Operations Plan

Supply Chain Design

Ram Babu Roy

Ref: Supply chain management: Strategy, planning and

operation,4th Edn: S Chopra, P Meindl, D V Kalra

Note: This study material has been prepared for the purpose
of classroom discussions only.
 The Supply Chain View
provide vital resources and inputs to the core processes
Support Processes

New
service/ product Customer
relationship

External customers
development
External suppliers

management

Supplier Order
relationship fulfillment
process process

sets of activities that deliver value to external customers

 What is a Supply Chain?
• All stages involved, directly or indirectly, in fulfilling a
customer request
• Includes manufacturers, suppliers, transporters,
warehouses, retailers, and customers (an integral part)
• Within company supply chain - product development,
marketing, operations, distribution, finance, customer
service
• Also includes flow of information, funds, and products in
both directions that fills a customer order.
• Management of these flows is key to the success or failure
of a firm
• All stages may not be present in all supply chains
(e.g., no retailer or distributor for Dell)
 The Objective of a Supply Chain
• Maximize overall value created
• Supply chain value: difference between what the final
product is worth to the customer and the effort the
supply chain expends in filling the customer’s request
• Value is correlated to supply chain profitability
(revenue - overall cost across the supply chain) to be
shared across all stages of the supply chain
• Supply chain success should be measured by total
supply chain profitability, not profits at an individual
stage
• Supply chain management is the management of
flows between and among supply chain stages to
maximize total supply chain profitability
 Supply Chain Strategy/Design
• Decisions about the structure of the supply chain
and what processes each stage will perform
• Strategic supply chain decisions
– Locations and capacities of facilities
– Products to be made or stored at various locations
– Modes of transportation
– Information systems
• Supply chain design must support strategic
objectives
• Supply chain design decisions are long-term and
expensive to reverse – must take into account
market uncertainty
 Supply Chain Planning
• Definition of a set of policies that govern short-term
operations
• Fixed by the supply configuration from previous phase
• Starts with a forecast of demand in the coming year,
demand uncertainty, exchange rates, competition
• Planning decisions:
– Which markets will be supplied from which locations
– Planned buildup of inventories
– Subcontracting, backup locations
– Inventory policies
– Timing and size of market promotions
 Supply Chain Operation
• Time horizon is weekly or daily
• Decisions regarding individual customer orders
• Supply chain configuration is fixed and operating
policies are determined
• Goal is to implement the operating policies as
effectively as possible
• Allocate orders to inventory or production, set
order due dates, generate pick lists at a
warehouse, allocate an order to a particular
shipment, set delivery schedules, place
replenishment orders
• Much less uncertainty (short time horizon)
 Process View of a Supply Chain
• Cycle view:
– processes in a supply chain are divided into a series of
cycles, each performed at the interfaces between two
successive supply chain stages
• Push/pull view:
– processes in a supply chain are divided into two
categories depending on the timing of their execution
relative to customer demand
– Pull: execution is initiated in response to a customer
order (reactive)
– Push: execution is initiated in anticipation of customer
orders (speculative)
 Cycle View of Supply Chains
Customer
Customer Order Cycle
Each cycle occurs
at the interface
between two
Retailer
successive stages Replenishment Cycle

Distributor

Manufacturing Cycle

Manufacturer
Procurement Cycle
Supplier
Clearly specifies the roles and responsibilities
of each member and the desired outcome
 Push/Pull View of Supply Chains
Procurement, Customer Order
Manufacturing and Cycle
Replenishment cycles

PUSH PROCESSES PULL PROCESSES

Customer
Order Arrives
1-10
 Supply Chain Macro Processes in a
Firm
• Strategic decisions relating to supply chain design –
how supply chain processes relate to customer orders
• The relative proportion of push and pull processes can
have an impact on supply chain performance
• Supply chain processes discussed in the two views can
be classified into
– Customer Relationship Management (CRM)
– Internal Supply Chain Management (ISCM)
– Supplier Relationship Management (SRM)
• Integration among the above three macro processes is
critical for effective and successful supply chain
management

1-11
 Support Processes
Capital acquisition
Budgeting
Recruitment and hiring
Evaluation and compensation
Human resource support and development
Regulatory compliance
Information systems
Enterprise and functional management
Financial resources for the organization to do
its work and to execute its strategy
Deciding how funds will be allocated over a
period of time
The acquisition of people
The assessment and payment of people for
the work and value creation
The preparation of people for their current
jobs and future skills and knowledge needs
The processes that ensure meeting all laws
and legal obligations
Movement and processing of data and
information to expedite operations and
decisions
The systems and activities that provide
strategic direction and ensure effective
execution of the work of the business
 SCM: Inventory Management
Cost Minimization Goal

