportation costs • Costs associated with lost
for the material you to the sourcing decision associated to maintaining associated with the sales (e.g., lost unit
source that are not affected by inventory, including cost of fulfillment contribution margin, client
the ordered quantity, i.e. capital (less inflation rate), goodwill, and future sales)
an amount per order obsolescence, and storage • Other warehousing costs or extra costs employed to
(warehouse, manpower, associated with the sales expedite orders when a
• e.g.: paperwork, clerical insurance, taxes, order fulfillment process stockout occurs (e.g.
time, cleaning of prod. shrinkage, refrigeration, emergency airplane
lines, labor cost during etc.) transportation)
equipment setup, and
opportunity cost of the • Includes transportation
capacity during setup costs that are charged per
unit and are associated
• Includes transportation with inventory
costs that are not replenishment
dependent on the order
quantity and are
associated with inventory
replenishment
1. These costs should be incremental in respect to the decision of ordering (versus not ordering) – and this depends on the horizon of the decision. In the short-
term, many costs are fixed and, therefore, not incremental. In the long-term, most costs are variable. 64

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65
Inventory models can be quite complex: we will focus on the essentials
▪ Goal 1: to build and reinforce intuition
▪ Create an understanding of the qualitative relationships among different types of

inventory and how optimal inventory levels are affected by various parameters
▪ Goal 2: know the ideas behind inventory software and systems
▪ Most commercial software (even those that cost millions of dollars) are primarily based
on models we cover in class
1. If demand is not independent then you must account for the covariance of demand of the two sources. The new demand = N(𝜇1 + 𝜇2 , 𝜎12 + 𝜎22 + 2𝜌𝜎1 𝜎2 ). 66
You can measure inventory in several ways:
What it means How to calculate it Where it is helpful

Quantity ▪ Measures inventory in terms ▪ Typically tracked and ▪ It is basis for all other
of physical units reported in the firm ERP expressions of inventory and
system (SAP, Oracle, etc) capacity analysis
Value ▪ Measures inventory in terms ▪ Inventory quantity * value ▪ Relevant measure for
of Dollars, Euros, etc…, per unit calculating inventory /
typically cost of the product ▪ Performed at item level, and working capital impact
at its current stage then aggregated
Turns ▪ Measures the number of ▪ 2 ways to approach it: ▪ More intuitive measure to
times the inventory “cycles” – Unit-based: speak about inventory
in a given period, typically a Total units sold / Average
year, indicative of the inventory units
operational efficiency – Value-based:
COGS / Average inventory
value
Days1 ▪ Measures the number of ▪ 365 / turns ▪ More intuitive measure to
days the current inventory = 365 * Avg inventory units / speak about inventory
will last, given expected Total units sold in a year
sales volume and no ▪ Inventory on hand/historical
replenishment or future demand or forecast
1 Days of Supply (DOS), Weeks of Supply (WOS), or Months of Supply (MOS) are all equivalent measures of inventory 67
Inventories are not all equal: we will focus on their function

Covered in this course
Type* Description
▪ Average inventory level between receipts of orders ("cycle"), used to meet expected
Cycle stock customer demand in the cycle
▪ Buffer inventory to protect against two sources of uncertainty: (i) actual demand
Safety stock exceeds expected demand or (ii) supply does not arrive in time
▪ Extra inventory put in to accommodate seasonal patterns when production is not

Seasonal stock sufficiently flexible (e.g., ice-cream production)
▪ Inventory built up in anticipation of future event such as industry shortage or

Forward purchase stock expected price increases
Reserve stock/ ▪ Inventory on hand, but reserved or "tagged" for specific customers or presentation
facing stock quantities/facing stock in retail
Sludge
▪ Excess inventory level due to system, human, or other errors – the inventory you
should not have!
▪ Inventory en route between shipment and delivery location, moving via truck, rail, air,
In-transit ocean or another transportation mode
▪ Inventory maintained between stages in a process to decouple them from one

