Slide #

Matching Supply with Demand:

An Introduction to Operations Management

Grard Cachon
ChristianTerwiesch
All slides in this file are copyrighted by Gerard Cachon and Christian
Terwiesch. Any instructor that adopts Matching Supply with
Demand: An Introduction to Operations Management as a required
text for their course is free to use and modify these slides as desired.
All others must obtain explicit written permission from the authors to
use these slides.
Slide #
The impact of location pooling on inventory
Suppose each territorys expected daily demand is 0.29, the required in-
stock probability is 99.9% and the lead time is 1 day with individual
territories or pooled territories.










Pooling 8 territories reduces expected inventory from 11.7 days-of-demand
down to 3.6.
But pooling has no impact on pipeline inventory.
Number of
territories
pooled
Pooled territory's
expected demand
per day
(a)
S units
(b)
days-of-
demand
(b/a)
units
(c)
days-of-
demand
(c/a)
1 0.29 4 3.4 11.7 0.29 1.0
2 0.58 6 4.8 8.3 0.58 1.0
3 0.87 7 5.3 6.1 0.87 1.0
4 1.16 8 5.7 4.9 1.16 1.0
5 1.45 9 6.1 4.2 1.45 1.0
6 1.74 10 6.5 3.7 1.74 1.0
7 2.03 12 7.9 3.9 2.03 1.0
8 2.32 13 8.4 3.6 2.32 1.0
Expected inventory Pipeline inventory

Slide #
Location pooling and the inventory-service tradeoff
curve
Location pooling shifts the
inventory-service tradeoff
curve down and to the right.
For a single product, location
pooling can be used to
decrease inventory while
holding service constant, or
increase service while
holding inventory cost, or a
combination of inventory
reduction and service
increase.
Or location pooling can be
used to broaden the product
line.
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0.96 0.97 0.98 0.99 1
In-stock probability
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Inventory-service tradeoff curve for different levels of location
pooling. The curves represent, from highest to lowest, individual
territories, two pooled territories, four pooled territories, and
eight pooled territories. Daily demand in each territory is
Poisson with mean 0.29 and the lead time is one day.
Slide #
Why does location pooling work?
Location pooling reduces
demand uncertainty as
measured with the
coefficient of variation.

Reduced demand
uncertainty reduces the
inventory needed to
achieve a target service
level

But there are declining
marginal returns to risk
pooling!
Most of the benefit
can be captured by
pooling only a few
territories.
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
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Number of territories pooled
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0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
2.2
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The relationship between expected inventory (diamonds) and the
coefficient of variation (squares) as territories are pooled. Daily
demand in each territory is Poisson with mean 0.29 units, the
target in-stock probability is 99% and the lead time is one day.
Slide #


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1 2 3 4 5 6 7 8
Number of distribution centers
0.00
0.50
1.00
1.50
2.00
2.50
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Slide #
Product pooling universal design
ONeill sells two Hammer 3/2 wetsuits that are identical except for the logo
silk screened on the chest.









Instead of having two Hammer 3/2 suits, ONeill could consolidate its
product line into a single Hammer 3/2 suit, i.e., a universal design, which we
will call the Universal Hammer.
Surf Hammer 3/2 logo Dive Hammer 3/2 logo
Slide #
Demand correlation
Correlation refers to
how one random
variables outcome
tends to be related to
another random
variables outcome.

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0 5 10 15 20

Random demand for two products (x-axis is
product 1, y-axis is product 2). In scenario 1
(upper left graph) the correlation is 0, in scenario
2 (upper right graph) the correlation is -0.9 and in
scenario 3 (the lower graph) the correlation is
0.90. In all scenarios demand is Normally
distributed for each product with mean 10 and
standard deviation 3.
Slide #


Surf demand
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Both ha ve
le ft ove r suits
Dive stoc ks
out, le ft ove r
surf suits
Both stoc k
out
Surf stoc ks
out, le ft ove r
dive suits
Q
surf
Q
dive
Slide #


