Introduction to Supply Chain

Analytics III
Rohit Kapoor
 Today’s Agenda

• Comprehensive Exercise
– Newsvendor Model
• Improvement over Newsvendor Model
– Exercise Problem
 Performance Measures
σ× L(Z)
• Expected lost sales
Expected Demand µ
• Expected sales
Q
• Expected leftover inventory
• Expected profit
• Fill rate Expected Sales/µ
• In-stock probability/Stockout probability
– Also known as service level
Quick Response

Rohit Kapoor
 Introduction
• Firm facing newsvendor situation
– Make to Stock
• Entire supply is committed before the random demand
occurs
– FG inventory
– The identity of the owner is not fixed when production of the unit
is initiated

• To reduce this impact

– Make to Order
• Dell model
 Further …
• Two extremes
– Intermediate?
– Suppose the lead time to receive an order is
• Short relative to the length of the selling season
– A firm can order few units before the season
» After observing early season sales, the firm submits a
second order
» That is received well before the end of the season
» Due to short lead time
 An Observation
• Logical move?
– Conservative initial order
• Second order to strategically respond to initial sales
– Slow moving items
» Not replenished mid-season – thereby reducing leftover inventory
– Fast-selling items
» Replenished – to reduce lost sales
• Concept of Quick Response
– To reduce the cost of mismatches
• Equivalent to Just-in-time practices in the automobile industry
– Grocery industry under the umbrella of Efficient Customer Response
 Newsvendor Model
• Mismatch Cost
– Tangible component?
– Intangible component?
 Apparel A Timeline and
Generate forecastEconomics
of demand and
submit an order
to TEC Spring selling season

Nov Dec Jan Feb Mar Apr May Jun Jul Aug

Receive order Left over

from TEC at the units are
end of the discounted
month
• Economics:
• Each suit sells for p = $180
• TEC charges c = $110 per
suit
• Discounted suits sell for v = $90
 Apparel A
• Cu
$70
• Co
$20 (leftover inventory sold at 50% discount)
• Expected Demand
3192 units
• Standard Deviation of Demand
1181
 Summary of Performance Measures
Order Quantity 4095 Units
F(Q) = Cu/(Cu + Co)
Expected Demand 3192 Units
µ
Std. Dev. Of Demand 1181
σ
Expected Lost Sales 150 Units σ * L(Z)
Expected Sales 3042 Units µ - Expected Lost Sales
Expected Leftover Inventory 1059 Units Q – Expected Sales
Expected Revenue 642870 $ Price * Expected Sales + Salvage Value * Expected Leftover Inventory

Expected Profit 191760 $ Cu * Expected Sales – Co * Expected Leftover Inventory

Mismatch Cost 31680 Cu * Expected Lost Sales + Co * Expected Leftover Inventory
Value of Perfect Information
 Further …
• With Crystal ball
Maximum profit?
• (p – c) * mu
$223,440
• Mismatch cost = Maximum Profit – Expected Profit
Cost to purchase crystal ball
• Minimizing mismatch cost
Is equivalent to maximizing expected profit
 An Observation
• How big is Mismatch Cost?
Ratio with maximum profit?
• 14.2%
With expected sales (per unit)
• $10.41
With expected revenue
• 4.9%
With expected profit
• 16.5%
 Worth of Reactive Capacity
• A fact
– Companies in apparel industries
• Net profit in the range of
2-5% of revenue
 Observation
• Mismatch cost
– Increases as demand variability increases
• Demand variability measure: CV
– Why CV is important measure?
 Some Guidelines
• CV values:
– Low
• CV value less than 0.25
– Medium
• 0.25 to 0.75
– High
• Above 0.75
– Above 1.5 is extremely high
– Anything above 3
» Demand forecast is essentially meaningless
 Measure of Demand Variability
• CV Probability (Demand Probability (Demand
Coefficient is less than 75%) of is within 25% of the
of Variation the Forecast) Forecast)
0.1 0.62% 98.76%
0.25 15.87% 68.27%
0.5 30.85% 38.29%
0.75 36.94% 26.11%
1 40.13% 19.74%
1.5 43.38% 13.24%
2 45.03% 9.95%
3 46.68% 6.64%
 Another Observation
• Mismatch cost
• Increases as critical ratio becomes smaller
– Observation
» The first term in the derivation
» Ratio of std. normal density function to the std. normal
distribution function
» It depends on z and z depends on critical ratio
» Higher the z implies CR to be high but ratio becomes
smaller
» Which implies for higher critical ratio, the mismatch cost
is lower
 Mismatch Cost as a %age of
Maximum Profit (Normally
Distributed Demand)
  Critical Ratio
Coefficient of Variation 0.4 0.5 0.6 0.7 0.8 0.9
0.10 9.66% 7.98% 6.44% 4.97% 3.50% 1.95%
0.25 24.15% 19.95% 16.10% 12.42% 8.75% 4.87%
0.40 38.63% 31.92% 25.76% 19.87% 14.00% 7.80%
0.55 53.12% 43.88% 35.41% 27.32% 19.25% 10.72%
0.70 67.61% 55.85% 45.07% 34.77% 24.50% 13.65%
0.85 82.10% 67.82% 54.73% 42.22% 29.75% 16.57%
1.00 96.59% 79.79% 64.39% 49.67% 35.00% 19.50%
 Concept of Reactive Capacity
Generate forecast Receive 1st order
of demand and from TEC at the
submit 1st order end of Jan Spring selling season
to TEC (Feb – Jul)

Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug

Observe Feb and Receive 2nd Left over

Mar sales and order from units are
submit 2nd order TEC at the discounted
to TEC end of Apr
 Complexities
• Choosing order quantities with two ordering opportunities
– vs. choosing a single order quantity
» More complex
• For example, in addition to our forecast of the entire season’s demand
– Now we need to worry about developing a forecast for demand in the second
half of the season
» given what we observe in the first two months of the season
• Furthermore, we do not know what will be our initial sales when we
submit our first order
» We may not anticipate all possible outcomes for initial sales
» Therefore, we may not have the appropriate response in the second order for all
those outcomes
• We may stock out within the first half of the season
– if our first order is not large enough
• Finally, some uncertainty still remain
» regarding demand in the second half of the season
 Some Basic Assumptions
• We do not run out of inventory
– before the second order arrives
• After we observe initial sales
– we are able to perfectly predict sales in the
remaining portion of the season
• Validity of the assumptions?
 An Example
• Lets, Say XYZ can send a second order
• TEC will charge 20% premium
• Q?
3,263
• Expected second order quantity?
437
• Expected profit
maximum profit – [co * Expected leftover inventory + cu * expected second
order quantity] ?
 Another Approach to Estimate
Expected Profit
• Estimate Q1
• Estimate Expected Lost Sales based on Q1
– This becomes equal to Q2
• Estimate Expected Sales from Q1
• Estimate Expected Leftover Inventory from Q1
• Expected Profit
= Price * Expected Sales from Q1
+ Salvage Value * Expected Leftover Inventory from Q1
– Cost of ordering Q1 – Cost of ordering Q2 + Price * Q2
 Analysis
• Expected profit with just one ordering
opportunity
$191,760
• Expected profit now
$203,666
• Increases in expected profit
6.2%
 Analysis
• Further,
– In terms of how much the IInd order reduces the
mismatch cost
• Mismatch cost with only 1 order
$31,680
• Mismatch cost now?
$223,440 - $203,666 = $19,774
38% reduction
 An Exercise Problem
• Sport’s Obermeyer?
 Situation

Asian
Supplier Cost ($10)
µ,σ (2100,
1200)
SO
Price ($22)
American Cost ($15)
Supplier
 Part I
a)?
Condition?
When demand will exceed 1500
b)?
Q = 1500
Second order to American Supplier
Expected Lost sales based on Q = 1500
c)?
Cu = 5
Co = 10
Q=?
d)?
e)?
 Part II a & b
a) Asian Supplier’s gross margin is $10  0.25 = $2.5
 2755 units are produced based on Critical Ratio
 so total profit is 2755  $2.5 = $6887.5
b) Asian Supplier’s regular production cost is 0.75  $10 = $7.5
 Asian Supplier’s expensive production cost is 2  $7.5 = 15
 Asian Supplier earns $2.5 on each of the 939 units in SO’s 1st order
 Asian Supplier charges 1.2  $10 = $12 for units in the 2nd
replenishment
 SO’s expected 2nd order quantity is 1267, and
 Asian Supplier “earns” $12 - $15 = -$3 on those units despite the
premium charged of 20%.
 Hence, Asian Supplier’s profit is $2.5  939 - $3  1267 = -
$1454.23
 Part II c
• Now Asian Supplier can produce more than 939 units
• The overage cost is $7.5 – 3 = $4.5
• If a unit is not produced in the 1st production run but could be
sold, Asian Supplier “earns” -$3 on that unit
• If the unit were produced in the 1st production run, Asian
Supplier earns $12 - $7.5 = $4.5
– Hence, the underage cost is $4.5 – (-$3) = $7.5
• In other words, every unit produced in the 1st production run that SO
eventually orders saves Asian Supplier $7.5 in profit relative to producing
that unit in the 2nd production run.
• The critical ratio is 7.5 / (7.5 + 4.5) = 0.625.
• Thus, Z = 0.3186. Therefore, Q = 2100 + 0.3186 * 1200 = 2482.
• Because that quantity is greater than SO’s initial order of 939,
– Asian Supplier should produce 2482 units in the 1 st production run.
 Part II d
• If Asian Supplier produces 2482, then its expected 2nd production run is
312 units:
L(0.3186) = 0.2597, 1200  0.2597 = 312
• Expected left over inventory is tricky to evaluate.
– Expected left over inventory with Q = 2482 is 694 units.
– Expected left over inventory with Q = 939 is 106 units.
– Hence, if Asian Supplier produces 2482 units and SO’s 1st order is 939 units,
then among the 1543 units (2482-939) Asian Supplier produces above SO’s
order,
• Asian Supplier can expect to have 694 – 106 = 588 remaining at the end of the season.
– TEC’s revenue is then revenue from the 1st order $10  939 = $9,390
+ revenue from the 2nd order $12  1267 = $15,204
+ revenue from left over inventory $3  588 = $1764
= for total revenue of $26,358.
– Costs include the 1st production run = 2482  $7.5 = $18,615
– and 2nd production run costs = 312  $15 = $4,680.
– Expected profit is then $26,358 - $18,615 - $4,680 = $3,063.