Decoupling inventory another and improve overall operating efficiency
* It is often hard to identify and differentiate among types. Most enterprise software do not track inventory per type. 68
Based on the context, you must choose between a single-period and a multi-period inventory
management model
Use Single
Period Model
(Newsvendor)
No Use Continuous
Review Model
Can we Yes
replenish
inventory?
Yes
Can we
Use Multiperiod
order
Model
anytime?
No
Use Periodic
Review Model
Source: adapted from Janice Hammond (2014), Core Reading: Inventory Management, Harvard Business School Publishing 69

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8a. Single period models: Newsvendor
▪ The newsvendor model applies to items:
▪ you can order only once – you cannot replenish after you have ordered
▪ with uncertain demand – you can forecast the demand, but there’s inherent
uncertainty
▪ Examples:
▪ Several fashion items that are purchased months in advance and go on sale at the end
of the season: clothes, watches, jewelry, etc.
▪ Items for which you contract only once per year, way in advance to the actual demand,
such as grapes sourced externally in the wine industry Cost of Cost of
Overstocking Understocking
▪ The model aims at determining the order quantity Q

that balances two costs: the cost of understocking (cu) Ordered
Quantity (Q)
Quantity
and the cost of overstocking (co) Demand
Period 2
Demand
Period 1
71
▪ How do you determine the cost of understock and the cost of overstock?
Cost of understock
Cu = (p – c) + B
= (1.00 – 0.30) + 0.13
= $0.83
The amount you receive The lost contribution margin of the item plus any
(negative if you have to pay)
for the leftovers after the
additional penalty incurred due to not satisfying
end of the period. E.g., the demand
discounted price for the item
during sales or the amount
Selling you have to pay to discard
Cost of overstock
unsold items (a negative
price (p)
salvage value in this case)
$1.00 Co = c - g
= 0.30 – 0.08
= $0.22
The costs incurred to have the unnecessary stock
minus what you can get for the leftovers
Variable
cost (c)
$0.30 Salvage
The amount you must pay
value (g) when you do not satisfy the
$0.08 demand (beyond lost
contribution margin)
Penalty
(B)
$0.13
Source: adapted from Janice Hammond (2014), Core Reading: Inventory Management, Harvard Business School Publishing 72
▪ To determine the order quantity, one must choose Q that makes expected costs of
understocking and overstocking equal for a marginal unit → determine the critical
ratio (CR)
Co
Cu
𝐶𝑂 ∗ 𝑃𝑟𝑜𝑏 𝐷 < 𝑄 = 𝐶𝑈 ∗ 𝑃𝑟𝑜𝑏(𝐷 > 𝑄)

𝐶𝑂 ∗ 𝑃𝑟𝑜𝑏 𝐷 < 𝑄 = 𝐶𝑈 ∗ (1 − 𝑃𝑟𝑜𝑏 𝐷 < 𝑄 )
𝑪𝑼
𝑪𝑹 = 𝑷𝒓𝒐𝒃 𝑫 < 𝑸 =
𝑪𝑼 + 𝑪𝑶
For our example:

Cu = $0.83 0.83
𝐶𝑅 = 𝑪𝑹 = 𝟎. 𝟕𝟗𝟎
Co = $0.22 0.83 + 0.22
73
▪ Given the Critical Ratio (CR), apply it to the NORM.INV function to determine Q that
minimizes total expected cost based on forecasted demand:
Example: for D = Normal Probability Demand with μ = 1000 and σ = 200
and CR = 0.790
Q* = NORM.INV(0.790, 1000, 200) = 1161.6 → Q*=1162
𝑸∗ = 𝟏𝟏𝟔𝟐
74

review

procurement Wrap-up


SCM as strategy

and SCM
75
8b. Multiperiod models: Continuous and Periodic review
For multiperiod models, the difference between continuous and periodic review lies on (i) how
often an order is placed and (ii) what quantity is ordered
Continuous Review Periodic Review
• Fixed order • Fixed order

quantity (Q) interval (R)
• Variable order • Variable order
interval (T) quantity (Q)
You can run simulations to compare policies yourself at https://luigilaporte.shinyapps.io/InventoryMgmtSim/ 76

