Managing The Supply Chain

Managing Business Process Flows: Ch 6
Supply Chain Management

Managing the Supply Chain
Key to matching demand with supply

Managing materials waiting time
Cost and Benefits of inventory
Inventory Analysis: Economies of Scale (Ch 6)

Palu Gear: Inventory management of a retailer: EOQ +
ROP
Levers for improvement
Copyright 2013 Pearson Education Inc. publishing as Prentice Hall
Key Financial Indicators of Supply Chain Performance
Return on Assets
Net Present Value

These are LAGGING indicators. What must the supply chain do to achieve
this?
Accurately Matching Demand with Supply is the Key

Challenge: Inventories
2008 Logistics costs (US economy)

Freight Transportation
Inventory Expense
Administrative Expense
Logistics related activity
$864Billion
$420 Billion
$60 Billion
9.4% of GDP
Inventory = Working capital

Reduced inventory implies less working capital
Why do inventories arise?

Mismatch between demand and supply
Costs of not Matching Supply and Demand
Cost of overstocking
liquidation, obsolescence, holding
Cost of under-stocking
lost sales and resulting lost margin
Where is the Flow Time?
Buffer
Waiting
Operation
Processing
5
Flow Times in White Collar Processes

Source: J. Blackburn
Industry
Process
Average
Flow Time
Theoretical
Flow Time
Flow Time
Efficiency
Life Insurance
New Policy
Application
72 hrs.
7 min.
0.16%
Consumer
Packaging
New
Graphic
Design
Consumer
Loan
18 days
2 hrs.
0.14%
24 hrs.
34 min.
2.36%
Hospital
Patient
Billing
10 days
3 hrs.
3.75%
Automobile
Manufacture
Financial
Closing
11 days
5 hrs
5.60%
Commercial
Bank
Operational Flows
Throughput R
Inventory I
FLOW TIME T
I=RT
Flow time T = Inventory I / Throughput R
Why do Buffers Build?

Why hold Inventory?
Economies of scale
Fixed costs associated with batches
Cycle/Batch stock
Quantity discounts
Trade Promotions
Uncertainty
Information Uncertainty
Supply/demand uncertainty
Seasonal Variability
Strategic
Safety stock
Flooding, availability
Seasonal stock
Strategic stock
Cost of Inventory
Physical holding cost

(out-of-pocket)
Financial holding cost
(opportunity cost)
Low responsiveness
Holding cost
to demand/market changes
to supply/quality changes
Pal Gear: Retail Inventory

Management & Economies of Scale
Annual jacket revenues at a Pal Gear retail store are roughly $1M. Pal
jackets sell at an average retail price of $325, which represents a mark-up
of 30% above what Pal Gear paid its manufacturer. Being a profit center,
each store made its own inventory decisions and was supplied directly from
the manufacturer by truck. A shipment up to a full truck load, which was
about 1500 jackets, was charged a flat fee of $2,200. To exploit economies
of scale, stores typically ordered full truck loads. (Pals cost of capital is
approximately 20%.)
What order size would you recommend for a Pal store in current supply
network?
manufacturer
retailer
10
Economies of Scale:
Inventory Build-Up Diagram
R: Annual demand rate,
Q: Number of wind breakers per
replenishment order
Number of orders per year = R/Q.
Inventory
Average number of wind breakers in

Q/2
inventory = Q/2 .
Inventory Profile:
# of wind breakers in
inventory over time.
-R = Demand
rate
cycle stock
Time t
11
Pal Gear: evaluation of current policy of ordering 1500 units
each time
1.
What is average inventory I?
2.
How often do we order?
3.
Annual throughput R =
# of orders per year =
Annual order cost =
What is total cost?
4.
I=
Annual cost to hold one unit H =
Annual cost to hold I =
TC =
What happens if order size changes?
12
Find most economical order quantity:

