OR and Supply Chain Management

Hillier, Liberman; Operations Research

Levi D, E Simchi, Keminsky P; Designing and Managing Supply Chain; TMH
Chopra, Meindil and Kalra; SCM-Strategy, planning and Operation; Pearson
Vollman, Berry et al: Mfg Planning and Control for SCM; TMH
Salvendi G; Hand Book of Industrial Engg; Wiley

August 2010 2
Introduction to SCM (Supply Chain Management)
SCM is comparatively new discipline developed in 1980s. It focus on coordination of
organizations, linked for fulfilling customer demands through distributors, manufacturers and
vendors. It has evolved from logistics and materials management functions.
In 1998, CLM (Council of Logistics Mgt) defined: Logistics is that part of the supply chain
process that plans, implements and controls the efficient, effective flow and storage of goods,
services and related information from the point-of-origin to the point-of-consumption in order to meet
customers requirements.
Historically, the term logistcs was used by Henri Jomini during 19
th
century to
cover the art of moving and marinating armies; consultants Oliver and
Webber used SCM in 1982, in the journal Logistics: the strategic issues
Thus, by definition logistics is a subset of SCM, but now it is used synonymously
with SCM. Other similar terms are Demand Chain Mgt and Value Chain,
though in some other context, like orchestration they are differentiated.
The Goal/objective is to manage entire chain in effective (Responsive) and efficient way to
generate surplus for all members including customers. Many times, cost increases with more
responsiveness. Decision must be taken how much responsive chain is required and then it is to be
optimized.
Importance of SCM increase with competition so as to increase efficiency
Globalization/ Demanding customer and Information Technology are great
catalyst/ enabler/ Impellers of SCM.
August 2010 3
Block diagram of SCM

Tier 3 to
Initial
suppliers
Tier 2
Suppliers
Tier 1
Suppliers
FOCAL ORGANIZATION
Tier 1
customer
Tier 2
customer
Tier 3
Consumer/
end-customer
1
1
1
1
1
2
2
2
2
n
n
n
n
n
I
n
i
t
i
a
l

s
u
p
p
l
i
e
r

T
i
e
r

3

t
o

n

s
u
p
p

T
i
e
r

3

t
o

n

c
u
s
t

C
o
n
s
u
m
e
r
/
e
n
d
-
c
u
s
t
o
m
e
r

1
FO
2
n
Managed links
Monitored links
Non managed links
INBOUND LOGISTICS MANUFACTURING OUTBOUND LOGISTICS
n-1
unit I Outline
Definition, Objective, Enablers/ Impellers of SCM
Historical evolution
Costs and opportunities in SC
Global optimization, Cross/ Inter-Organizational view
Challenges and Difficulties in SCM
Performance Drivers/ Metrics in SCM
Decision Phases in a Supply Chain
Cyclic, Push/ Pull Process View of a Supply Chain
Strategic-Fit Concepts
Concepts of Variance Reduction by risk pooling and
Bullwhip effect

August 2010 4
August 2010 5
Historical background/ Evolution of SCM
1. Evolution followed from
Sourcing and supply logistics to Integrated Materials mgt
(encompassed mfg) + Distribution logistics to SCM
2. It is forced by global competition, 60 years of practical experience and
knowledge of business-world in 3 main disciplines of
Industrial Engg
Operations mgt and
Physical distribution
And it is made possible by revolution in Info Tech.
3. In 1910, though Ford had achieved vertically integrated materials mgt to
make model T car from iron ore in 81 Hrs, but it was missing variety
production (probably they did not include waiting time also)
- In 1980s mfg system revolution started by attention and investments in JIT
lean mfg, TQM and six sigma processes resulting in practically most
efficient mfg systems.
- In 1995 Dell-computers used mfg and distribution innovations (cross
docking) to manage a responsive Supply chain.
-Thus organizations are now discovering that next step is effective and
efficient SCM to maintain and increase market share.
4. Table 1.1 shows decreasing logistics costs and increasing inventory turns
August 2010 6
Year
Nominal
GDP
Value of
All
Business
Inventory
Percent of
Inventory
Carrying
Rate
Inventory
Carrying
Costs
Transport
ation
Costs
Administr
ative
Costs
Total U.S.
Logistics
Cost
Logistics
cost (% of
GDP)
Inventory
Turn =
(GDP/Inven
tory)
1980 2800 692 31.8 220 214 17 451 16.1 4.0
1981 3130 747 34.7 259 228 19 506 16.2 4.2
1982 3260 760 30.8 234 222 18 474 14.5 4.3
1983 3540 758 27.9 211 243 18 472 13.3 4.7
1984 3930 826 29.1 240 268 20 528 13.4 4.8
1985 4220 847 26.8 227 274 20 521 12.3 5.0
1986 4450 843 25.7 217 281 20 518 11.6 5.3
1987 4740 875 25.7 225 294 21 540 11.4 5.4
1988 5100 944 26.6 251 313 23 587 11.5 5.4
1989 5480 1005 28.1 282 329 24 635 11.6 5.5
1990 5800 1041 27.2 283 351 25 659 11.4 5.6
1991 5990 1030 24.9 256 355 24 635 10.6 5.8
1992 6340 1043 22.7 237 375 24 636 10.0 6.1
1993 6640 1076 22.2 239 396 25 660 9.9 6.2
1994 7050 1127 23.5 265 420 27 712 10.1 6.3
1995 7400 1211 24.9 302 441 30 773 10.4 6.1
1996 7810 1240 24.4 303 467 31 801 10.3 6.3
1997 8320 1280 24.5 314 503 33 850 10.2 6.5
1998 8700 1317 24.4 321 529 34 884 10.1 6.6
1999 9270 1381 24.1 333 554 35 922 9.9 6.7
2000 9820 1478 25.3 374 594 39 1006 10.2 6.6
2001 10130 1403 22.8 320 609 37 966 9.5 7.2
2002 10490 1451 20.7 300 582 35 918 8.8 7.2
2003 11000 1494 20.1 300 607 36 944 8.6 7.4
2004 11740 1627 20.4 332 644 39 1015 8.6 7.2
Source : Adapted Rosalyn Wilson, 16th Annual " State of Logistics Report,SCM Prof essionals, Oak Brook, II, 2005.
Table :- U.S. Logistics Cost, 1980-2004: ($ Billion)
Logistics in the Manufacturing Firm


August 2010 7
1-7
Profit 4%
Logistics Cost 21%
Marketing Cost 27%
Manufacturing Cost 48%
Profit
Logistics
Cost
Marketing
Cost
Manufacturing
Cost
Reasons/ drivers for renewed interest in SCM
SCM is a Critical Success Factor (CSF). Supply chain design, planning and operation
decisions play a significant role in the success or failure of an organization.
Following are some reasons which compelled organizations to adopt SCM:
Competition: Porter model and competition based on cost, quality, delivery speed and variety are
the main reasons/ drivers of SCM. It is specially important to established/ saturated products
because for new products effectiveness and acceptance is more important than efficiency.
Proliferation in product variety: Organizations have realized that variety is an effective way to
increase demand by satisfying growing range of customer tastes. Simple products like soap have
more than hundred varieties. Each variety is called a SKU (Stock Keeping Unit).
Shorter Product Life Cycles: Due to increased competition and variety PLC are becoming
shorter day by day. It implies obsolescence and thereby importance of low inventories and high
inventory-turns. In environment of monopoly and high inflation, inventories used to be assets
(in balance sheet they were included as assets), but with competition and controlled inflation,
inventories are liabilities.
High level of outsourcing: Acceleration of outsourcing is mainly due to the JIT lean mfg
concepts and the famous article on Core Competency by late Prof CK Prahalad. SCM network
design and channel-member selection closely depend on outsourcing. Supply contracts, few
suppliers and vendor ratings are preferred over tendering process.
Shift in power structure in SCM: With restrictions on monopoly and globalizations of markets,
the channels closer to customers are becoming more powerful. There is high competition for
limited retail shelf-space, and new products can find place only by attractive offers to retailers.
Globalization of mfg: Concept of world-class competitive mfg has complicated materials sourcing
and physical flow. Chips are mfd at Taiwan, tested in Europe, assembled in high price products in
USA and sold in international markets.
August 2010 8
August 2010 9
Importance of SCM, cross-organizational view
An CEO remarked Marketing is too important to be left to Marketing Department (function of an
organzn). Similarly logistics is too important to be left to logistic department.
It stresses that these functions should not be limited to the department silo,
rather they should be integrated over the organization and should be cross-
functional.
To remove confusion over terminology, we can say that logistics is a functional
department of an organization whereas SCM is cross functional, integrated
view of not only intra-organization but among different inter-organizations
linked in SCM. A chain is as strong as the weakest link.
Thus SCM takes a cross-organizational view to optimize entire value chain.
Concept of orchestration imply more than integration and coordination due to
issue of lead in decision making (power and control). Who is orchestrator and
who is orchestratee? Once chain metrics are agreed to, most logical player
should orchestrate to optimize chain in routine way. It reduces time in formal
decision making through endless coordination meetings.
Concepts of functionality and cross functionalities (Integration) are explained in
next slides
August 2010 10
Pure/ Full Functional Info System
It is a set of independent systems not subsystems
STRATEGIC
PLANING
(TOP MGT)


