Supply Chain Management

Lecture 9

Outline

• Today– Chapter 6– Skipping

• 3e: Section 6.5 p. 164-175, 4e: Section 6.6 p. 160-171• AM Tires: Evaluation of Supply Chain Design Decisions

Under Uncertainty

• Thursday– Finish Chapter 6 start with Chapter 7

• Homework 2 – Due Friday February 12 before 5:00pm

• If you email “save as” .doc and .xls format

Example: Dell Facility Location

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What are the decisions?

What are the constraints?

Example: SC Consulting Facility Location

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Making Network Design Decisions in Practice

• Computer models versus sound judgment– Most facility location decisions are based on tariffs and

tax incentives

Example: Dell Facility Location

Romenia Poland Ireland DemandFrance 23 19 31 15,000Germany 9 15 11 20,000Italy 23 21 40 13,000Spain 29 26 40 12,000United Kingdom 33 36 20 19,000Capacity 40,000 40,000 40,000Fixed operating cost 18,000,000.00$ 17,500,000.00$ 24,500,000.00$

Example: SC Consulting Facility Location

State L.A. Tulsa Denver Seattle Trip demandWashington $150 $250 $200 $25 40Oregon $150 $250 $200 $75 35California $75 $200 $150 $125 100Idaho $150 $200 $125 $125 25Nevada $100 $200 $125 $150 40Montana $175 $175 $125 $125 25Wyoming $150 $175 $100 $150 50Utah $150 $150 $100 $200 30Arizona $75 $200 $100 $250 50Colorado $150 $125 $25 $250 65New Mexico $125 $125 $75 $300 40North Dakota $300 $200 $150 $200 30South Dakota $300 $175 $125 $200 20Nebraska $250 $100 $125 $250 30Kansas $250 $75 $75 $300 40Oklahoma $250 $25 $125 $300 55Fixed Cost $165,428 $131,230 $140,000 $145,000Office Capacity 675 675 675 675

Travel Cost

Impact of Uncertainty in Network Design

• Supply chain network design decisions include– Facility location (number of facilities)– Capacity allocation (size of each facility)– Market and supply allocation (distribution)

These decisions, once made, cannot be changed easily in the short-term, they remain in place for several years

A decision that looks very good under the current environment may be quite poor if the situation changes

Demand, prices, exchange rates, and the competitive market change constantly

Supply Chain Risk

Supply failure

Commodity price volatility

Internal product failures

Lower consumer spending

Natural disaster

Supply Chain Risks to be Considered During Network Design

Category Risk DriversDisruptions Natural disaster, war, terrorism

Labor disputes, supplier bankruptcyDelays High capacity utilization at supply source

Inflexibility of supply sourcePoor quality or yield at supply source

Systems risk Information infrastructure breakdownSystem integration or extent of systems being networked

Forecast risk Inaccurate forecasts due to long lead times, seasonality,product variety, short life cycles, small cusomter baseBullwhip effect or information distortion

Intellectual property risk Vertical integration of supply chainGlobal outsourcing and markets

Procurement risk Exchange-rate riskFraction purchased from a single sourceIndustry-wide capacity utilization

Receivables risk Number of customersFinancial strength of customers

Inventory risk Rate of product obsolescenceInventory holding costProduct valueDemand and supply uncertainty

Capacity risk Cost of capacityCapacity flexiblityDoes offshoring increase or decrease these risks?

Supply Chain Risk

Supply Chain Risk

“Significant supply chain disruptions can reduce your company’s revenue, cut into your market share, inflate

your costs, send you over budget, and threaten production and distribution. You can’t sell goods you can’t manufacture or deliver. Such disruptions also

can damage your credibility with investors and other stakeholders, thereby driving up your cost of capital”

Source: FM Global – The New Supply Chain Challenge: Risk Management in a Global Economy

Managing a Supply Chain is Not Easy

• Uncertainty and risk factors– 1997 Raw material shortages

• Boeing inventory write down of $2.6 billion– 2000 Nike glitch in demand planning software

• Shortage of popular Air Jordan footwear• Nike announced a $100 million sales loss