Spreadsheet for a Pal Gear retailer
Number of units Number of

per order/batch Batches per
Q
Year: R/Q
50
62
100
31
150
21
200
15
250
12
300
10
350
9
400
8
450
7
500
6
510
6
520
6
530
6
540
6
550
6
600
5
650
5
700
4
750
4
800
4
850
4
900
3
1000
3
Annual
Annual
Setup Cost Holding Cost
$
135,385 $
1,250
$
67,692 $
2,500
$
45,128 $
3,750
$
33,846 $
5,000
$
27,077 $
6,250
$
22,564 $
7,500
$
19,341 $
8,750
$
16,923 $
10,000
$
15,043 $
11,250
$
13,538 $
12,500
$
13,273 $
12,750
$
13,018 $
13,000
$
12,772 $
13,250
$
12,536 $
13,500
$
12,308 $
13,750
$
11,282 $
15,000
$
10,414 $
16,250
$
9,670 $
17,500
$
9,026 $
18,750
$
8,462 $
20,000
$
7,964 $
21,250
$
7,521 $
22,500
$
6,769 $
25,000
Annual
Total Cost
$
136,635
$
70,192
$
48,878
$
38,846
$
33,327
$
30,064
$
28,091
$
26,923
$
26,293
$
26,038
$
26,023
$
26,018
$
26,022
$
26,036
$
26,058
$
26,282
$
26,664
$
27,170
$
27,776
$
28,462
$
29,214
$
30,021
$
31,769
$160,000
Setup Cost
$140,000
Holding Cost
$120,000
Total Cost
$100,000
$80,000
$60,000
$40,000
$20,000
$0
100 200 300 400 500 600 700 800 900 1000
Order (batch) size Q
13
Accurate Response to Scale Economies:

Economic Order Quantity EOQ
Total annual
costs
2 SRH
H Q/2: Annual
holding cost
S R /Q:Annual
setup cost
Order Size Q
Fixed cost per order
The order quantity that

minimizes total supply
chain cost is:
2SR
QEOQ
H
Annual unit demand

Annual unit holding cost
14
Optimal Economies of Scale:

For a Pal Gear retailer
R = 3077 units/ year = 59 units/wk
r = 0.20/year
C = $ 250 / unit
S = $ 2,200 / order
Unit annual holding cost = H = 0.20/yr x $250 = $50/yr

Optimal order quantity = Q = sqrt(2 x 3077 x 2200/50) = 520
Number of orders per year = R/Q = 5.9
Time between orders = Q/R = 0.17yr = 8.8weeks
Annual order cost = (R/Q)S = $13,008.87/yr
Average inventory I = Q/2 = 260
Annual holding cost = (Q/2)H =$13,008.87/yr
Average flow time T = I/R = 0.084 yr = 4.4weeks
15
Costs associated with batches
Order Costs (S)

Setup/Changeover of process
Transportation
Receiving
Holding costs (H)

Physical holding cost
Cost of capital
Cost of obsolescence
16
Optimal Economies of Scale:

Managerial Insights
2 SR
QEOQ
H
CEOQ 2 SRH
How cut inventories (economically smart)?
Budgeting for growth

Last FY:
Next year:
Sales = $100M
Sales = $200M
Inventories = $20M
Inventories = ?
Days-of-inventory:
Centralized inventory management
17
Learning Objectives:
Batching & Economies of Scale
Increasing batch size Q of order (or production) increases
average inventories (and thus flow times).

Average inventory for a batch size of Q is Q/2.
The optimal batch size minimizes supply chain costs by
trading off setup cost and holding cost and is given by the
EOQ formula.
To reduce batch size, one must reduce setup cost (time).
Economies of scale are manifested by the square-root
relationship between QEOQ and (R, S):
If demand increases by a factor of 4, it is optimal to increase batch size
by a factor of 2 and produce (order) twice as often.