TACTICAL
PLANNING
MIDDLE Mgt


OPERATION
PLANING
BOTOM Mgt
UDS
(DSS)


SDS
(MIS)

TPS

OFFICE
AUTOM
FI
N
A
N
C
E

A
N
D
A
/
C
H
U
M
A
N

R
E
S
M
G
T
P
R
O
C
U
R
M
E
N
T
M
F
G

DI
S
T
R
B
N
Sa
le
s
M
R
K
T

I
N
F
O
R
M
A
TI
O
N

M
G
T
D
a
t
a

B
a
s
e

D
a
t
a

B
a
s
e

D
a
t
a

B
a
s
e

D
a
t
a

B
a
s
e

D
a
t
a

B
a
s
e

August 2010 11
Ideal/ Fully Cross Functional System
It is a set of subsystems

UDS
(DSS)

SDS
(MIS)


TPS

OFFICE
AUTOM
INTEGRATED DATA BASE
F
I
N
A
N
C
E

A
N
D

A
/
C

H
U
M
A
N

R
E
S

M
G
T

P
R
O
C
U
R
M
N
T
,

M
F
G
,

D
I
S
T
R
N

S
A
L
E
S

A
N
D

M
A
R
K
E
T
I
N
G

I
N
F
O

S
Y
S
T
E
M


STRATEGIC
PLANING
(TOP MGT)


TACTICAL
PLANNING
MIDDLE Mgt


OPERATION
PLANING
BOTOM Mgt
August 2010 12
State of Art, Real Life Cross functional IS


UDS
(DSS)

SDS
(MIS)


TPS

OFFICE
AUTOM
INTEGRATED DATA BASE
ERP, Enterprise Resource Planning
FIN HRM PROCUR MFG DIST MKTG INFO
SALE
SCM
CRM
EAI, Enterprise Application Integrator
STRATEGIC
PLANING
(TOP MGT)


TACTICAL
PLANNING
MIDDLE Mgt


OPERATION
PLANING
BOTOM Mgt
August 2010 13
Expanding integration and strategic scope
Traditionally, responsibility of logistics (making product/material available to consumer)
was considered with distributors. SCM has evolved from expanding strategic scope of
logistics and integrating to cross-company/ organizational level.
Integration hierarchy is as follow:
1.Intra-company Intra-functional intra-operational scope: Minimize local cost view.
2.Intra-company intra-functional Inter-operational scope: Minimize functional cost view.
3.Intra-company inter-functional scope: Min. company cost/ Max. profit (Efficient Org.)
4.Inter-company inter-functional scope: maximize SC surplus (Supra System) View
(Efficient SCM)
4
3
2 1
August 2010 14
Evolution of SC and Orchestration
Along with expanding integration, the problem of system development and leadership
must be solved. Normally the organization having greatest stake and influence takes the
lead, but he must receive faith of all members. Evolution of SC over time and along
concept-integration-system development phases is depicted below.
Expanding level
of co-ordination
over time
Between Net-
Work of
Organization
With Customer
(Mass-
Customization)
Between
organizations
Within
organization
Time-Evolution
Development
Phases
Concept Integration System
Demand Net-
Work Mgt
E-based Net-Work
synchronization
Net-Work
Orchestration
Demand Chain
Mgt
E-based coordinated
Scheduling
System Support for
Mass Customization
Supply chain
Mgt
Information System
(EDI)
MRP, ERP, DRP

Lean Mfg
Logistics
Cross functional
BPR
Basic Scheduling
System
CONSISTENCY BEST PRACTICE
Competitive Advantage
August 2010 15
Challenges and difficulties in SCM
Challenges to SCM are mainly due to:
(A) Global optimization
(B) Environment of uncertainties and dynamism over time.
A1 Complex network opt: A big NW of SCM results due to large area/ distances and no. of nodes.
A2 Conflicting Objectives: Autonomous member orgn of SCM-NW often have conflicting interest.
A3 Product and variety changes: Due to competition and short PLC it occur frequently.

B1 Demand uncertainty: Volume of demand changes over time due to:
1. Seasonal Variations
2. Trend and trend changes (rate)
3. Lack of communication/ coordination and Bullwhip effect
4. Competitors price strategy
5. Advertising and sales promotion by gift/ discounts.
B2 Supply uncertainty: It is due to environment of competition and government regulations.
B3 Financial uncertainty: due to high lead time, allocation of resources and changes in demand.
B4 Forecast uncertainty: Even best FC are after all FC-meaning actuality may be different.
B5 Production lead time uncertainty: due to breakdowns in raw material, power, m/c and labour
B6 Transport lead time uncertainty: due to carrier failures, blockages and weather
B7 Product Uncertainty: due to obsolescence and expiry
Decision Phases of a Supply Chain
August 2010 16
Functional decisions
SC functions (Drivers/ Enablers) are different from
organization functions.
1.Facilities 2. Sourcing
3.Inventory 4.Transportation
5.Information 6. Pricing

Planning-hierarchy (cross functional or entire
organization-wide decisions)

Supply chain Strategy or design
Supply chain Tactical planning
Supply chain operation
Facilities Network
Facilities Network is answer to where the SC activities are performed. It
includes initial or original suppliers/ vendors, manufacturers,
warehouse, transit stores, retail stores and consumers.
Role: Provide economies of scale and productivity improvements by
centralization, though responsiveness is reduced.
Decisions: 1. Membership, 2. location, 3. capacity,
4. production-flexibility, 5. extent of coordination
Metrics:
1. unit production cost, 2.cycle time (WIP/TH),
3. product variety, 4.contribution of top 20% SKU,
5. set-up/ down-time/ idle-times ratio to process time,
6. defects, 7. average batch size,
8. due-date service levels.

August 2010 17
Sourcing
Sourcing is the process of obtaining services/ materials
Role: Initially material procurement was main function. SC concept has
enlarged-functions scope and make-or-buy/outsource are important
decisions to it. Next-day-packet-delivery is normally outsourced.
Decisions:
o In-house/ outsource (make/buy),
o single/ portfolio of suppliers,
o criteria for vendor rating and selection,
o negotiation,
o supply contracts and procurement
Metrics: 1. average/ range of purchase price and quantity;
2. supply quality 3. supply lead time,
4. fraction on time delivery, 5. days payable outstanding,
6. supplier reliability.

August 2010 18
Inventory
Inventory exist due to mismatch in demand-supply time,
number & variety. It is a necessary load for economies of
scale and responsiveness at the same time.
Role: Inventory is kept throughout SC as raw material, WIP or finished
goods. It is a major source of cost, affect cycle time & responsiveness.
Inventory as WIP increase cycle time (=WIP/ constant-Throughput-flow)
which reduce responsiveness to new orders, but on the contrary
responsiveness improve by inventory as finished goods (Buffer).
Decisions- 1. Economic Batch Size, 2. safety/ buffer stock,
3. service level, 4. seasonal inventory
Metrics:
1.Cash-to-cash cycle time;
2. Average -inventory,
3.Average-Inventory turns,
4.Average-replenishment batch size,
5.Average-safety inventory,
6.% products with more than n-days inventory,
7.due-date order fill rate,
8.fraction of time out of stock,
9.fraction of obsolete inventory.