The Total-Cost Curve is U-Shaped

Q D The total cost curve reaches its
TC = H + S minimum where the carrying
2 Q and ordering costs are equal
Annual Cost

Ordering Costs

Order Quantity (Q)

QO (optimal order quantity)
2DS 2(Annual Demand )(Order or Setup Cost )
Q OPT = =
H Annual Holding Cost
 Quantity Discounts
• Two general cases:
– Carrying cost is constant – a single minimum point
• Compute the common minimum point
• Identify the feasible range
• Compute the total cost for the minimum point and for the price
breaks of all lower unit costs
– Stated as percentage of unit price – different minimum
points
• Beginning with the lowest price, compute the minimum points
for each price range until a feasible minimum point
• If the minimum point is not feasible in the lowest price range,
compare the total costs at break points for all lower prices with
the total cost of the feasible minimum points
When to Reorder with EOQ Ordering
• Reorder Point - When the quantity on hand
of an item drops to this amount, the item is
reordered
• Safety Stock - Stock that is held in excess of
expected demand due to variable demand
rate and/or lead time.
• Service Level - Probability that demand will
not exceed supply during lead time.
 Safety Stock
Quantity
Expected demand
during lead time

Maximum probable demand

during lead time

ROP

Safety stock
Safety stock reduces risk of LT Time
stockout during lead time
 Service Level
• Product with limited useful life (perishables)
• Cunderstocking = Revenue per unit – Cost per unit
• Coverstocking = Original cost per unit – Salvage value per unit
• Service Level = Cu/(Cu+Co)
• For uniform distribution [a,b]: optimal stocking level = a +
SL*(b-a)
• For uniform distribution: optimal stocking level = mean
demand + zSL*σ
• For discrete stocking levels – ratio Cs/(Cs+Ce) may not
coincide with a feasible stocking level – chose next higher
level
 Example
• Demand for long-stemmed red roses at a
small flower shop can be approximated using
a Poisson distribution that has a mean of four
dozen per day. Profit on the roses is $3 per
dozen. Leftover flowers are marked down and
sold at a loss of $2 per dozen. Assume that all
marked-down flowers are sold. What is the
optimum stocking level?
 Solution
• Cu = $3
• Co = $2
• SL = 3/5=0.6
• Poisson distribution for a mean of 4
Demand (dozen per day) Probability Cummulative Probability
0 0.02 0.02
1 0.07 0.09
2 0.15 0.24
3 0.20 0.43
4 0.20 0.63
5 0.16 0.79
Determinants of the Reorder Point
• The rate of demand
• The lead time
• Demand and/or lead time variability
• Stockout risk (safety stock)

• If Demand and lead time are constant

– ROP = d * LT
• If demand or lead time is variable
– ROP = Exp Demand during lead time + Safety Stock
 Service Level and Reorder Point
• Service level = 100 percent – Stockout Risk
• Service level of 95% doesn’t mean that 95% of
the demand will be satisfied.
The ROP based on a normal
Distribution of lead time demand

Service level
Risk of
a stockout
Probability of
no stockout

ROP Quantity
Expected
demand Safety
stock
0 z z-scale
 Example: Data with demand during
lead time
• Expected lead time demand = 50
• σ =5
dLT

• Risk = 3%
• Service level = 1-0.03 = 0.97
• Z = +1.88
• ROP = 50+9.4 = 59.4
 Variability in demand during the
period and lead time
• If only demand is variable
– σ = σ *sqrt(LT)
dLT d

– ROP = avg(d)*LT + z* σdLT

• If only lead time is variable
– σ = d*σ
dLT LT

– ROP = avg (LT)*d + z*d* σ LT

• If both demand and lead time are variable

– σ = sqrt[σ ^2*avg (LT) + {avg(d)}^2* σ2 ]
dLT d LT

– ROP = avg (d)*avg (LT) + z* σdLT

 Problem
• Assume that the demand varies with an average daily demand of 33 units
and its standard deviation is 3 units per day. There are three channel
points (namely, processing at supplier end, inbound transport to pool
point, outbound transport from pool point to distributor) throughout the
supply channel between source point and the customer. The distribution
of the time taken (by these three activities) that constitute the order
replenishment lead time is given by the mean (X) and variance (s2) as
shown below. Assume that no significant amount of inventory is
maintained at the pool point or in the trucks.
•
• Xp (processing) = 1, sp2 (processing) = 0.2
•
• Xi (inbound) = 2, si2 (inbound) = 0.5
•
• Xo(outbound) = 2, so2 (outbound) = 0.25
•
• Find the reorder level if the desired service level (SL) is 80%.
 Solution

service level 80% z= 0.85

d 33
sd 3
LT 5 D during LT 165
s^2LT 0.95
s^2dLT 1079.55 32.86

safety stock = 27.92803027

ROP = 192.928
 SCM: Network Design
• Factors Influencing
Network Design Decisions
– Strategic
– Technological
– Macroeconomic
– Political
– Infrastructure
– Competitive
– Logistics and facility costs
The Cost-Response Time Frontier

