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
?
?
?
What are the decisions?
What are the constraints?
Example: SC Consulting Facility
Location
?
?
?
?
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
France
Germany
Italy
Spain
United Kingdom
Capacity
Fixed operating cost
Poland
Ireland
23
19
31
9
15
11
23
21
40
29
26
40
33
36
20
40,000
40,000
40,000
$ 18,000,000.00 $ 17,500,000.00 $ 24,500,000.00
Demand
15,000
20,000
13,000
12,000
19,000
Example: SC Consulting Facility
Location
State
L.A.
Washington
$150
Oregon
$150
California
$75
Idaho
$150
Nevada
$100
Montana
$175
Wyoming
$150
Utah
$150
Arizona
$75
Colorado
$150
New Mexico
$125
North Dakota
$300
South Dakota
$300
Nebraska
$250
Kansas
$250
Oklahoma
$250
Fixed Cost
$165,428
Office Capacity
675
Travel Cost
Tulsa
Denver
Seattle Trip demand
$250
$200
$25
40
$250
$200
$75
35
$200
$150
$125
100
$200
$125
$125
25
$200
$125
$150
40
$175
$125
$125
25
$175
$100
$150
50
$150
$100
$200
30
$200
$100
$250
50
$125
$25
$250
65
$125
$75
$300
40
$200
$150
$200
30
$175
$125
$200
20
$100
$125
$250
30
$75
$75
$300
40
$25
$125
$300
55
$131,230 $140,000 $145,000
675
675
675
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
Demand, prices, exchange rates, and the competitive
market change constantly
A decision that looks very good under the current
environment may be quite poor if the situation changes
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
Disruptions
Risk Drivers
Natural disaster, war, terrorism
Labor disputes, supplier bankruptcy
Delays
High capacity utilization at supply source
Inflexibility of supply source
Poor quality or yield at supply source
Systems risk
Information infrastructure breakdown
System integration or extent of systems being networked
Forecast risk
Inaccurate forecasts due to long lead times, seasonality,
product variety, short life cycles, small cusomter base
Bullwhip effect or information distortion
Intellectual property risk Vertical integration of supply chain
Global outsourcing and markets
Procurement risk
Exchange-rate risk
Fraction purchased from a single source
Industry-wide capacity utilization
Receivables risk
Number of customers
Financial strength of customers
Inventory risk
Rate of product obsolescence
Inventory holding cost
Product value
Demand and supply uncertainty
Capacity risk
Cost of capacity
Capacity flexiblity
Does 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
Supplier
Manufacturer
Distributor
Retailer
Customer
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
0
1
2
3
4
5
Option 1
$
Option 2
-1,000,000
300,000
300,000
300,000
300,000
300,000
500,000 $
-1,400,000
400,000
400,000
400,000
400,000
400,000
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
Net Present Value
• Given a stream of cash flows C0, C1, …, CT over
the next T periods and a rate of return k
Year
0
1
2
3
4
5
Option 1
Option 2
-1000000/(1+0.1)^0
-1000000 -1400000/(1+0.1)^0
-1400000
-1,000,000
-1,400,000
300000/(1+0.1)^1
272727
400000/(1+0.1)^1
363636
300,000
400,000
300000/(1+0.1)^2
247934
400000/(1+0.1)^2
330579
300,000
400,000
300000/(1+0.1)^3
225394
400000/(1+0.1)^3
300526
300,000
400,000
300000/(1+0.1)^4
204904
400000/(1+0.1)^4
273205
300,000
400,000
300000/(1+0.1)^5
186276
400000/(1+0.1)^5
248369
300,000
400,000
$
137,236
116,315
500,000 $
600,000
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
T
NPV = C0 + ∑
(
1
1+k
t=1
T
NPV = ∑
t=0
Ct
t
(1 + k)
t
)C
t
Year
0
1
2
3
4
5
Option 1
-1000000/(1+0.1)^0
300000/(1+0.1)^1
300000/(1+0.1)^2
300000/(1+0.1)^3
300000/(1+0.1)^4
300000/(1+0.1)^5
Net Present Value
If…
NPV > 0
NPV < 0
NPV = 0
Then…
Investment adds value
Investment substracts value
Investment would neither add
or substract value
So…
The project may be accepted
The project should be rejected
Decision 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
NPV =
(1 + k)0
=
2,000
(1.1)0
= $ 5,471
C1
+
(1 + k)1
+
2,000
(1.1)1
C2
+
(1 + k)2
+
2,000
1.12
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
NPV =
(1 + k)0
C1
+
(1 + k)1
C2
+
(1 + k)2
22,000
= (1.1)0
22,000
+ (1.1)1
22,000
+ 1.12
= $ 60,182
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
• Multiplicative binomial
p
p
p
Pu
P
p
1-p
1-p
Pu4
Pu3
1-p
1-p
Pu2
1-p
Pd
Pu5
Pu4d
Pu3d
Pu2d
Pud
p
Pu3d2
Pu2d2
Pud2
Pd2
Pu2d3
Pud3
Pd3
Pud4
Pd4
Pd5
Binomial Representation of Uncertainty
• Additive binomial
p
p
p
p
p
P
1-p
1-p
1-p
1-p
P+4u-d
P+3u-d
1-p
P+u
P+4u
P+3u
P+2u
P+5u
P+2u–d
P+3u-2d
P+u-d
P+2u-2d
P-d
P+u-2d
P+2u-3d
P-2d
P+u-3d
P-3d
P+u-4d
P-4d
P-5d
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
P = 120*85+(0.6*12240+0.4*8160)/1.1 = 19844
Period 1
Period 0
0.6
0.6
Period 2
D=144
P = 12240
D=96
P = 8160
D=64
P = 5440
D=120
0.4
D=100
0.4
0.6
P = 100*85+
D=80
(0.6*19844+0.4*13229)/1.1 = 24135
0.4
P = 80*85+(0.6*8160+0.4*5440)/1.1 = 13229
Example: Decision Tree Analysis
•
Three options for Trips Logistics
1. 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