August 2010 19
Transportation
Transportation provides an important value addition in SC-
the value of place and value of time, though it does not
change form of basic materials.

Role: It moves material from a location to other. It has important
bearing on cost and responsiveness. Many times it is outsourced.

Decisions:
1.Transportation mode,
2.channel routes/paths,
3.Size- full truck load/ LTL
Metrics:
1.Average Inbound/ outbound-transport cost,
2.Average shipment-size,
3.Average shipment cost,
4.fraction of transport by different modes.

August 2010 20
Information
Information is a key/ meta-driver affecting other drivers.
Quality info on demand-supply improve utilization, response
Role: SC concepts are developed along-with IT revolution, because it is
the great catalyst/ enabler/ driver of other SC functions . Without IT, it
would not have been possible to reap benefit of SCM. Info requirement
for Push control (Forecast-AP-MPS-MRP) are different from Pull control
(Forecast but use actual demand quickly to entire chain-conwip) of flow.
Info sharing is crucial to SC coordination and strategic partnership.
Units of distributer/ manufacturer/ vendor must share actual demand
info in timely manner to optimize SC surplus using uphill skier concept
Decisions- Pull feedback/ Push feed-forward flow process control,
Decoupling point, Info-sharing units and methods
Technology-Bar-code, EDI, Internet, ERP, SCM, RFID (Radio Freq. ID)
Metrics: Forecast horizon, frequency of update, seasonal factors,
variance from plan forecast error, ratio of demand variability to order
variability.

August 2010 21
Pricing
Pricing is a process to decide price of goods/services. It
affect demand (elasticity), customer segment/ expectations
and responsiveness of SC. Discounts can shift volume, time

Role: Pricing depend on competitive-strategy/ market-segment decision

Decisions:
Economies of scale- high/ low fixed costs, EPBQ, quantity discount;
Steady-low; High-low (discount-seasons),
Menu pricing (venue/ time dependent, seasonal declaration).
Metrics:
Profit margin, days sales-outstanding,
fixed/ variable costs, average/ range of sales price,
average order size, range of sales in specific times.
Tradeoffs between cost, quality, responsiveness, customer value,
inventory, obsolesce must be understood. Activity Based Costing useful

August 2010 22
August 2010 23
Summery of SC Drivers and Metrics
Facilities (mfr, warehouse) Network (where): Decisions- Member, location, capacity;
Metrics: unit production cost, cycle time (WIP/TH), product variety, volume contribution of
top 20% SKU, set-up/ process/ down and idle times ratio, defects, average batch size, due-
date service levels.
Inventory (what): Decisions- Economic Batch Size, safety/ buffer stock, service level.
Metrics: cash-to-cash cycle time; Average -inventory, A-Inventory turns, A-replenishment
batch size, A-safety inventory, % products with more than n-days inventory, due-date order
fill rate, fraction of time out of stock, fraction of obsolete inventory.
Transportation (how): Decisions-Transportation mode, channel routes, path, size/ LTL
Metrics: Average Inbound/ outbound-transport cost, A shipment-size, A shipment cost,
fraction of transport by different modes.
Information: Decisions- Pull feedback/ Push feed-forward process control, info-sharing,
Technology-bar-code, EDI, Internet, ERP, SCM, RFID (Radio Frequency IDentification).
Metrics: Forecast horizon, frequency of update, seasonal factors, variance from plan
forecast error, ratio of demand variability to order variability.
Sourcing: Decisions-, in-house/ outsource (make/buy), vendor rating and selection,
supply contracts. Metrics: average/ range of purchase price and quantity; supply lead time,
supply quality, fraction on time delivery, days payable outstanding, supplier reliability.
Pricing: Decisions- quantity discount; steady-low / high-low, menu pricing (venue-time).
Metrics: Profit margin, days sales-outstanding, fixed/ variable costs, average/ range of
sales price, average order size, range of sales in specific periods.
Key Issues and Planning Decisions in SCM
August 2010 24
Following key issues/ decisions in SCM must be considered by management at
strategic (few years), tactical (months) and operational (weeks) planning level

S1. Distribution Network: identify critical members, NW configuration, site locations and volume
S2. Strategic alliance/partnership: forced by competition, it need info sharing, coordinated plan
S3. Product Design: design for mfg (DFM), Design For Environment, transportation, inventory
S4. Mnfg strategy: engr to order (ETO), MTO, Modular mfg (ATO), MTS drastically affect lead-time
S5. Outsourcing: core competency, make/buy, risk assessment in outsourcing, vendor assessment
S6. IT: hardware, networking and software are great catalyst/enablers. Info sharing is must for co-ordn

T1. Forecasting demand: to decide master production schedule (MPS), resources, subcontract
T2. Supply contracts: specifying pricing, volume discounts, delivery lead times along with quality
T3. Distribution strategies customer-product-warehouse/mfg link, third party logistics, cross dock
T4. Inventory management: planning and control
T5. Marketing promotion time, discount and size

O1. Customer Order, MPS: allocate resources, due date planning and control, kanban/ conwip
O2. Material receipt/ dispatch: schedule, pick-list and control
O3. Maintenance/ breakdown contingency plans
O4. Quality, TQM, six sigma, lean mfg, low mfg lead times, all waste-reduction
Customer value: Success of SCM finally depend on how consumers value product, price, time
August 2010 25
Key concept in SCM, Value Chain and Info-support
Many info systems can provide strategic advantages over competitor and
some of them have become must for modern mgt: bank, rail/Air ticket.
Adm. coordination and support (Collaborative workflow syst).
HRM (Strategic Info Syst-SIS = Employee career developt)
Technology Development (SIS = CAD-CAM, CIM, CAE)
Procurement of Resources (e-commerce, auctions, exchange)
Inbound
Logistics
(Automa
ted JIT
procure
ment)
Mfg.
(FMS,
Automa
ted
Factory)
Outbound
Logistics
(Online
POS and
Order
processing)
Sales and
Marketing
(Interactive
targeted
marketing)
Customer
Servicing
(CRM)
Support
Process



Primary
Process
C
O
M
P
E
T
I
T
I
V
E

A
D
V

August 2010 26
Process view of Supply Chain







Procurement Cycle Mfg Cycle Replenishment Cycle
Process-based view: a five stages SC is essentially a business process that
links Supplier, Manufacturer, Distributor, Retailers, Customers in the form of
a chain with four interface-cycles to develop and deliver products/services
Grouped into cycles
Customer Order Cycle
Material/ Product flow Info and Fund flow
Process/flow view: how to design/manage individual cycles and
coordinate them to achieve best SC performances
Supplier Manufr. Distributor Retailer Customer
August 2010 27
SCM - A Process/Activity Picture




SCM activities and main business processes
(Source: Ernst and Young Consulting)
Cycle View of Supply Chains
interface-cyclic processes comprise of following process
August 2010 28
Customer Order Cycle
Replenishment Cycle
Manufacturing Cycle
Procurement Cycle
Customer
Retailer
Distributor
Manufacturer
Supplier
August 2010 29
Cyclic-processes in supply/ demand Chain
A closer look: all the activities involved in delivering a product from raw material
through to the customer, including
sourcing materials & parts,
manufacturing & assembly (configuration, customisation),
warehousing & inventory tracking,
order entry mgmt and delivery to the customer
information systems necessary to monitor all of these activities.
Each interface-cyclic processes comprise of following processes

Marketing
of Product
By Supplier
Placing
Order
By Buyer
Receiving
Order
By Supplier
Supply
Order-item
By Supplier
Receiving
Items
By Buyer
Return
Fund + Info
By Buyer
To suppliers
Push/Pull View of Supply Chains
A Pull process is one driven by customer order and
A Push process is one started by supplier/ mfr in anticipation of customer order

August 2010 30
Procurement,
Manufacturing and
Replenishment cycles
Customer Order
Cycle
Customer
Order Arrives
PUSH PROCESSES PULL PROCESSES
August 2010 31
Push-Pull view of Manufacturing Strategies
A Pull process is one driven by customer order and
A Push process is one started by supplier/ mfr in anticipation of customer order
A supply/ demand chain can be a pull process (ETO) or a combination of Push
and Pull processes depending on the customer order decoupling point