To reduce batch size by a factor of 2, setup cost has to be reduced by a
factor of 4.
18
Role of Leadtime L:
Pal Gear cont.
The lead time from when a Pal Gear retailer places an order to when the
order is received is two weeks. If demand is stable as before, when should
the retailer place an order?
Inventory Profile:
Inventory
-R
Time t
Two key decisions in inventory management are:

How much to order?
When to order?
19
Continuous Review Policy: Ordering Decisions and

the Re-order Point
I(t)
ROP
-R
L
Place
order n
L
Receive
Place
Receive
Place
order n order n+1 order n+1 order n+2
time
20
ROP and Inventory position
ROP = L R
But if lead time L is greater than time between orders, there will be more
than one order outstanding
Inventory position = Inventory level (On-hand inventory) + On-order
inventory
21
Order Policies
Continuous Review: Ability to monitor inventory continuously and take

action
Order fixed quantity whenever inventory position reaches re-order point
Periodic Review: Monitor inventory periodically and take action

Order sufficient quantities at periodic intervals (e.g., every Monday) to raise
inventory position to a target level (order up to level or OUL),
22
Inventory Profile for a Periodic Review Policy: Example Ch 6
OUL = 1800
Inventory Position
Q=1200 units
On-hand inventory
1200 units
Recd.
600 units
1200 units
Recd.
L=1 week
1
L=1 week
2
Review Period Tr=2
Order
Placed
Order
Recd.
Order
Placed
Order
Recd.
23
Periodic Review: Palu Gear
OUL = (L+Tr) R
Suppose Palu Gear placed orders 4 weeks; then Tr = 4 weeks
With L = 2 weeks,
OUL = (4+2) x 59 = 354 units.
24
Learning Objectives:
Batching & Economies of Scale
Increasing batch size of production (or purchase) increases
average inventories (and thus cycle times).

Average inventory for a batch size of Q is Q/2.
The optimal batch size trades off setup cost and holding cost.
To reduce batch size, one has to reduce setup cost (time).
Square-root relationship between Q and (R, S):
If demand increases by a factor of 4, it is optimal to increase batch size
by a factor of 2 and produce (order) twice as often.

To reduce batch size by a factor of 2, setup cost has to be reduced by a
factor of 4.
Continuous vs. Periodic Review
25
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Managing The Supply Chain

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Managing Business Process Flows: Ch 6

Supply Chain Management

Key to matching demand with supply

Inventory Analysis: Economies of Scale (Ch 6)

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Key Financial Indicators of Supply Chain Performance

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Accurately Matching Demand with Supply is the Key

2008 Logistics costs (US economy)

Inventory = Working capital

Why do inventories arise?

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Costs of not Matching Supply and Demand

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Where is the Flow Time?

Flow Times in White Collar Processes

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Why do Buffers Build?

Physical holding cost

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Pal Gear: Retail Inventory

Number of orders per year = R/Q.

Average number of wind breakers in

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Pal Gear: evaluation of current policy of ordering 1500 units

What is average inventory I?

How often do we order?

What is total cost?

What happens if order size changes?

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Find most economical order quantity:

Number of units Number of

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Accurate Response to Scale Economies:

Fixed cost per order

The order quantity that

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Annual unit demand

Optimal Economies of Scale:

Unit annual holding cost = H = 0.20/yr x $250 = $50/yr

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Costs associated with batches

Order Costs (S)

Holding costs (H)

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Optimal Economies of Scale:

How cut inventories (economically smart)?

Budgeting for growth

Centralized inventory management

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

average inventories (and thus flow times).

The optimal batch size minimizes supply chain costs by

by a factor of 2 and produce (order) twice as often.

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Two key decisions in inventory management are:

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Continuous Review Policy: Ordering Decisions and

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

ROP and Inventory position

Copyright 2013 Pearson Education Inc. publishing as Prentice Hall

Continuous Review: Ability to monitor inventory continuously and take

Periodic Review: Monitor inventory periodically and take action