Supply Chain Management

1
Supply Chain Management

• Lecture 8

2
Outline

• Today
• Chapter 6
• Skipping Section 6.5
• AM Tires Evaluation of Supply Chain Design
  Decisions Under Uncertainty (p. 164-175)
• Next week
• Finish Chapter 6 start Chapter 7
• Thursday September 24
• Bring your laptop if you can
• Homework 2
• Due Tuesday September 22 before class

3
CUAccelerate

• CUAccelerate event Tuesday September 22
• Executives from
• Gaming
• Security
• Project Management
• Green IT
• Healthcare
• Aerospace and
• Consulting Industries
• Program
• Dinner - 430 pm on the Engebretson Quad BBQ
  area 
• Breakout Sessions 6 to 8 pm, KOBL Bldg 
• Network with Innovative Technology Executives to
  Learn How They Became Leaders in Their
  Industries 
• Sponsor
• Society for Information Management and Leeds
  School of Business, Operations and Information
  Management Department 
• One lucky student will win an HP Netbook Computer
  courtesy of SIM

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Supply Chain Risks to be Considered During
Network Design
5
Supply Chain Risk
Supply failureCommodity price
volatility Internal product failures Lower
consumer spending Natural disaster
6
Supply Chain Risk
Significant supply chain disruptions can reduce
your companys revenue, cut into your market
share, inflate your costs, send you over budget,
and threaten production and distribution. You
cant sell goods you cant 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
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Managing a Supply Chain is Not Easy

• Uncertainty and risk factors
• Raw material shortages
• Boeing inventory write down of 2.6 billion
• Sales shortfall
• Sales decline at US Surgical Corporation
  resulting in a loss of 22 million
• Stiff competition
• Intel reported a 38 decline in quarterly profit

8
Managing a Supply Chain is Not Easy

• Uncertainty and risk factors
• 2005 Hurricane Katrina
• PG coffee supplies from sites around New Orleans
• Six month impact
• 2002 West Coast port strike
• Losses of 1B/day
• Store stock-outs, factory shutdowns
• 2001 India earthquake
• Supply interruptions for apparel manufacturers
• 1999 Taiwan earthquake
• Supply interruptions for HP and Dell

9
Impact of Uncertainty in Network Design
Manufacturer
Distributor
Retailer
Customer
Supplier
Building flexibility into supply chain operations
allows the supply chain to deal with uncertainty
in a manner that will maximize expected profits
10
Supply Chain Risk
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Risk Mitigation Strategies
12
Global Supply Chain Network and Risk
Toyota has 53 overseas manufacturing companies in
27 countries and regions. Toyota cars are sold in
more than 170 countries and regions
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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
14
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

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Discounted Cash Flow Analysis

• The present value (PV) of future cash is found by
  using a discount rate 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

16
Net Present Value

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

17
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

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Net Present Value
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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

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Example Net Present Value

• Target.com can choose between two options
• 3 year lease contract at 1 per sq.ft.
• Spot market rate expected at 1.20 per sq.ft. per
  year for each of the next 3 years

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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

5,471
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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

60,182
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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
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Decision Trees

• A decision tree is a graphic device used to
  evaluate decisions under uncertainty
• What are the sources of uncertainty in supply
  chain decisions?
• Price, demand, inflation rate, exchange rate, etc
• What supply chain decisions benefit from the use
  of decision trees?
• Sign a long-term warehousing contract or get
  space in the spot market?
• How much capacity should the facility have? What
  fraction of this capacity should be flexible?

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Binomial Representation of Uncertainty

• Multiplicative binomial

Pu5
p
Pu4
p
Pu3
1-p
Pu4d
p
Pu2
1-p
Pu3d
p
Pu
p
1-p
Pu2d
P
Pu3d2
1-p
Pud
Pu2d2
Pd
1-p
Pud2
Pu2d3
Pd2
Pud3
Pd3
Pud4
Pd4
Pd5
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Binomial Representation of Uncertainty

• Additive binomial

P5u
p
P4u
p
P3u
1-p
P4u-d
p
P2u
1-p
P3u-d
p
Pu
p
1-p
P2ud
P
P3u-2d
1-p
Pu-d
P2u-2d
P-d
1-p
Pu-2d
P2u-3d
P-2d
Pu-3d
P-3d
Pu-4d
P-4d
P-5d
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Decision Trees
P
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Decision Tree Analysis

• Identify the duration of each period and the
  number of time periods T to be evaluated
• Identify the factors associated with the
  uncertainty
• Identify the representation of uncertainty
• Identify the periodic discount rate k
• Represent the tree, identifying all states and
  transition probabilities
• Starting at period T, work back to period 0
  identify the expected cash flows at each step

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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)

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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 10090 9,000
• C1 9090 8,100
• C2 8090 7,200
• NPV(Old)
• 9,000/1.10 8,100 /1.11 7,200 /1.12
• 9,000 7,364 5,950
• 22,314