Inventory Location
Cust.-order decoupling pt
Mfg strategy/ environment
Supplier Raw Material WIP Finished Goods
^ ^ ^ ^
ETO MTO ATO MTS
ETO = Engineer To Order; MTO = Make To Order
ATO = Assemble To Order (Modular Mfg); MTS = Make To Stock/ Store
Push-Pull Boundary
Customer Order
Push Process
Pull process
August 2010 32
Macro view of SCM processes
Macro view of SCM divides it in three major parts- Inbound logistics, mfg and
outbound logistics. The three groups of processes for these are
CRM- Customer Relationship Management
ISCM/ PPC- Internal SCM/ Production Planning and Control
SRM- Supplier Relationship Management
SRM ISCM/ PPC CRM
Supplier Manufacturer Customer
Sourcing
Negotiate
Buy/ supply contracts
Design collaboration
Supply collaboration

Strategic Planning
Demand Planning
Supply planning
Fulfillment
Field services
Marketing
Pricing
Selling
Call center
Order mgt
Converting Push Process to Pull Process- VMI
ETO is a good pull process but cycle time/ responsiveness is poor.
MTS is a push process with danger of high inventory and obsolesce,
but response time is very less due to Finished Goods Buffer.
Can we convert MTS to Pull process?
Answer is Yes, by use of VMI (Vendor Managed Inventory).
VMI use Uphill-Skier Concept that uphill skier must protect down-skier.
In VMI certain inventory is kept at a point from where consumers can
take it, pay for it and this info is quickly passed to the supplier, who
takes responsibility of replenishment in time. Enabling technology is
EDI (Electronic Data Interchange) at POS (Point Of Sale/ Use). This
concept is similar to Kanban/ Conwip concept of JIT/ lean mfg.
The same information (actual demand data) can be shared quickly by
transporter, manufacturer and vendors to synchronize the flow of
Finished Goods, assemblies, components and raw materials.
August 2010 33
August 2010 34
Strategic-fit Concepts
This concept is vital to SC design. It asks for aligning SCM strategy with the
competitive and responsiveness strategies of the company. If this alignment
is not done, then conflict in goals may occur in the chain.
e.g. if the marketing advertises to provide variety in short times, but distributor
is targeting low cost transport economies, the customer is very likely to be
disappointed.
Strategic-fit is a three step process:
Understanding the customer uncertainty and supply chain uncertainty on
Implied Demand/ Supply Uncertainty (IDSU) scale
Understanding SC effectiveness/ capability and responsiveness (RES)
Achieving strategic fit between implied demand/ supply uncertainty and
responsiveness
SCM Responsiveness/
Effectiveness
Implied demand/supply
uncertainty
August 2010 35
Implied Demand/ Supply Uncertainty (IDSU)
The marketing concepts group customers in different segments depending on
their needs and preferences.
Effect on Implied Demand/ Supply Uncertainty increases with customer needs and supplier
incapability:
Customer needs
High variety requirement
Low lead time requirement
Highly variable lot quantity
High service levels
High Rate of product Innovation
Supplier incapability (most of these are addressed in JIT-lean mfg)
frequent breakdown
limited supply capacity
unpredictable, low yields and rejections
evolving production processes
poor quality
Normally high IDSU causes high forecast error, high stock out, high cost and high price margin

August 2010 36
SC effectiveness/ capability/ responsiveness
SC efficacy/ responsiveness is similar to the Demanding-Customer needs:
respond to wide range of quantity demand variations
Meet short lead times
Handle large variety of products
Meet high service levels
Build highly innovative products
Handle material/ part supply uncertainties
At practical level there are tradeoff between the cost and the responsiveness/
effectiveness of Supply Chain. But the Ideal goal of SCM has to be to
provide most responsive SC at minimum cost. Thus we can say that SCM is
art of simultaneously fulfilling all demanding customer needs in most
efficient manner at lower costs.
Many SCM books do not discuss this concept.
The reason may be the assumption that competition creates demanding
customer and the SCM has to be more responsive as well as efficient.
SC effectiveness/
responsiveness
Cost
More efficient

Less efficient
SCM efforts
August 2010 37
SC effectiveness/ capability/ responsiveness-contd.
Another reason is that concept of strategic fit is actually concept of
market segmentation, based on customer needs and preferences. A
cup of tea is available in Rs 3, 5, 10, 20 and 100. Thus the first priority
of SC is to be effective (responsive) to the target market segment and
second priority is to be efficient as per the definition of logistics.
Concept of strategic fit, thus stresses the priority of effectiveness to
be greater than efficiency.
Concept of IDSU, Implied demand/ supply Uncertainty on the same
scale can also be explained by the fact that demand (-) / supply (+)
are always relative and cancel each other. A high demand does not
have any meaning if supply is higher than the high demand.

August 2010 38
Variance Reduction by Inventory Risk-Pooling
This is based on statistical theory that pooled variance is sum of
individual variances.
Thus if there are four retail stores with average demand of 100 and
demand variance of 25 ( = 5) and the target is 99% service level
then each retail store has to keep an inventory of 115 (average + 3 )
and total 460 inventory is required.
If we pool the inventory at nearby warehouse, then pooled demand
average is 400 and pooled variance is under-root of (25+25+25+25=)
100 i.e. 10. Now for the same service level from the pooled
warehouse, the inventory requirement is 430 (pooled average+ 3
pooled ).
This principle is useful for last mile delivery of bulky white goods
(Washing machines, refrigerators, air conditioners, gym-equipments),
where delivery time is a day or more and transport cost are also
saved and shared with the consumer in big cities.
This example contrast with providing cement silo at concrete-mix units?
Decentralizing supply point- using VMI
In contrast to risk pooling there is an example of
decentralizing the supply of cement to the ready-
concrete-mix supplier units, who get order at about 5 pm,
and need cement urgently. This problem was solved by
provision of cement-silo to different concrete-mix units by
the cement supplier, metering cement used, for payment
Another important aspect of this set up is to do away with
order-fulfillment cycle and associated costs and delays.
The main difference between these examples is the
responsiveness required.
Thus the SC facility network design and processes
depends highly on SC responsiveness strategy

August 2010 39
August 2010 40
Concept of Bull-Whip Effect
Bullwhip effect is amplification in upstream demand due to fear of stock-out.
If demand has growing trend, it doesnt pose major problem, but when demand
dips, bullwhip is disastrous and leads to excessive inventory write-off/ obsolescence.
Example: Let demand of a customer rise 10% for 5 wks and dip 10 % next 5 wks
Mfr keeps next wk inventory of two times current wk demand and supplier of parts
follow similar policy. Orders and deliveries are made in the same period needed.
I ------ S ------- M ------- C
Unit 2 OUTLINE
Design of Supply Chain Facility Network
Role of Distribution in the Supply Chain
Factors Influencing Distribution Network Design
Data aggregation and transport costs
Design Options for a Distribution Networks
E-Business and the Distribution Network
NW decisions, costs influenced by NW design
Facility Network design phases and models
August 2010 41
The Role of Distribution in the Supply Chain
Distribution: the steps taken to move and store a product
from the supplier stage to the customer stage in a supply
chain
Distribution directly affects cost and the customer experience
and therefore drives profitability
Choice of distribution network can achieve supply chain
objectives from low cost to high responsiveness
The ownership structure of the distribution network can have
as big an impact as the type of distribution network
The choice of a distribution network has very long-term
consequences
Product, price, commoditization, and criticality have an impact
on the type of distribution system preferred by customers