Hi Local FG
Mix
Regional FG

Local WIP
Cost Central FG

Central WIP

Central Raw Material and Custom production

Custom production with raw material at suppliers

Low
Low Response Time Hi
 Service and Number of Facilities
Response
Time

Number of Facilities
 Cost Buildup as a Function of Facilities
Total Costs

Percent Service
Cost of Operations

Level Within
Promised Time
Facility cost
Inventory
Transportation
Labor

Number of Facilities
A Framework for Global Site Location
Competitive STRATEGY GLOBAL COMPETITION
PHASE I
Supply Chain
INTERNAL CONSTRAINTS Strategy
Capital, growth strategy, TARIFFS AND TAX
existing network INCENTIVES

PRODUCTION TECHNOLOGIES REGIONAL DEMAND

Cost, Scale/Scope impact, support PHASE II Size, growth, homogeneity,
required, flexibility Regional Facility local specifications
Configuration
COMPETITIVE
ENVIRONMENT POLITICAL, EXCHANGE
RATE AND DEMAND RISK

PHASE III
Desirable Sites AVAILABLE
INFRASTRUCTURE
PRODUCTION METHODS
Skill needs, response time

FACTOR COSTS PHASE IV LOGISTICS COSTS

Labor, materials, site specific Location Choices Transport, inventory, coordination
Evaluating Supply Chain Design Options
Discounted Cash Flow Analysis
1
Discount factor =
1 + 𝑘𝑘
𝑇𝑇 𝑡𝑡
1
𝑁𝑁𝑁𝑁𝑁𝑁 = 𝐶𝐶0 + � 𝐶𝐶𝑡𝑡
1 + 𝑘𝑘
𝑡𝑡=1
where
𝐶𝐶0 , 𝐶𝐶1 , . . . , 𝐶𝐶𝑇𝑇 is a stream of cash flows over T periods
𝑁𝑁𝑁𝑁𝑁𝑁 = the net present value of this stream of cash flows
𝑘𝑘 = rate of return (or discount rate)

• Compare NPV of different supply chain design options

• The option with the highest NPV will provide the
greatest financial return
 NPV Example: Lease decision at Trips Logistics

• How much space to lease in the next three years

• Demand = 100,000 units
• Requires 1,000 sq. ft. of space for every 1,000
units of demand
• Revenue = $1.22 per unit of demand
• Decision is whether to sign a three-year lease or
obtain warehousing space on the spot market
• Three-year lease: cost = $1 per sq. ft.
• Spot market: cost = $1.20 per sq. ft.
• k = 0.1
 NPV Example: Trips Logistics (Contd.)

For leasing warehouse space on the spot market:

Expected annual profit = 100,000 x $1.22 – 100,000 x
$1.20 = $2,000
Cash flow = $2,000 in each of the next three years
C1 C2
NPV (no lease) = C0 + +
1 + k (1 + k )2
2000 2000
= 2000 + + 2
= $5,471
1.1 1.1
 NPV Example: Trips Logistics
Whether to lease warehouse space for the coming three years and the
quantity to lease
For leasing warehouse space with a three-year lease:
Expected annual profit = 100,000 x $1.22 – 100,000 x $1.00 = $22,000
Cash flow = $22,000 in each of the next three years
C1 C2
NPV (lease) = C0 + +
1 + k (1 + k )2
22000 22000
= 22000 + + 2
= $60,182
1.1 1.1
The NPV of signing the lease is $54,711 higher; therefore, the manager
decides to sign the lease
However, uncertainty in demand and costs may lead to rethink
decision
 Supply Chain Network Design Decisions
• To estimate the uncertainty in the forecast of demand
and price and then incorporate this uncertainty in the
decision-making process
• Should the firm sign a long-term contract for
warehousing space or get space from the spot market
as needed?
• What should the firm’s mix of long-term and spot
market be in the portfolio of transportation capacity?
• How much capacity should various facilities have?
• What fraction of this capacity should be flexible?
 Decision Tree Methodology
1. A decision tree is a graphic device that can be used to evaluate
decisions under risky business environment
2. Identify the duration of each period (month, quarter, etc.) and the
number of periods T over the which the decision is to be evaluated.
3. Identify factors such as demand, price, and exchange rate, whose
fluctuation will be considered over the next T periods.
4. Identify representations of uncertainty for each factor; that is,
determine what distribution to use to model the uncertainty.
5. Identify the periodic discount rate k for each period.
6. Represent the decision tree with defined states in each period, as
well as the transition probabilities between states in successive
periods.
7. Starting at period T, work back to period 0, identifying the optimal
decision and the expected cash flows at each step. Expected cash
flows at each state in a given period should be discounted back
when included in the previous period.
 Example: Logistics
• 1000 sq. ft. of warehouse space needed for 1000 units of
demand
• Current demand = 100,000 units per year
• Binomial uncertainty: Demand can go up by 20% with
p = 0.5 or down by 20% with 1-p = 0.5
• Lease price = $1.00 per sq. ft. per year
• Spot market price = $1.20 per sq. ft. per year
• Spot prices can go up by 10% with p = 0.5 or down by 10%
with 1-p = 0.5
• Revenue = $1.22 per unit of demand
• k = 0.1
 Decision Tree
Period
Period 2 D=144
Period 1 p=$1.45
0.25
0 0.25
D=144
p=$1.19
D=120
p=$1.32
0.25 D=96
0.25 p=$1.45
0.25
D=144
0.25 D=120 p=$0.97
p=$1. 08
D=100 D=96
p=$1.20 0.25 p=$1.19