Surf demand
Left over
suits
Stock outs
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Slide #
Key driver of product pooling
Product pooling is most
effective if the coefficient
of variation of the
Universal product is
lower than the coefficient
of variation (COV) of the
individual products:
COV for Surf and
Dive Hammers =
1181/2192 = 0.37
COV for Universal
Hammer =
1670/6384 = 0.26
Negative correlation in
demand for the individual
products is best for
reducing COV
( )
|
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\
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+ =

o
n Correlatio 1 demand pooled of variation of t Coefficien
2
1
380000
390000
400000
410000
420000
430000
440000
450000
-1 -0.5 0 0.5 1
Correlation
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
0.40
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The correlation between surf and dive demand for the Hammer 3/2 and
the expected profit of the universal Hammer wetsuit (decreasing curve)
and the coefficient of variation of total demand (increasing curve)
Slide #
Lead time pooling consolidated distribution
Consider the following two systems:
In each case weekly demand at each store is Poisson with mean 0.5
and the target in-stock probability at each store is 99.5%
DC demand is normally
distributed with mean 50 and
standard deviation 15
If demands were
independent across stores,
then DC demand would
have a standard deviation of
sqrt(50) = 7.07
Slide #
Consolidated distribution results







Consolidated distribution
reduces retail inventory by more than 50%!
is not as effective at reducing inventory as location pooling
but consolidated distribution keeps inventory near demand,
thereby avoiding additional shipping costs (to customers) and
allowing customers to look and feel the product
reduces inventory even though the total lead time increases from 8 to 9
weeks!
Direct
delivery
supply chain
Centralized
inventory
supply chain
Location
pooling
Expected total inventory at the stores 650 300 0
Expected inventory at the DC 0 116 116
Pipeline inventory between
the DC and the stores 0 50 0
Total 650 466 116
Slide #


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0 10 20 30 40 50 60 70
Standard deviation of weekly demand across all stores
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Slide #


200
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700
1 2 3 4 5 6 7 8
Lead time from supplier (in weeks)
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Slide #
Four possible capacity configurations: no flexibility
to total flexibility
The more links in the configuration, the more flexibility constructed
In the 16 link configuration plant 4 is flexible enough to produce 4 products
but plant 5 has no flexibility (it produces a single product).
Slide #
How is flexibility used
Flexibility allows production shifts to high selling products to avoid lost sales.
Consider a two plant, two product example and two configurations, no
flexibility and total flexibility:




If demand turns out to be 75 for product A, 115 for product B then..
Product Demand Plant 1 Plant 2 Sales
A 75 75 0 75
B 115 0 100 100
Total Sales 175
Plant Utilization 88%
Production
With no flexibility
Product Demand Plant 1 Plant 2 Sales
A 75 75 0 75
B 115 15 100 115
Total Sales 190
Plant Utilization 95%
Production
With total flexibility
Slide #
The value of flexibility
Adding flexibility increases capacity utilization and expected sales:














Note: 20 links can provide nearly the same performance as total flexibility!
800
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900
950
1000
80 85 90 95 100
Expected capacity utilization, %
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No flexibility
Total flexibility
20 links
11 links
12 links
These data are
collected via simulation
Slide #
Chaining: how to add flexibility
A chain is a group of plants and products connected via links.
Flexibility is most effective if it is added to create long chains.
A configuration with 20 links can produce nearly the results of total flexibility
as long as it constructs one large chain:
Hence, a little bit of flexibility is very useful as long as it is designed correctly
Slide #
When is flexibility valuable?
Observations:
Flexibility is most valuable
when capacity approximately
equals expected demand.
Flexibility is least valuable
when capacity is very high or
very low.
A 20 link (1 chain)
configuration with 1000 units of
capacity produces the same
expected sales as 1250 units
of capacity with no flexibility.
If flexibility is cheap relative
to capacity, add flexibility.
But if flexibility is expensive
relative to capacity, add
capacity.
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1000
60 70 80 90 100
Expected capacity utilization, %
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20 links, 1
chain
C=500
C=750
C=880
C=1000
C=1130
C=1250
C=1500

C = total capacity of all ten plants
Slide #
One way to make money with capacity pooling:
contract manufacturing
A fast growing industry:











But one with low margins:
Total revenue of six leading contract manufacturers
by fiscal year: Solectron Corp, Flextronics
International Ltd, Sanmina-SCI, Jabil Circuit Inc,
Celestica Inc and Plexus Corp. (Note, the fiscal
years of these firms vary somewhat, so total
revenue in a calendar year will be slightly
different.)
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Fiscal year
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2003 data:
Firm Revenue* Cost of goods* Gross Margin
Flextronics 14,530 13,705 5.7%
Solectron 11,014 10,432 5.3%
Sanmina-SCI 10,361 9,899 4.5%
Celestica 6,735 6,474 3.9%
Jabil Circuit 4,729 4,294 9.2%
Plexus 807 755 6.4%
* in millions of $s