August 2010 42
Elements/ costs Influenced by Network Design
Distribution network performance is evaluated along two dimensions
Customer needs that are met
Cost of meeting customer needs
Elements of customer service influenced by network structure:
Response time
Product variety
Product availability
Customer experience
Order visibility
Return-ability
Supply chain costs affected by network structure:
Inventories
Transportation
Facilities and handling
Information
August 2010 43
August 2010 44
Factors influencing Facility (SC) Network design
Strategic and Offshore facilities
1. Offshore low-cost facility for export which can migrate to 2. Source facility for global supply
3. Server facility for regional low cost -can migrate 4.Contributor facility for product/process dev.
5. Outpost facility to gain local skills and 6. Lead facility for advanced technologies.
Production Technology Fixed Cost (low/ high), Production Flexibility, Volume Dismantling
Macroeconomic 1.Tariffs and taxes 2. Exchange rates 3. Demand risk
Political Culture, Independent and clear Legal Systems
Infrastructural Transport, Utilities (water/ electricity, sewage), labor, education
Competitive
1. Positive Externalities (co-location benefits)- Malls (variety-convenience) v/s specialty choice mkt
2. Locating to split market-(a). standard price and compete for more customer-> tend to be close
0|__a____|__1-b-a__|____b___| 1, N
a
=(1+a-b)/2, N
b
=(1+b-a)/2, IDEAL (travel) a=b= 1/4
(b). Price compete-> tend to be away
Socioeconomic Backward area development incentives,
Logistic & facility costs- depends on SC NW- number of facilities, locations and capacities
Response time -low response time require more and close facilities- incur high costs.
Data collection and aggregation
Distribution has to cover large geographical area, large no of dealers/
customers, and large product variety, which require millions of data.
Data aggregation methods are required to reduce amount of
planning data.
Customers located in close proximity are aggregated using grid
network or clustering techniques. Postal zip codes can be used for
aggregation of area data.

Items are aggregated into reasonable no of product groups based on
a) Distribution pattern of same source-destination or logistic
characteristic of weight/ volume
b) Product type when variation is minimal in model type packaging,
style

Aggregation into 150-200 groups give 1-2% error, but it result in better
forecasts and planning.

August 2010 45
Transport and ware-house costs
Transport costs plays important role in SC.
Following characteristics of transport costs/rates should be considered for modeling:
o Transport can be handled internally (Annual cost/ annual volume delivered) or outsourced
o Transport rates are almost linear with distance but not with volume
o Transportation of truckload is economical than less-than-truckload (LTL)
o TL costs/ rates may not be symmetric due to terrain or traffic demand (e.g. up/ down mountain)
o LTL rates are based on basic types of 1. Class 2.Exception 3. Commodity
o Rail and road transport divide items into 20 to 30 Classes based on density, ease of handling,
liability for damage. Approximate distance (rate basis number) also affect tabled rates.
o Exception and Commodity rates are specialized rates for specialized products or commodity.
o LTL rates vary widely.
o Overnight delivery is mostly outsourced and important in responsive SC
o Mileage estimates can also be calculated by longitude and latitude of two place.
Ware house and distribution costs include three components
1. Handling costs (labor and utility costs proportional to volume handled)
2. Fixed costs ( incremental in steps depending on size/capacity of warehouse)
3. Storage costs (Inventory holding costs, proportional to average inventory levels)

August 2010 46
Design Options for a Distribution Network
1. Manufacturer Storage with Direct Shipping
2. Manufacturer Storage with Direct Shipping and
In-Transit Merge
3. Distributor Storage with Carrier Delivery
4. Distributor Storage with Last Mile Delivery
5. Manufacturer or Distributor Storage with
Customer Pickup
6. Retail Storage with Customer Pickup

August 2010 47
Manufacturer Storage with Direct Shipping
Retailer pass customer demands to mfr. who supply directly
August 2010 48
Manufacturer
Retailer
Customers
Product Flow
Information and Fund Flow
In-Transit Merge Network
Variety demand of customers are segregated at in-transit pt
August 2010 49
Factories
Retailer
Product Flow
Information, Fund Flow
In-Transit Merge by Carrier
Customers
Distributor Storage with Carrier Delivery
Distributor/ retailers receive and store, then deliver to cust.
August 2010 50
Factories
Customers
Product Flow
Information, Fund Flow
Warehouse Storage
by
Distributor/Retailer
Distributor Storage with Last Mile Delivery
Goods stored at distributor/ retailer, delivered to close cust.
August 2010 51
Factories
Customers
Product Flow
Information Flow
Distributor/Retailer
Warehouse
Mfr./ Distributor Storage with Customer Pickup
Goods transferred to cross-dock dist. centers to pickup pt.
August 2010 52
Factories
Retailer
Pickup Sites
Product Flow Information Flow
Cross Dock DC
Customer Flow
Customers
Comparison of Delivery Network Designs
PERFORMANCE RANKING 1-6
August 2010
53
Information
Facility & Handling
Transportation
Inventory
Returnability
Order Visibility
Customer
Experience
Product Availability
Product Variety
Response Time
Manufacturer
storage with
pickup
Distributor
storage with
last mile
delivery
Distributor
Storage with
Package Carrier
Delivery
Manufacturer
Storage with In-
Transit Merge
Manufacturer
Storage with Direct
Shipping
Retail Storage
with Customer
Pickup


1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
2
2
2
2
2
2
2
2
2
2
3
3
3
3
3
3
3
3
3
3
4
4
4
4
4
4
4
4
4
4
4
4
4
1-5
5
5
5
5 5
5
6
6
5
Delivery Networks for Desired SC Characteristics
August 2010 54

E-Business and the Distribution Network
Effect on customer service compared to brick and mortar stores:
Response time: Low for digital-soft-downloading-products (Program, music, finance-equity/MF)
High for physical products due to less distribution centers.
Product variety: Large. e.g. amazon.com
Product availability: Better even for physical products due to fast demand info to SC
Customer experience: Better access (distance), convenience (24*7), customization.
Absence of feeling and testing
Time to market: Faster for new products.
Order visibility: Status of order to be provided on web; ready, identified, located, transport.
Return ability: Difficult to return, proportion of returns are also high due to absence of feel.
Direct sales: Possible in e-business, less intermediaries, high revenue collection. e.g. Dell
Flexibility of pricing, portfolio and promotion: fast by a click on data, easy promotion-Airline
Fund transfer: easy and fast by card/password and a click
Effect on Costs:
Facilities costs: Low due to less no of DC, customer participation in selection, autoprocess
Inventory cost: Lower due to SC coordination and match between demand and supply info
Transportation cost: increase inventory aggregation and outbound transport cost.
Information cost: Increase marginally, if existing distribution facilities have IT in place.

August 2010 55
Network Design Decisions


Facility role
Facility location
Capacity allocation
Market and supply allocation

August 2010 56
August 2010 57
SC Facility NW design; Costs & Response
R
E
S
P
O
N
S
E

T
I
M
E
/

T
O
T
A
L

C
O
S
T

C
O
S
T

Number of facilities
Number of facilities
Facility cost
Inventory cost
Transportation cost
Costs and response
Total Costs

Response time/
Servicing Problems
Labor cost
Conventional Network
Conventional NW
August 2010 58
Materials
DC
Com
pone
nt
Man
ufact
uring
Vendor
DC
Finished
Goods DC
Components
DC
Vendor
DC Plant
Warehouse
Finished
Goods DC
Customer
DC
Customer
DC
Customer
DC
Customer
Store
Vendor
DC
Custome
r
Store
Customer
Store
Tailored Network: Multi-Echelon FG Network
Multi echelon NW
August 2010 59
Regional
Finished
Goods DC
Regional
Finished
Goods DC
Customer 1
DC
Store 1
National
Finished
Goods DC
Local DC
Cross-Dock
Local DC
Cross-Dock
Local DC
Cross-Dock
Customer 2
DC
Store 1 Store 2
Store 2 Store 3 Store 3
Framework for Network Design Decisions
Phase I Supply Chain Strategy
Phase II - Regional Facility Configuration based on production costs
Phase III Desirable Sites based on demand centers and volumes
Phase IV Site selection and demand/supply allocations
Phase I: SC Strategy relates to targeted response time/ customer
segment, make/ buy, network design, transportation, inventory,
information, product mix and pricing decisions.
Phase II: Major portion of a product cost owes to production/ purchase
costs. Using input data of fixed costs of capacitated production
centers and variable costs of production + regional transport, IPP
models are used to find out Regional Facility Configuration.
Phase III: Ensuring response time requirements and using input data of
demand center volumes and coordinates, desired warehouse
coordinates are calculated using gravity models.
Phase IV: Regional Facility supply capacity and warehouse demand
allocations are decided using data of transport costs between
supply-demand and the transport optimization models.
August 2010 60
August 2010 61
A Framework for Network Design Decisions
Facility NW decision
PHASE I
Supply Chain
Strategy
PHASE II
Regional Facility
Configuration
PHASE III
Desirable Sites
PHASE IV
Location Choices
Competitive STRATEGY
INTERNAL CONSTRAINTS
Capital, growth strategy,
existing network
PRODUCTION TECHNOLOGIES
Cost, Scale/Scope impact, support
required, flexibility
COMPETITIVE
ENVIRONMENT
PRODUCTION METHODS
Skill needs, response time
FACTOR COSTS
Labor, materials, site specific
GLOBAL COMPETITION
TARIFFS AND TAX
INCENTIVES
REGIONAL DEMAND
Size, growth, homogeneity,
local specifications
POLITICAL, EXCHANGE
RATE AND DEMAND RISK
AVAILABLE
INFRASTRUCTURE
LOGISTICS COSTS
Transport, inventory, coordination
Phase II Capacitated Facility Location Model
Integer programming