In continuous review, an order is placed every time your inventory position reaches the
reorder point (ROP)
Continuous Review • Inventory position: the sum of on hand inventory (the

inventory physically in possession) and the in-transit
inventory (orders placed that have not arrived yet)
• Trigger an order: as inventory is depleted by sales or

consumption, the inventory position decreases until it
reaches the reorder point (ROP), triggering an order
• Order quantity: orders are placed with a fixed quantity

(Q) which is often determined by balancing ordering
costs and inventory holding costs
» The higher the Q, the higher the average inventory (the

red dashed line in the top chart) increasing annual
holding costs
» The lower the Q, the more orders are placed per year,
increasing annual ordering costs
» EOQ = economic order quantity
77
In continuous review, the EOQ functions as a guideline to choose Q and reduce annual costs
Economic Order Quantity (EOQ) • Annual holding costs: are a linear function of the order
Costs quantity and are on average equal to (Q/2) * h

($)
• Annual ordering costs: are a linear function of the
number of orders (N= D/Q) and are on average equal to
(D/Q) * K
• Summing both costs, we find the minimum total annual

cost for which Q = Q* (the optimal quantity) = EOQ
• Important: the cost curve is almost flat in the vicinity

of the optimal Q*, which means approximate
calculations lead to near optimal results
• Assumptions – if they do not hold, Q* can be ≠ EOQ:

2𝐷𝐾 » Demand is constant1
𝐸𝑂𝑄 =
ℎ » Ordering cost is completely independent of quantity
» Unitary cost is completely independent of quantity

• D - demand or annual usage [units/time]
(e.g., no quantity discounts)
• h - holding cost [$/unit/time] » The entire order is received at the same time (e.g., no
• K - ordering cost [$/order] partial deliveries)
1 Minor deviations from the constant demand assumption (i.e., CV of demand < 0.5) lead to a total annual cost near optimal costs 78
In continuous review, the EOQ functions as a guideline to choose Q and reduce annual costs
Economic Order Quantity (EOQ) Example: demand is 10,400 units per year. Ordering cost
Costs K=$40 per order which cover associated labor costs and
($)
freight (fixed). Material costs are $10/unit, firm cost of capital
is 15% per year and inventory physical holding cost rate is
15% per year, so h = $10 * (15% + 15%) = $3/unit/year
• If you order Q = 400
» Annul holding costs = Q/2*h = 400/2 * $3 = $600/year

Annual ordering costs = D/Q*K = 10,400/400 * $40 =
$1,040/year
Total annual costs = $600 + $1,040 = $1,640/year
• If you order Q = 800
» Annul holding costs = Q/2*h = 800/2 * $3 = $1200/year

Annual ordering costs = D/Q*K = 10,400/800 * $40 =
2𝐷𝐾 2 ∗ 10,400 ∗ 40 $520/year
𝐸𝑂𝑄 = =
ℎ 3 Total annual costs = $1200 + $520 = $1,720/year
• If you order Q = EOQ?

𝐸𝑂𝑄 = 526.6 𝑢𝑛𝑖𝑡𝑠 » Annul holding costs = Q/2*h = 526.6 * $3 = $789.93/year
Annual ordering costs = D/Q*K = 10,400/526.3 * $40 =
Attention: D and h must be on the same time base. If h is in $789.94/year
$/unit/year, demand must be expressed in units/year.
Total annual costs = $1,579.87/year
Source: Janice Hammond (2014), Core Reading: Inventory Management, Harvard Business School Publishing 79
In continuous review, the ROP must cover demand over the lead time + safety stock
• Scenario 1 - Deterministic demand and lead time: if

both demand and lead time are known and constant, just
anticipate the order – for example, if demand is 200 units
per week and lead time is 1 week, set ROP = 200*1 = 200
and order exactly when inventory position reaches 200
𝑅𝑂𝑃 = 𝐷 ∗ 𝐿
= demand * lead time
• Scenario 2 - Either demand or lead time (or both)

have variability: safety stock is needed because if
demand during lead time is above the average of 200
units, stock will not be enough and a stockout will occur
like in the period between points d and e in the chart on
the left
» Add a safety stock to protect against the