– 2001 9/11• Trucks full of parts queued up for miles at the US-Canadian

border– 2002 West Coast port strike

• Losses of $1B/day• Store stock-outs, factory shutdowns

– 2007 Mattel recall• A sub-sub-contractor used lead-based paint from a non-

authorized third-party supplier

Impact of Uncertainty in Network Design

Manufacturer Distributor Retailer CustomerSupplier

Building flexibility into supply chain operations allows the supply chain to deal with uncertainty more

effectively

Risk Mitigation Strategies

Discounted Cash Flow Analysis

• Supply chain network design decisions should be evaluated as a sequence of cash flows over the duration that they will be in place

Year Option 1 Option 20 -1,000,000 -1,400,0001 300,000 400,0002 300,000 400,0003 300,000 400,0004 300,000 400,0005 300,000 400,000

500,000$ 600,000$

Discounted Cash Flow Analysis

• Supply chain network design decisions should be evaluated as a sequence of cash flows over the duration that they will be in place– Discounted cash flow (DCF) analysis

• Evaluates the net present value (NPV) of any stream of future cash flows

• Allows for comparing two or more cash flow streams in terms of their present financial value

Discounted Cash Flow Analysis

• The present value of future cash is found by using a rate of return k– A dollar today is worth more than a dollar tomorrow– A dollar today can be invested and earn a rate of return

k over the next period

Today… Tomorrow…$1 $1*(1 + k)

$1/(1 + k) $1

Today… Tomorrow…$1 $1*(1 + k)

Net Present Value

• Given a stream of cash flows C0, C1, …, CT over the next T periods and a rate of return k

Year Option 1 Option 20 -1,000,000 -1,400,0001 300,000 400,0002 300,000 400,0003 300,000 400,0004 300,000 400,0005 300,000 400,000

500,000$ 600,000$

Year Option 1 Option 20 -1000000/(1+0.1) 0̂ -1400000/(1+0.1) 0̂1 300000/(1+0.1) 1̂ 400000/(1+0.1) 1̂2 300000/(1+0.1) 2̂ 400000/(1+0.1) 2̂3 300000/(1+0.1) 3̂ 400000/(1+0.1) 3̂4 300000/(1+0.1) 4̂ 400000/(1+0.1) 4̂5 300000/(1+0.1) 5̂ 400000/(1+0.1) 5̂

Year Option 1 Option 20 -1000000 -14000001 272727 3636362 247934 3305793 225394 3005264 204904 2732055 186276 248369

137,236$ 116,315$

Net Present Value

• Given a stream of cash flows C0, C1, …, CT over the next T periods and a rate of return k

• The net present value (NPV) of this cash flow stream is given by

Year Option 10 -1000000/(1+0.1) 0̂1 300000/(1+0.1) 1̂2 300000/(1+0.1) 2̂3 300000/(1+0.1) 3̂4 300000/(1+0.1) 4̂5 300000/(1+0.1) 5̂

11 + k( )

t

t=1

T

NPV = C0 + ∑ Ct

Ct

(1 + k)t

t=0

T

NPV = ∑

If… Then… So…NPV > 0 Investment adds valueNPV < 0 Investment substracts valueNPV = 0 Investment would neither add

or substract value

Net Present Value

If… Then… So…NPV > 0 Investment adds value The project may be acceptedNPV < 0 Investment substracts value The project should be rejectedNPV = 0 Investment would neither add

or substract valueDecision should be based on other criteria

Example: Net Present Value

• Fulfillment by Amazon– Warehousing and other

logistics services– Amazon will pick, pack, and

ship your product to your customer

• Target.com – Estimated demand 100,000

units for online orders– Required space 1,000 sq. ft.

for every 1,000 units– Revenue $1.22 for each unit

of demand

Example: Net Present Value

• Target.com can choose between two options– Spot market rate expected at $1.20 per sq.ft. per year

for each of the next 3 years– 3 year lease contract at $1 per sq.ft.