August 2010 62
y
i
= 1 if plant is located
at site i, 0 otherwise
x
ij
= Quantity shipped
from plant site i to
customer j
f
i
=fixed facility cost
c
ij
=production and
transport cost
D
j
= total demand
K
i
= total supply
} 1 , 0 { ;
,..., 1 ,
,..., 1 ,
. .
1
1
1
1 1 1
e s
= s
= =
+

=
=
=
= = =
y y
y
K x
D x
x c
y f
i
m
i
i
i
i
n
j
ij
j
n
i
ij
n
i
m
j
ij ij
i
n
i
i
k
n i
m j
t s
Min
Formulating Facility NW Regional Location Problem
August 2010 63
Capacitated allocation IPP model- phase II

Result of Solver for regional location problem
August 2010 64
Solution by Excell-solver

Phase III- Desired Location
to reduce response time and transportation
Gravity model

August 2010 65
Ton-km Center Solution
x,y: Warehouse Coordinates
x
n
, y
n
: Coordinates of delivery
location n
d
n
: Distance to delivery
location n
D
n
: Annual tonnage to
delivery location n
F
n
= Transportation cost per
ton-km

=
=
=
=
=
=
+ =
k
n n
n
k
n n
n
n
k
n n
n
k
n n
n
n
n
d
F
D
d
F
y
D
d
F
D
d
F
x
D
y y
x
x
d
n
n
y
n
n
x
n
n
1
1
1
1
2
2
) (
) (
Min
F
D d
n n
n
Excell solution for Desired location- Gravity Model
August 2010 66


Phase IV- Site Selection & Capacity Allocation
Based on results of phase III for desired location sites,
decisions are taken to select nearby sites for
warehouses, assembly/ cross-docking or manufacturing.
Transportation model is again used with new data for
selected desired sites to allocate demand and supply to
these sites. Phase III and IV decisions must consider the
response time requirements.
Difference between phase II and IV models is that phase II
model uses variable production and regional transport
costs. It also consider fixed/ overhead costs of
production to decide plant locations, but Phase IV model
uses only transportation/ distribution costs for allocating
demands to supply facilities.
August 2010 67
Phase IV- Site Selection & Capacity Allocation
Based on results of phase III for desired location sites,
decisions are taken to select nearby sites for
warehouses, assembly/ cross-docking or manufacturing.
Transportation model is again used with new data for
selected desired sites to allocate demand and supply to
these sites. Phase III and IV decisions must consider the
response time requirements.
Difference between phase II and IV models is that phase II
model uses variable production and regional transport
costs. It also consider fixed/ overhead costs of
production to decide plant locations, but Phase IV model
uses only transportation/ distribution costs for allocating
demands to supply facilities.
August 2010 68
Phase IV Capacity Allocation
August 2010 69
Flexibility in SC Network
Flexibility in SC network plays an important role to mitigate different
risks and uncertainties. Three broad categories are:
New-product flexibility
Product-mix flexibility
Volume flexibility
Jordan and Graves make an important observation that the marginal
benefits derived from flexibility decreases with increase in flexibility.
Thus some flexibility is very valuable, too much is not worth to its costs.
Lim also observes that smaller chains contain impact of supply
disruptions more effectively than one long chain.

August 2010 70
Factory, Products
Dedicated NW Full flexible NW
Chained NW,
one long chain
Short Chained
(Contained NW )
Facility Location - Generalized model- Notations
D
j
=Annual demand from customer j, m= number of demand points indexed by j
W
e
= ware house capacity at site e, t= number of warehouses indexed by e
K
i
= factory capacity at site i, n= number of factories indexed by i
S
h
= supply capacity at supplier site h, l= number of suppliers indexed by h
F
i
= fixed cost of locating plant at site i, f
e
= fixed cost of locating ware house at site e
c
hi
= cost of shipping a unit from h to i x
hi
= quantity shipped from h to i
c
ie
= cost to produce & ship a unit i to e x
ie
= quantity shipped from i to e
c
ej
= cost of shipping a unit from e to j x
ej
= quantity shipped from e to j
y
i
= 1 if factory is located at site i else 0 y
e
= 1 if warehouse is located at site e else 0

Suppliers=l Plants=n warehouses=t Markets=m
h=1 to l i=1 to n e= 1 to t j= 1 to m






August 2010 71
Part II, logistics and SCM
August 2010 72 Prof. S. N. Varma
Outsourcing and strategic alliance
Outline
Difference between bid
purchase(ReqForQt, CBE) and JIT
purchase
Role and benefits of outsourcing and
purchases
Risk of outsourcing
Impact of internet on outsourcing
Procurement strategy
For bid purchasing, component/ products
should be standardized to the extend
possible, drawings must be freezed,
detailed bid documents must be prepared,
and many suppliers should take part which
require extended advertising. JIT
purchasing, on the contrary rely on long
relationship with few suppliers, few
documents for the process of coordination
and pricing, supplier evaluation process
and standing orders for flexible volumes to
adjust to forecasts and demands.

August 2010 73 Prof. S. N. Varma
Role of outsourcing and purchase

Outsourcing is becoming an important
strategy for conventional as well as JIT
manufacturers for reducing cost of product
from 90s. It is specially useful for rapidly
changing technology and obsolescence in
products. Some of the motivations for
outsourcing are:
1. Economies of scale- suppliers aggregate
demands for this economy
2. Risk pooling- demand uncertainty
transferred to supplier who pool risk
3. Reduce capital Investment of buyer,
supplier share it with many buyers
4. Focus on core competency
5. Increased flexibility - ability to better
react to customer demands
- ability to reduce product
development time
-ability to gain access to new
technologies
August 2010 74 Prof. S. N. Varma

Risk of outsourcing

IBM had outsourced chip to Intel and Disk
Operating System (DOS) to Microsoft and
lost major opportunities
Two substantial risks are:
1. Loss of competitive knowledge and
insights to cross functional team
2. Conflictive objectives. Transferring
demand uncertainty is difficult in case of
decreasing demands. Design changes
have also to be coordinated.
Fine and Whitney classify reasons for
outsourcing into two category:
1. Dependency on capacity- the buying firm
has knowledge and skill to produce
component but still it outsource for cost
reduction
2. Dependency on knowledge- buying firm do
not have core competency


August 2010 75 Prof. S. N. Varma

Two types of products:

Two types of products:
1. Modular Product - components are
independent of each other
- components are
interchangeable
- standard interfaces are
used
- a component can be
changed independently
- customer preference determine
product configuration
2. Integral Product - cant be made from off
the shelf components
- components perform
multiple functions
- designed as single system,
top-down design
- evaluated as single system
performance
In real life very few products are truly
modular or integral. However most
products can be put between the
continuum of truly modular product like a
Computer and integral product like an
airplane
August 2010 76 Prof. S. N. Varma
Framework for make/Buy decisions
Type of Product Dependency on
knowledge and
capacity
Independent for
knowledge,
dependency for
capacity
Independent for
knowledge and
capacity
Modular Outsourcing is
Risky
Outsourcing is an
opportunity
Opportunity to
reduce cost
through
outsourcing
Integral Outsourcing is
very Risky
Outsourcing is
option
Keep production
Internal
August 2010 77 Prof. S. N. Varma
Cost and risk tradeoff in purchasing
A portfolio approach based on cost-risk
trade off can use three types of
approaches for purchasing
1. Base commitment level- for a minimum
volume at an agreed low cost
2. Flexible Option level-buyer pays small
cost upfront in return for a commitment to
get supply up to a level paying additional
for more. In this case total cost is higher
than the base commitment level cost.
3. Spot purchasing- normally for additional
supplies and competition.
August 2010 78 Prof. S. N. Varma
Quantity
Option Levels
High Inventory
Risk to
supplier
Do not Apply
Low Price and
Shortage Risk
to Buyer
Inventory Risk
to buyer
Low High
Quantity Base Commitment level