variability of demand and/or lead time during the
period of exposure
𝑅𝑂𝑃 = 𝜇𝐷 ∗ 𝜇𝐿 + 𝑆𝑆
= avg. demand * avg. lead time +
safety stock
In English, the safety stock protects…
𝑆𝑆 = 𝑧 ∙ 𝜇𝐿 ∙ 𝜎𝐷2 + 𝜇𝐷2 ∙ 𝜎𝐿2
… with a desired
probability
… against variability in demand

during average lead time
… and during variability of lead time

against average demand
[1] This example assumes non-stock out probability, i.e., cycle service level. [2] In case of periodic review, the review period should be added to the lead time.
81
Safety stock explicitly looks at the probability of … and is calculated based on

stockout based on historical volatility of demand … several parameters1
𝑆𝑆 = 𝑧 ∙ 𝜇𝐿 ∙ 𝜎𝐷2 + 𝜇𝐷2 ∙ 𝜎𝐿2
𝜇𝐿 = Average lead time,

SQRT due to convolution of normal
distribution to cover >1 periods of
replenishment leadtime2
Order 𝜎𝐷 = Standard deviation of demand3

qty Cycle
stock
𝜇𝐷 = Average demand
Concerned 𝜎𝐿 = Standard deviation of lead time2

Safety about demand
greater than
stock the mean z = Safety factor
Possible Cycle service level Z
Lead time shortage event 95.0% 1.65
99.0% 2.33
= NORM.S.INV(0.99) in Excel
[1] This example assumes non-stock out probability, i.e., cycle service level. [2] In case of periodic review, the review period should be added to the lead time.
[3] In case of make to forecast (i.e., when the ordering quantity is updated based on forecasts), the standard deviation of forecast errors should be used.
82
The two most common measures of service level are cycle service level (CSL) and fill-rate (FR)
Assume we replenish 20 units each week and observe the following demand:
CSL, Cycle Service Level (or in stock rate, or alpha service level)
Stocked out Cycle service level:

20 2 out of 10 ▪ Easier to model
periods: ▪ But less intuitive to
25 23 interpret
15 15 16 14 Resulting
10 12 12
8 CSL = 80%
Z in the SS formula is
based on cycle service
level
FR, Fill-rate (or beta service level)
5 3
20 Filled 142 out of Fill-rate:
150 units ▪ More difficulty to
model
20 20 Resulting ▪ But more intuitive
15 15 16
10 12 12 14 FR = 94.6% to interpret
8
1 2 3 4 5 6 7 8 9 10
Periods For any given CSL:
FR > CSL
83
A continuous review example with safety stock:
• Example A: average demand is 200 units/week, with a

standard deviation of 50 units/week. Lead time is 1 week
fixed with no variability. Set service level = 95% (only 5%
of probability of a stockout occurring in each cycle).
» 𝑅𝑂𝑃 = 𝜇𝐷 ∗ 𝜇𝐿 + 𝑆𝑆
» 𝑆𝑆 = 𝑧 ∙ 𝜇𝐿 ∙ 𝜎𝐷2 + 𝜇𝐷
2
∙ 𝜎𝐿2 = 𝜇𝐿 ∙ 𝜎𝐷2 + 𝜇𝐷
2
∙0=
𝑺𝑺 = 𝒛 ∙ 𝝈𝑫 𝝁𝑳
» z = NORM.S.INV(0.95) = 1.65
» 𝑆𝑆 = 1.65 ∙ 50 ∙ 1 = 82.5 units
» 𝑅𝑂𝑃 = 200 ∗ 1 + 𝑆𝑆 = 𝟐𝟖𝟐. 𝟓 units
• Example B: same case, but with a standard deviation of

lead time of 0.2 weeks
» 𝑆𝑆 = 1.65 ∙ 1 ∙ 50 2 + 200 2 ∙ 𝟎. 𝟐 2 = 105.7 units
» 𝑅𝑂𝑃 = 200 ∗ 1 + 𝑆𝑆 = 𝟑𝟎𝟓. 𝟕 units
In periodic review, an order is placed every R units of time, but the quantity is defined in each
order to restore inventory position up to the base inventory level (S)
Periodic Review
• Base level or up-to level (S): the reference level
employed to determine que quantity to be ordered
» Q = S – inventoryPosition
» Q is the quantity needed to restore the inventory