Example: Net Present Value

• Expected annual profit if space is obtained from spot market using discount factor k = 0.1

Ct = (100,000 x $1.22) – (100,000 x $1.20) = $2,000

C1

(1 + k)1

C2

(1 + k)2

C1

(1 + k)0NPV = + +

= $ 5,471

2,000(1.1)1

2,0001.12

2,000(1.1)0= + +

Example: Net Present Value

• Expected annual profit if space is obtained by a 3 year lease using discount factor k = 0.1

Ct = (100,000 x $1.22) – (100,000 x $1.00) = $22,000

C1

(1 + k)1

C2

(1 + k)2

C1

(1 + k)0NPV = + +

= $ 60,182

22,000(1.1)1

22,0001.12

22,000(1.1)0= + +

Example: Net Present Value

• NPV(Spot) = $5,471 and NPV(Lease) = $60,182 – The NPV of signing the lease is $54,711 higher

But we ignored uncertainty. Uncertainty in demand and costs may change the outcome

Binomial Representation of Uncertainty

Pu3d2

Pu2d3

Pu4d

Pu5

Pud4

Pd5

Pu3d

Pu2d2

Pu4

Pud3

Pd4

Pu3

Pu2d

Pud2

Pd3

Pu2

Pud

Pd2

Pu

Pd

P

• Multiplicative binomial

p

1-p

p

1-p

p

1-p

p

1-p

p

1-p

Binomial Representation of Uncertainty

P+3u-2d

P+2u-3d

P+4u-d

P+5u

P+u-4d

P-5d

P+3u-d

P+2u-2d

P+4u

P+u-3d

P-4d

P+3u

P+2u–d

P+u-2d

P-3d

P+2u

P+u-d

P-2d

P+u

P-d

P

• Additive binomial

p

1-p

p

1-p

p

1-p

p

1-p

p

1-p

Decision Trees

P

Decision Trees

• A decision tree is a graphic device used to evaluate decisions under uncertainty

1. Identify the duration of each period and the number of time periods T to be evaluated

2. Identify the factors associated with the uncertainty

3. Identify the representation of uncertainty

4. Identify the periodic discount rate k

5. Represent the tree, identifying all states and transition probabilities

6. Starting at period T, work back to period 0 identify the expected cash flows at each step

Example: Decision Tree Analysis

• What product to make for the next three years using a discount factor k = 0.1?– Old product with certain demand ($90 profit/unit)– New product with uncertain demand ($85 profit/unit)

Example: Decision Tree Analysis

• Old product with certain demand ($90 profit/unit)– Annual demand is expected to be 100 units this year,

90 units next year, and 80 units in the following year– Cash flows for the three periods

• C0 = 100*90 = $9,000

• C1 = 90*90 = $8,100

• C2 = 80*90 = $7,200

– NPV(Old) • = 9,000/1.10 + 8,100 /1.11 + 7,200 /1.12

• = 9,000 + 7,364 + 5,950• = $ 22,314

Example: Decision Tree Analysis

• New product with uncertain demand ($85 profit/unit)– Annual demand expected to go up by 20% with

probability 0.6– Annual demand expected to go down by 20% with

probability 0.4

Example: Decision Tree Analysis

1. Identify the duration of each period and the number of time periods T to be evaluated• Duration of each period is 1 year, T = 3

2. Identify the factors associated with the uncertainty• Demand D

3. Identify the representation of uncertainty• D may go up by 20% with probability 0.6• D may go down by 20% with probability 0.4

4. Identify the periodic discount rate k• k = 0.1

Example

5. Represent the tree, identifying all states as well as all transition probabilities

D=144

D=96

D=64

D=120

D=80

D=100

0.6

0.4

Period 0

Period 2

0.6

0.4

0.6

0.4

Period 1 P = 12240

P = 8160

P = 5440P = 80*85+(0.6*8160+0.4*5440)/1.1 = 13229

P = 120*85+(0.6*12240+0.4*8160)/1.1 = 19844

P = 100*85+(0.6*19844+0.4*13229)/1.1 = 24135

Example: Decision Tree Analysis

• Three options for Trips Logistics1. Get all warehousing space from the spot market as

needed

2. Sign a three-year lease for a fixed amount of warehouse space and get additional requirements from the spot market

3. Sign a flexible lease with a minimum change that allows variable usage of warehouse space up to a limit with additional requirement from the spot market