D=80 D=96
p=$1.32 p=$0.97

0.25 D=64
p=$1.45
D=80
p=$1.08 D=64
p=$1.19

D=64
p=$0.97
 Logistics Example
• Assumption: Trips Logistics must satisfy a demand
• From node D=120, p=$1.32 in Period 1, there are four possible
states in Period 2
• Evaluate the expected profit in Period 2 over all four states
possible from node D=120, p=$1.32 in Period 1 to be
EP(D=120,p=1.32,1) = 0.25xP(D=144,p=1.45,2) +
0.25xP(D=144,p=1.19,2) +
0.25xP(D=96,p=1.45,2) +
0.25xP(D=96,p=1.19,2)
= 0.25x(-33,120)+0.25x4,320+0.25x(-22,080)+0.25x2,880
= -$12,000
 Logistics Example
• The present value of this expected value in Period 1 is
PVEP(D=120, p=1.32,1) = EP(D=120,p=1.32,1) / (1+k)
= -$12,000 / (1+0.1)
= -$10,909
• The total expected profit P(D=120,p=1.32,1) at node
D=120,p=1.32 in Period 1 is the sum of the profit in Period 1 at
this node, plus the present value of future expected profits
possible from this node
P(D=120,p=1.32,1) = [(120,000x1.22)-(120,000x1.32)] +
PVEP(D=120,p=1.32,1)
= -$12,000 + (-$10,909) = -$22,909
 Logistics Example
• For Period 0, the total profit P(D=100,p=120,0) is the sum of
the profit in Period 0 and the present value of the expected
profit over the four nodes in Period 1
EP(D=100,p=1.20,0) = 0.25xP(D=120,p=1.32,1) +
0.25xP(D=120,p=1.08,1) +
0.25xP(D=96,p=1.32,1) +
0.25xP(D=96,p=1.08,1)
= 0.25x(-22,909)+0.25x32,073+0.25x(-15,273)+0.25x21,382
= $3,818
PVEP(D=100,p=1.20,0) = EP(D=100,p=1.20,0) / (1+k)
= $3,818 / (1 + 0.1) = $3,471
 Logistics Example
P(D=100,p=1.20,0) = 100,000x1.22-
100,000x1.20 + PVEP(D=100,p=1.20,0)
= $2,000 + $3,471 = $5,471
• Therefore, the expected NPV of not signing the
lease and obtaining all warehouse space from
the spot market is given by NPV(Spot Market) =
$5,471
• Using the same approach for the lease option,
NPV(Lease) = $38,364
Evaluating Flexibility Using Decision Trees
• Decision tree methodology can be used to evaluate flexibility within the
supply chain
• Suppose the manager at Trips Logistics has been offered a contract
where, for an upfront payment of $10,000, the company will have the
flexibility of using between 60,000 sq. ft. and 100,000 sq. ft. of
warehouse space at $1 per sq. ft. per year. Trips must pay $60,000 for
the first 60,000 sq. ft. and can then use up to 40,000 sq. ft. on demand
at $1 per sq. ft. as needed.
• Using the same approach as before, the expected profit of this option is
$56,725
• The value of flexibility is the difference between the expected present
value of the flexible option and the expected present value of the
inflexible options
• The flexible option has an expected present value $8,361 greater than
the inflexible lease option (including the upfront $10,000 payment)