position up to the base level
• S must cover three components:
» the average demand during the review period (R),

i.e., the demand expected for the next cycle
» the average demand during the average lead time,

since material takes time to be replenished
» the safety stock to protect against demand or lead

time variability during review period + lead time
» 𝑆𝑆 = 𝑧 ∙ (𝝁𝑳 + 𝑹) ∙ 𝜎𝐷2 + 𝜇𝐷
2
∙ 𝜎𝐿2
» 𝑆 = 𝜇𝐷 ∙ 𝑅 + 𝜇𝐷 ∙ 𝜇𝐿 + 𝑆𝑆
» 𝑺 = 𝝁𝑫 ∙ 𝝁𝑳 + 𝑹 + 𝑺𝑺
85
In periodic review, an order is placed every R units of time, but the quantity is defined in each
order to restore inventory position up to the base inventory level (S)
Periodic Review • Example: average demand is 200 units/week, with a

standard deviation of 50 units/week. Lead time is on
average 1 week with a standard deviation of 0.2 weeks.
Inventory is periodically reviewed, every 2 weeks.
Assuming service level = 95%, current inventory on hand
equals 272 units and there are no previous orders in-
transit, how much should be ordered (Q)?
» 𝑆 = 𝜇𝐷 ∗ (𝜇𝐿 + 𝑅) + 𝑆𝑆
» 𝑆𝑆 = 𝑧 ∙ (𝜇𝐿 +𝑅) ∙ 𝜎𝐷2 + 𝜇𝐷

2
∙ 𝜎𝐿2
= 1.65 ∙ (𝟏 + 𝟐) ∙ 50 2 + 200 2 ∙ 0.2 2 = 157.4 units
» 𝑆 = 200 ∗ 1 + 2 + 𝑆𝑆 = 600 + 157.4 = 757.4 units
» 𝑄 = 𝑆 − 𝑖𝑛𝑣𝑃𝑜𝑠 = 757.4 − 272 = 𝟒𝟖𝟓. 𝟒 units
86
▪ Both in periodic and continuous review, we can employ the Critical Ratio (CR) to
determine the safety factor z that minimizes the costs of overstocking and
understocking:
▪ After the order is placed, there is a time during which you cannot replenish inventory:
the period of exposure (i.e., for continuous review, the lead time; for periodic review,
the lead time + the review period)
▪ Therefore, considering the demand over the period of exposure, one should choose Q
that balances expected costs of overstock (co) and understock (cu)
▪ cu is the cost of losing one unit of sales which is at least the unit contribution
margin (i.e., unit price minus variable costs)
▪ co must be approximated based on some assumption – for reasonably demanded

items, one can assume that an item that is not sold in this cycle will be sold in the
next cycle, therefore co is the inventory holding costs for one unit during one cycle
▪ for continuous review, 𝑐𝑜 = ℎ ⋅ 𝑇 = ℎ ⋅ 𝑄/𝐷
▪ for periodic review, 𝑐𝑜 = ℎ ⋅ 𝑅

87
understocking:
▪ Using cu and co, calculate CR = 𝑐𝑢 /(𝑐𝑢 + 𝑐𝑜 )
▪ Finally, choose z = NORM.S.INV(CR) and employ it in the safety stock (SS) calculation
▪ To understand why, remember that you choose the SS to add extra protection to the
average demand during the period of exposure
Continuous review Periodic review
Distribution of demand Distribution of demand