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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

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Example Decision Tree Analysis

• 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
• Identify the factors associated with the
  uncertainty
• Demand D
• 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
• Identify the periodic discount rate k
• k 0.1

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Example

• Represent the tree, identifying all states as
  well as all transition probabilities

Period 2
D144
Period 1
0.6
Period 0
D96
D120
0.6
0.4
D100
0.6
0.4
D80
D96
0.4
D64
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Example

• Represent the tree, identifying all states as
  well as all transition probabilities

Period 2
P 1208510608/1.1 19844
P 12240
Period 1
D144
0.6
Period 0
D120
0.6
0.4
P 8160
D100
D96
0.6
0.4
D80
P 1008517198/1.1 24135
0.4
P 5440
P 80857072/1.1 13229
D64
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Example Decision Tree Analysis

• Three options for Target.com
• Get all warehousing space from the spot market as
  needed
• Sign a three-year lease for a fixed amount of
  warehouse space and get additional requirements
  from the spot market
• 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

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Example

• 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
• Identify the factors associated with the
  uncertainty
• Demand D and warehouse space spot price p
• Identify the representation of uncertainty
• D may go up or down by 20 with probability 0.5
• p may go up or down by 10 with probability 0.5
• Identify the periodic discount rate k
• k 0.1

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Example

• Represent the tree, identifying all states

0.25
0.25
0.25
0.25
0.25
Period 0
0.25
D100
0.25
p1.20
0.25
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Example Option 1 (Spot)
Period 2

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• C(D 144,000, p 1.45, 2) 144,000 x 1.45
  208,800
• R(D 144,000, p 1.45, 2) 144,000 x 1.22
  175,680
• P(D 144,000, p 1.45, 2) R C
  175,680 208,800 33,120

D144
p1.45
D144
p1.19
D96
p1.45
D144
p0.97
D96
p1.19
D96
p0.97
D64
p1.45
D64
p1.19
D64
p0.97
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Example Option 1 (Spot)
Period 2

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

D144
p1.45
D144
p1.19
D96
p1.45
D144
p0.97
D96
p1.19
D96
p0.97
D64
p1.45
D64
p1.19
D64
p0.97
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Example Option 1 (Spot)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• EP(D 120, p 1.22, 1) 0.25xP(D 144, p
  1.45, 2) 0.25xP(D 144, p 1.19, 2)
  0.25xP(D 96 p 1.45, 2) 0.25xP(D 96, p
  1.19, 2) 12,000
• PVEP(D 120, p 1.22, 1) EP(D 120, p
  1.22, 1)/(1k) 12,000/1.1
  10,909

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Example Option 1 (Spot)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• P(D 120, p 1.32, 1) R(D 120, p 1.22,
  1) C(D 120, p 1.32, 1) PVEP(D 120, p
  1.22, 1) 146,400 - 158,400
  (10,909) 22,909

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Example Option 1 (Spot)

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

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Example Option 1 (Spot)

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

NPV(Spot) 5,471
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Example Option 2 (Fixed lease)

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

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Example Option 2 (Fixed lease)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• P(D , p , 2) R(D , p , 2) C(D , p , 2)
• P(D , p , 2) Dx1.22 (100,000x1.00 Sxp)

8
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Example Option 2 (Fixed lease)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• P(D , p , 1) R(D , p , 1) C(D , p , 1)
  PVEP(D , p , 1)
• P(D , p , 1) Dx1.22 (100,000x1.00 Sxp)
  EP(D , p , 1)/(1k)

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Example Option 2 (Fixed lease)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• P(D , p , 0) R(D , p , 0) C(D , p , 0)
  PVEP(D , p , 0)
• P(D , p , 0) 100,000x1.22 100,000x1.00
  16,364/1.1

NPV(Fixed lease) 38,364
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Example Option 3 (Flexible lease)

• Flexible lease rules
• Up-front payment of 10,000
• Flexibility of using between 60,000 and 100,000
  sq.ft. at 1.00 per sq.ft. per year
• Additional space requirements from spot market

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Example Option 3 (Flexible lease)

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

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Example Option 3 (Flexible lease)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• P(D , p , 2) R(D , p , 2) C(D , p , 2)
• P(D , p , 2) Dx1.22 (Wx1.00 Sxp)

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Example Option 3 (Flexible lease)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• P(D , p , 1) R(D , p , 1) C(D , p , 1)
  PVEP(D , p , 1)
• P(D , p , 1) Dx1.22 (Wx1.00 Sxp) EP(D
  , p , 1)/(1k)

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Example Option 3 (Flexible lease)

• Starting at period T, work back to period 0
  identify the expected cash flows at each step
• P(D , p , 0) R(D , p , 0) C(D , p , 0)
  PVEP(D , p , 0)
• P(D , p , 0) 100,000x1.22 100,000x1.00
  38,198/1.1

NPV(Flexible lease) 56,725 10,000 46,725
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