August 2010 Prof. S. N. Varma 79
12
Inventory
Management
12-81
Learning Objectives
Define the term inventory and list the major
reasons for holding inventories; and list the
main requirements for effective inventory
management.
Discuss the nature and importance of service
inventories
Discuss periodic and perpetual review
systems.
Discuss the objectives of inventory
management.
Describe the A-B-C approach and explain how
it is useful.
12-82
Learning Objectives
Describe the basic EOQ model and its
assumptions and solve typical problems.
Describe the economic production
quantity model and solve typical
problems.
Describe the quantity discount model
and solve typical problems.
Describe reorder point models and solve
typical problems.
Describe situations in which the single-
period model would be appropriate, and
solve typical problems.
12-83
Independent Demand
A
B(4) C(2)
D(2) E(1) D(3)
F(2)
Dependent Demand
Independent demand is uncertain.
Dependent demand is certain.
Inventory: a stock or store of goods
Inventory
12-84
Inventory Models
Independent demand finished goods,
items that are ready to be sold
E.g. a computer
Dependent demand components of
finished products
E.g. parts that make up the computer
12-85
Types of Inventories
Raw materials & purchased parts
Partially completed goods called
work in progress
Finished-goods inventories
(manufacturing firms)
or merchandise
(retail stores)
12-86
Types of Inventories (Contd)
Replacement parts, tools, & supplies
Goods-in-transit to warehouses or
customers
12-87
Functions of Inventory
To meet anticipated demand
To smooth production requirements
To decouple operations
To protect against stock-outs
12-88
Functions of Inventory (Contd)
To take advantage of order cycles
To help hedge against price increases
To permit operations
To take advantage of quantity
discounts
12-89
Objective of Inventory Control
To achieve satisfactory levels of
customer service while keeping
inventory costs within reasonable
bounds
Level of customer service
Costs of ordering and carrying inventory
Inventory turnover is the ratio of
average cost of goods sold to
average inventory investment.
12-90
A system to keep track of inventory
A reliable forecast of demand
Knowledge of lead times
Reasonable estimates of
Holding costs
Ordering costs
Shortage costs
A classification system
Effective Inventory Management
12-91
Inventory Counting Systems
Periodic System
Physical count of items made at periodic
intervals
Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item
12-92
Inventory Counting Systems
(Contd)
Two-Bin System - Two containers of
inventory; reorder when the first is
empty
Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
0
214800 232087768
12-93
Lead time: time interval between
ordering and receiving the order
Holding (carrying) costs: cost to carry
an item in inventory for a length of time,
usually a year
Ordering costs: costs of ordering and
receiving inventory
Shortage costs: costs when demand
exceeds supply
Key Inventory Terms
12-94
ABC Classification System
Classifying inventory according to some
measure of importance and allocating
control efforts accordingly.
A - very important
B - mod. important
C - least important
Figure 12.1
Annual
$ value
of items
A
B
C
High
Low
Low
High
Percentage of Items
12-95
Cycle Counting
A physical count of items in inventory
Cycle counting management
How much accuracy is needed?
When should cycle counting be performed?
Who should do it?
12-96
Economic order quantity (EOQ) model
The order size that minimizes total annual
cost
Economic production model
Quantity discount model
Economic Order Quantity Models
12-97
Only one product is involved
Annual demand requirements known
Demand is even throughout the year
Lead time does not vary
Each order is received in a single
delivery
There are no quantity discounts

Assumptions of EOQ Model
12-98
The Inventory Cycle
Figure 12.2
Profile of Inventory Level Over Time
Quantity
on hand
Q
Receive
order
Place
order
Receive
order
Place
order
Receive
order
Lead time
Reorder
point
Usage
rate
Time
12-99
Total Cost
Annual
carrying
cost
Annual
ordering
cost
Total cost = +
TC =
Q
2
H
D
Q
S
+
12-100
Cost Minimization Goal
Order Quantity
(Q)
The Total-Cost Curve is U-Shaped
Ordering Costs
Q
O
A
n
n
u
a
l

C
o
s
t

(optimal order quantity)
TC
Q
H
D
Q
S = +
2
Figure 12.4C
12-101
Deriving the EOQ
Using calculus, we take the derivative of
the total cost function and set the
derivative (slope) equal to zero and solve
for Q.
Q =
2DS
H
=
2( Annual Demand )(Order or Setup Cost )
Annual Holding Cost
OPT
12-102
Minimum Total Cost
The total cost curve reaches its
minimum where the carrying and
ordering costs are equal.


Q
2
H
D
Q
S
=
12-103
Production done in batches or lots
Capacity to produce a part exceeds the
parts usage or demand rate
Assumptions of EPQ are similar to EOQ
except orders are received
incrementally during production
Economic Production Quantity (EPQ)
12-104
Only one item is involved
Annual demand is known
Usage rate is constant
Usage occurs continually
Production rate is constant
Lead time does not vary
No quantity discounts
Economic Production Quantity
Assumptions
12-105
Economic Run Size
Q
DS
H
p
p u
0
2
=

12-106
Total Costs with Purchasing Cost
Annual
carrying
cost
Purchasing
cost
TC = +
Q
2
H
D
Q
S
TC =
+
+
Annual
ordering
cost
PD +
12-107
Total Costs with PD
C
o
s
t

EOQ
TC with PD
TC without PD
PD
0
Quantity
Adding Purchasing cost
doesnt change EOQ
Figure 12.7
12-108
Total Cost with Constant Carrying
Costs
OC
EOQ
Quantity
T
o
t
a
l

C
o
s
t

TC
a
TC
c
TC
b
Decreasing
Price
CC
a,b,c
Figure 12.9
12-109
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.
12-110
Determinants of the Reorder
Point
The rate of demand
The lead time
Demand and/or lead time variability
Stockout risk (safety stock)
12-111
Safety Stock
LT
Time
Expected demand
during lead time
Maximum probable demand
during lead time
ROP
Q
u
a
n
t
i
t
y

Safety stock
Figure 12.12
Safety stock reduces risk of
stockout during lead time
12-112
Reorder Point
ROP
Risk of
a stockout
Service level
Probability of
no stockout
Expected
demand
Safety
stock
0 z
Quantity
z-scale
Figure 12.13
The ROP based on a normal
Distribution of lead time demand
12-113
Orders are placed at fixed time intervals
Order quantity for next interval?
Suppliers might encourage fixed
intervals
May require only periodic checks of
inventory levels
Risk of stockout
Fill rate the percentage of demand
filled by the stock on hand

Fixed-Order-Interval Model
12-114
Tight control of inventory items
Items from same supplier may yield
savings in:
Ordering
Packing
Shipping costs
May be practical when inventories
cannot be closely monitored

Fixed-Interval Benefits
12-115
Requires a larger safety stock
Increases carrying cost
Costs of periodic reviews
Fixed-Interval Disadvantages
12-116
Single period model: model for ordering
of perishables and other items with
limited useful lives
Shortage cost: generally the unrealized
profits per unit
Excess cost: difference between
purchase cost and salvage value of
items left over at the end of a period
Single Period Model
12-117
Continuous stocking levels
Identifies optimal stocking levels
Optimal stocking level balances unit
shortage and excess cost
Discrete stocking levels
Service levels are discrete rather than
continuous
Desired service level is equaled or
exceeded
Single Period Model
12-118
Optimal Stocking Level
Service Level
So
Quantity
Ce Cs
Balance point
Service level =
Cs
Cs + Ce
Cs = Shortage cost per unit
Ce = Excess cost per unit
12-119
Example 15
Ce = $0.20 per unit
Cs = $0.60 per unit
Service level = Cs/(Cs+Ce) = .6/(.6+.2)
Service level = .75
Service Level = 75%
Quantity
Ce Cs
Stockout risk = 1.00 0.75 = 0.25
12-120
Too much inventory
Tends to hide problems
Easier to live with problems than to
eliminate them
Costly to maintain
Wise strategy
Reduce lot sizes
Reduce safety stock
Operations Strategy
Considerations in Inventory Systems
Type of customer demand