over the lead time over the lead time +
review period
𝑧 ⋅ 𝜎𝐷 𝐿+𝑅 =
𝑧 ⋅ 𝜎𝐷𝐿 =
𝜇𝐷𝐿 = 𝜇𝐷 ∙ 𝜇𝐿 𝜇𝐷(𝐿+𝑅) = 𝜇𝐷 ∙ 𝜇𝐿 + 𝑅 𝑧 ∙ (𝜇𝐿 +𝑅) ∙ 𝜎𝐷2 + 𝜇𝐷2 ∙ 𝜎𝐿2
𝑧 ∙ 𝜇𝐿 ∙ 𝜎𝐷2 + 𝜇𝐷2 ∙ 𝜎𝐿2
(average demand (average demand over
over lead time) lead time + review period) 88
understocking:
▪ Consequently, items with higher unit contribution margin should have higher
targets of cycle service level
▪ Example with continuous review:
General: inventory holding cost rate = 35% per year; cycle duration (i.e., T=Q/D) = 30 days for both
items
Item A: price = $100, variable costs = $20 Item B: price = $50, variable costs = $20
Cu = 100 – 20 = $80 Cu = 50 – 20 = $30
Co = (35% * $20) * 30/365 = $0.575 Co = (35% * $20) * 30/365 = $0.575
CR = Cu/(Cu+Co) = 99.3% CR = Cu/(Cu+Co) = 98.1%
89
In-transit (or pipeline) stock results from goods being tied up en route while between locations
Type*
There are 2 drivers of in-
transit inventory: … and it is calculated as
Cycle stock
▪ Average transit time Pipeline stock Average transit Average demand

Safety stock
between locations (PS) time (𝝁𝑻𝑹 ) (𝝁𝑫 )
units days units / day
▪ Average volume = x
Seasonal stock
▪ The primary lever to reduce in-transit inventory is to reduce transit times, which largely
Forward purchase stock depend on transportation modes – e.g., while air freight is the fastest mode, it’s also the most
expensive; while ocean freight is the slowest mode, it’s also the cheapest
Reserve stock/ ▪ You incur in holding costs for in-transit stock, either explicitly or implicitly (absorbed by the
facing stock
supplier and included in the price):
▪ If you pay in advance, you incur in opportunity costs of capital; if you do not, your supplier
Sludge
finances that inventory until you pay (e.g., during transit)
▪ You might have to pay explicitly for insurance: it depends on the incoterms of the
In-transit transaction
▪ In short: there is in-transit inventory whenever there is transit time, and it increases costs
Decoupling inventory for the supply chain overall
* It is often hard to identify and differentiate among types. Most enterprise software do not track inventory per type. 90
Putting it all together, total annual costs can be determined as:
Inventory
location
𝑇𝐶 = 𝑃𝐶 + 𝑂𝐶 + 𝐻𝐶 + 𝐹𝐶 + 𝑆𝑜𝐶
Total Purchase Ordering Holding Fulfillment Stockout
Costs Costs Costs Costs Costs Costs
• Assuming the • Transportation costs • Non-trivial

simplification that associated with the mathematical
costs (i.e. the price you fulfillment modeling → many
pay to your provider) alternatives not
does not change with • Other warehousing covered in the course
quantities, Purchase costs associated with
Costs are not relevant the sales order • Covered by
to define the policy fulfillment process determining z from the
decision (Q*) approximate critical
• Therefore, they do not ratio as shown before
• With quantity affect the
discounts, these costs replenishment policy • For more information,
are relevant though decision directly see Chopra & Meindl,
(indirectly due to their “Supply Chain
effect on demand and Management _
demand variability) Strategy, Planning, and
Operation”, Pearson.
91
Inventory
location
𝑇𝐶 = 𝑃𝐶 + 𝑂𝐶 + 𝐻𝐶 + 𝐹𝐶
Total Purchase Ordering Holding Fulfillment h’: holding cost rate for
pipeline stock, which does
Costs Costs Costs Costs Costs not include warehousing
costs, for example
𝐷 𝑄
𝑇𝐶 = 𝐷 ∗ 𝑐 + ∗𝐾 + ∗ ℎ + 𝑆𝑆 ∗ ℎ + 𝑃𝑆 ∗ ℎ′ + 𝐹𝐶
𝑄 2
Purchase Ordering Holding Holding Holding Fulfillment
Costs cost cost of cost of cost of costs
cycle safety pipeline
stock stock stock
Input Continuous Review Periodic Review
Quantity (Q) Fixed, and can be determined based on Variable; on average, Q=D*R
EOQ
Safety Stock
𝑆𝑆 = 𝑧 ∙ 𝜇𝐿 ∙ 𝜎𝐷2 + 𝜇𝐷2 ∙ 𝜎𝐿2 𝑆𝑆 = 𝑧 ∙ (𝜇𝐿 +𝑅) ∙ 𝜎𝐷2 + 𝜇𝐷2 ∙ 𝜎𝐿2
Pipeline Stock PS = 𝜇 𝑇𝑅 ⋅ 𝜇𝐷 PS = 𝜇 𝑇𝑅 ⋅ 𝜇𝐷
92
Inventory
location
𝐷 𝑄
𝑇𝐶 = 𝐷 ∗ 𝑐 + ∗𝐾 + ∗ ℎ + 𝑆𝑆 ∗ ℎ + 𝑃𝑆 ∗ ℎ′ + 𝐹𝐶
𝑄 2
▪ Several trade-offs affect how you make a good use of logistics and inventory, such as:
▪ faster replenishments are more expensive but reduce your safety and pipeline stocks, leading to
savings in holding costs
▪ a local supplier can imply higher purchasing costs (and holding cost per unit) but the corresponding
reduced lead time reduces safety stocks and pipeline stocks
▪ streamlining the ordering process reduces ordering costs and allows for lower inventories due to a
lower Q (lower cycle stock)
▪ faster fulfillment might cost more but might attract and maintain satisfied customers who buy more
▪ a supply chain configuration can be near-optimal for one product but not recommended for
another: a segmented supply chain is necessary!
93
▪ And, directionally, some levers affect inventories differently
Lever EOQ SS
Ordering Cost Increases
Demand Rate Increases
Lead Time Increases
Demand Uncertainty Decreases
Shortage Cost Decreases
Lead Time Uncertainty Increases
Interest Rate Decreases
Warehouse Rental Cost Increases
94
▪ Finally, you can employ these calculations to set targets for inventory and determine
potential savings
Bottom-up estimate of savings
Current stock: Usually average of last

12-24 months
-x%
Special stock:
Special stock Direct input after discussions
Pipeline stock Pipeline stock:
Demand over transit time
Cycle stock Cycle stock:

Based on order quantity (EOQ or direct
input)
Safety stock Safety stock:

As discussed, to protect against
variability of demand or lead time for a
chosen target cycle service level
Current Target
Stock stock
95
▪ But remember that a reduction of $X in inventory generates two cash flows:
▪ A one-time positive $X from the reduction in Working Capital Requirements, plus
▪ An on-going positive flow from the annual reduction of expenses related to inventory =
$100k * physical inventory holding cost rate (i.e., the part of the inventory holding rate
in h which covers obsolescence and storage, such as warehouse, manpower, insurance,
taxes, shrinkage, refrigeration, etc.)
𝐹𝐶𝐹𝑡 = 1 − 𝑇𝑎𝑥𝑅𝑎𝑡𝑒 ⋅ 𝐸𝐵𝐼𝑇𝑡 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛𝑡 − 𝐶𝑎𝑝𝐸𝑥𝑡 − ∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡𝑠𝑡
2) … creating a one-time positive cashflow
3) But the reduction in expenses related to

physical inventory holding will occur every
period starting from the current (i.e., it is
either a perpetuity or a flow of several years)
∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡𝑠𝑡 = ∆𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦𝑡 + ∆𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑡 − ∆𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑡

1) A reduction of inventory will lead to reduction in
working capital requirements in the first period…
96

review

procurement Wrap-up


SCM as strategy

and SCM
97
9. Fundamental concepts: wrap-up
▪ Purchasing evolved into a strategic role in the organization: source external resources to
support the company’s strategy
▪ It can create and capture value through cost savings but also through a balanced
perspective on quality, risk, speed, innovation, and sustainability
▪ The procurement strategy must align the procurement organization, processes, and
tools to the firm’s strategy and the external environment
▪ Procurement’s fundamental processes include strategic sourcing, category management,

source to contract, procure to pay, contract management, and supplier management
▪ Procurement’s decisions affect several costs which are often hidden and involve trade-offs
that are affected by scale, quality, speed, supply risk, sustainability, and the size of the
supply base
▪ Segmenting procurement operations is necessary to allow prioritization of limited