Planning time horizon

Replenishment lead time

Constraints and relevant costs
Relevant Inventory Costs
Ordering costs

Receiving and inspections costs

Holding or carrying costs

Shortage costs
Inventory Management Questions
What should be the order quantity (Q)?
When should an order be placed, called a
reorder point (ROP)?
How much safety stock (SS) should be
maintained?
Inventory Models
Economic Order Quantity (EOQ)
Special Inventory Models
With Quantity Discounts
Planned Shortages
Demand Uncertainty - Safety Stocks
Inventory Control Systems
Continuous-Review (Q,r)
Periodic-Review (order-up-to)
Single Period Inventory Model
Inventory Levels For EOQ Model
0
U
n
i
t
s

o
n

H
a
n
d

Q
Q
D
Time
Annual Costs For EOQ Model
0
100
200
300
400
500
600
700
800
900
A
n
n
u
a
l

C
o
s
t
,

$
Order Quantity, Q
Holding Cost
Ordering Cost
Total Cost
EOQ Formula
Notation
D = demand in units per year
H = holding cost in dollars/unit/year
S = cost of placing an order in dollars
Q = order quantity in units
Total Annual Cost for Purchase Lots

EOQ

TCp S D Q H Q = + ( / ) ( / ) 2
EOQ
DS
H
=
2
Annual Costs for Quantity Discount Model
0 100 200 300 400 500 600 700
22,000



21000



20000




2000




1000
C = $20.00 C = $19.50 C = $18.75
Order quantity, Q
Inventory Levels For Planned Shortages
Model
Q
Q-K
0
-K
T1 T2
TIME
T
Formulas for Special Models
Quantity Discount Total Cost Model

Model with Planned Shortages




TC CD S D Q I CQ
qd
= + + ( / ) ( / ) 2
TC S
D
Q
H
Q K
Q
B
K
Q
b
= +

+
( )
2 2
2 2
Q
DS
H
H B
B
*
=
+
|
\

|
.
|
2
K Q
H
H B
* *
=
+
|
\

|
.
|
Values for Q* and K* as A
Function of Backorder Cost
B Q* K* Inventory Levels


B
0< < B
B 0
2DS
H
2DS
H
H B
B
+
|
\

|
.
|
undefined
Q
H
H B
*
+

Q*
0
0
0
0
Demand During Lead Time Example
+
+ + =
u=3
o =15 .
u=3 u=3
u=3
o =15 . o =15 .
o
L
= 3
d
L

=12 ROP
s s
Four Days Lead Time
Demand During Lead time
o =15 .
Safety Stock (SS)
Demand During Lead Time (LT) has
Normal Distribution with
-
-
SS with r% service level

Reorder Point

Mean d LT
L
( ) ( ) = u
Std Dev LT
L
. .( ) o o =
SS z LT
r
= o
ROP SS d
L
= +
Continuous Review System (Q,r)
Average lead time usage, d
L
Reorder point, ROP
Safety stock, SS
Inventory on hand
EOQ
EOQ
d
1
d
2
d
3
Amount used during first lead time
First lead
time, LT
1
Order 1 placed
LT
2 LT
3
Order 2 placed Order 3 placed
Shipment 1 received
Shipment 2 received Shipment 3 received
Time
Periodic Review System
(order-up-to)
RP RP RP
Review period
First order quantity, Q1
d
1
Q
2
Q
3
d
2
d
3
Target inventory level, TIL
Amount used during
first lead time
Safety stock, SS
First lead time, LT
1
LT
2
LT
3
Order 1 placed Order 2 placed Order 3 placed
Shipment 1 received Shipment 2 received Shipment 3 received
Time
Inventory on Hand
Inventory Control Systems
Continuous Review System




Periodic Review System


EOQ
DS
H
ROP SS LT
SS z LT
r
=
= +
=
2
u
o
RP EOQ
TIL SS RP LT
SS z RP LT
r
=
= + +
= +
/
( )
u
u
o
ABC Classification of Inventory Items
0
10
20
30
40
50
60
70
80
90
100
110
P
e
r
c
e
n
t
a
g
e

o
f

d
o
l
l
a
r

v
o
l
u
m
e
Percentage of inventory items (SKUs)
A B
C
Inventory Items Listed in Descending
Order of Dollar Volume
Monthly Percent of
Unit cost Sales Dollar Dollar Percent of
Inventory Item ($) (units) Volume ($) Volume SKUs Class

Computers 3000 50 150,000 74 20 A
Entertainment center 2500 30 75,000

Television sets 400 60 24,000
Refrigerators 1000 15 15,000 16 30 B
Monitors 200 50 10,000

Stereos 150 60 9,000
Cameras 200 40 8,000
Software 50 100 5,000 10 50 C
Computer disks 5 1000 5,000
CDs 20 200 4,000

Totals 305,000 100 100
Single Period Inventory Model
Newsvendor Problem Example
D = newspapers demanded
p(D) = probability of demand
Q = newspapers stocked
P = selling price of newspaper, $10
C = cost of newspaper, $4
S = salvage value of newspaper, $2
C
u
= unit contribution: P-C = $6
C
o
= unit loss: C-S = $2
Single Period Inventory Model Expected
Value Analysis
Stock Q
p(D) D 6 7 8 9 10

.028 2 4 2 0 -2 -4
.055 3 12 10 8 6 4
.083 4 20 18 16 14 12
.111 5 28 26 24 22 20
.139 6 36 34 32 30 28
.167 7 36 42 40 38 36
.139 8 36 42 48 46 44
.111 9 36 42 48 54 52
.083 10 36 42 48 54 60
.055 11 36 42 48 54 60
.028 12 36 42 48 54 60

Expected Profit $31.54 $34.43 $35.77 $35.99 $35.33

Single Period Inventory Model Incremental
Analysis
E (revenue on last sale) E (loss on last sale)

P ( revenue) (unit revenue) P (loss) (unit loss)

P D Q C P D Q C
u o
( ) ( ) > > <
>
>
| | 1 < > < P D Q C P D Q C
u o
( ) ( )
P D Q
C
C C
u
u o
( ) < s
+

(Critical Fractile)
where:
C
u
= unit contribution from newspaper sale ( opportunity cost of underestimating demand)
C
o
= unit loss from not selling newspaper (cost of overestimating demand)
D = demand
Q = newspaper stocked
Critical fractile for the newsvendor problem
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
P
r
o
b
a
b
i
l
i
t
y
Newspaper demand, Q
P(D<Q)
(C
o
applies)
P(D>Q)
(C
u
applies)
0.722
Retail Discounting Model
S = current selling price
D = discount price
P = profit margin on cost (% markup as decimal)
Y = average number of years to sell entire stock of dogs at
current price (total years to clear stock divided by 2)
N = inventory turns (number of times stock turns in one year)
Loss per item = Gain from revenue
S D = D(PNY)

) 1 ( PNY
S
D
+
=
Topics for Discussion
Discuss the functions of inventory for different
organizations in the supply chain.
How would one find values for inventory costs?
How can information technology create a competitive
advantage through inventory management?
How valid are the assumptions for the EOQ model?
How is a service level determined for inventory items?
What inventory model would apply to service capacity
such as seats on an aircraft?
Interactive Exercise
The class engages in an estimation of the cost
of a 12-ounce serving of Coke in various
situations (e.g., supermarket, convenience
store, fast-food restaurant, sit-down restaurant,
and ballpark). What explains the differences?
Role of Inventory in Services
Decoupling inventories
Seasonal inventories
Speculative inventories
Cyclical inventories
In-transit inventories
Safety stocks