resources to achieve firms’ goals
98
9. Fundamental concepts: wrap-up
▪ Logistics and SCM are concerned with how to match supply and demand by offering the
right product, in the right place, at the right time
▪ Logistics and SCM are strategic because they affect both top and bottom line: service
levels affect immediate and future revenue, while inventories and logistics affect expenses
▪ The economics of logistics are largely based on scale: consolidation and spreading fixed
costs
▪ The economics of inventory include trade-offs between several costs, including

inventory holding costs and ordering costs
▪ A balanced supply chain is built on an appropriate mix of inventory and logistics to

achieve the desired service level
▪ But there is no absolutely superior supply chain: the performance of a supply chain
configuration depends on product and demand characteristics; thus, a supply chain
strategy must be chosen based on a segmented and end-to-end perspective
99

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Operaciones de Clase Mundial

Material Adicional de Consulta

Prof. Luigi Laporte

Introduction Economics of Inventory and SCM

1. Definitions and overview 7. Economics of SCM

Procurement Fundamentals a) Single period models: Newsvendor

b) Multiperiod models: Continuous and Periodic

3. Fundamental processes and concepts in

4. Segmenting procurement operations

Logistics & SCM Fundamentals

5. The importance of logistics and SCM for the firm:

6. Fundamental processes and concepts in Logistics

▪ Topics will be in…

▪ the scope of functions such as Procurement, Manufacturing, and Logistics

▪ the interfaces among them,

▪ We are interested in what the General Manager must know

1. to define a solid firm’s strategy based on an end-to-end perspective about Operations

Purchasing, Procurement, or Sourcing?

▪ There is no clear agreement on the definition and differences. Alternatives include:

1. a broadly indiscriminate use: Purchase = Procure = Source

2. “Procurement is the business management function that ensures identification, sourcing,

Purchasing, Procurement, or Sourcing?

▪ There is no clear agreement on the definition and differences. Alternatives include:

4. Procurement = Purchasing + Supplier Management (Lysons & Farrington, 2020)

5. Sourcing includes tasks and operations needed to obtain external resources, as

Purchasing, Procurement, or Sourcing?

Procurement Manufacturing Logistics

3. Sourcing materials is inscribed in a broader supply chain management perspective

Source: own elaboration. 6

Logistics, Supply Chain Management (SCM), or both?

▪ Professional associations and international programs have rebranded, signaling a trend:

▪ The trend signaled an increasing recognition of the importance of cross-firm collaboration

Logistics, Supply Chain Management (SCM), or both?

▪ Some alternative definitions include:

Logistics, Supply Chain Management (SCM), or both?

▪ Some alternative definitions include:

Logistics, Supply Chain Management (SCM), or both?

▪ We will give preference to the following perspective:

Supply Chain Management (SCM)

Procurement Manufacturing Logistics

1. SCM includes logistics activities, which include warehousing and transportation

2. Inventory Management crosses procurement, manufacturing, and logistics, and is a

Source: own elaboration. 10

Putting it all together: Operations and Supply Chain Management

Operations and Supply Chain Management (SCM)

Suppliers Procurement Manufacturing Logistics Marketing Clients

A. Superior results require cross-functional collaboration and strategic alignment based on a

Source: own elaboration. 11

Introduction Economics of Inventory and SCM

1. Definitions and overview 7. Economics of SCM

Procurement Fundamentals a) Single period models: Newsvendor

b) Multiperiod models: Continuous and Periodic

3. Fundamental processes and concepts in

4. Segmenting procurement operations

Logistics & SCM Fundamentals

5. The importance of logistics and SCM for the firm:

6. Fundamental processes and concepts in Logistics

▪ Examples of value creation or capturing in these dimensions include:

▪ Procurement must evaluate these dimensions combined in their sourcing decisions!

Introduction Economics of Inventory and SCM

1. Definitions and overview 7. Economics of SCM

Procurement Fundamentals a) Single period models: Newsvendor

b) Multiperiod models: Continuous and Periodic