Supply Chain Management SYST 4050 Slides Supply Chain Management Lecture 9 Chapter 1

Outline Today Thursday Homework 2 Chapter 6 Skipping SYST 4050 Slides 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 Chapter 1

Example: Dell Facility Location SYST 4050 Slides Example: Dell Facility Location ? ? ? What are the decisions? What are the constraints? Chapter 1

Example: SC Consulting Facility Location SYST 4050 Slides Example: SC Consulting Facility Location ? ? ? ? Chapter 1

Making Network Design Decisions in Practice SYST 4050 Slides Making Network Design Decisions in Practice Computer models versus sound judgment Most facility location decisions are based on tariffs and tax incentives Chapter 1

Example: Dell Facility Location SYST 4050 Slides Example: Dell Facility Location Chapter 1

Example: SC Consulting Facility Location SYST 4050 Slides Example: SC Consulting Facility Location Chapter 1

Impact of Uncertainty in Network Design SYST 4050 Slides 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 Chapter 1

Supply Chain Risk Supply failure Commodity price volatility SYST 4050 Slides Supply Chain Risk Supply failure Commodity price volatility Internal product failures Lower consumer spending Natural disaster Chapter 1

Supply Chain Risks to be Considered During Network Design SYST 4050 Slides Supply Chain Risks to be Considered During Network Design Does offshoring increase or decrease these risks? Chapter 1

SYST 4050 Slides Supply Chain Risk Chapter 1

SYST 4050 Slides 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” In a study of more than 800 companies that announced a supply chain disruption between 1989 and 2000, Singhal and Hendricks found that, during a three-year span, regardless of industry, disruption cause or time period, affected companies experienced 33- to 40-percent lower stock returns relative to their peers. Likewise, share price volatility in the year after the disruption was 13.5 percent higher when compared with the volatility in the year before the disruption. They also determined that, in the year leading up to companies announcing a supply chain disruption, such firms experienced seven-percent lower sales growth, 11-percent higher cost, and a 14-percent increase in inventories. Source: FM Global – The New Supply Chain Challenge: Risk Management in a Global Economy Chapter 1

Managing a Supply Chain is Not Easy SYST 4050 Slides 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 Chapter 1

Impact of Uncertainty in Network Design SYST 4050 Slides Impact of Uncertainty in Network Design Supplier Manufacturer Distributor Retailer Customer Natural disasters, supplier bankruptcies, labor disputes, information infrastructure breakdown, inaccurate forecasts, exchange rate risks Uncertainty is propagated through the supply chain(s) and leads to inefficient processes If there is no uncertainty in the supply chain, the performance can be optimal The presence of uncertainty stimulates the creation of buffers in time, capacity and inventory to prevent a possible bad performance of the chain. These buffers restrict the operational performances and may cancel the competitive advantage of the organization Building flexibility into supply chain operations allows the supply chain to deal with uncertainty more effectively Chapter 1

Risk Mitigation Strategies SYST 4050 Slides Risk Mitigation Strategies Chapter 1

Discounted Cash Flow Analysis SYST 4050 Slides 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 Supply chain network design decisions are in place for a long time, so they should be evaluated over an extended period Supply chain network design decisions should be evaluated as a sequence of cash flows over the duration that they will be in place as a sequence of cash flows over that period Chapter 1

Discounted Cash Flow Analysis SYST 4050 Slides 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 Supply chain network design decisions are in place for a long time, so they should be evaluated over an extended period Supply chain network design decisions should be evaluated as a sequence of cash flows over the duration that they will be in place as a sequence of cash flows over that period Chapter 1

Discounted Cash Flow Analysis SYST 4050 Slides 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 Discount rate: The rate used to discount future cash flows to their present values Chapter 1

SYST 4050 Slides Net Present Value Given a stream of cash flows C0, C1, …, CT over the next T periods and a rate of return k Chapter 1

SYST 4050 Slides 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 1 1 + k ( ) t t=1 T NPV = C0 + ∑ Ct Ct (1 + k) t t=0 T NPV = ∑ Chapter 1

SYST 4050 Slides Net Present Value Chapter 1

Example: Net Present Value SYST 4050 Slides 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 Chapter 1

Example: Net Present Value SYST 4050 Slides 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. Chapter 1

Example: Net Present Value SYST 4050 Slides 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 (1 + k)1 C2 (1 + k)2 (1 + k)0 NPV = + + 2,000 (1.1)1 1.12 (1.1)0 = + + = $ 5,471 Chapter 1

Example: Net Present Value SYST 4050 Slides 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 (1 + k)1 C2 (1 + k)2 (1 + k)0 NPV = + + 22,000 (1.1)1 1.12 (1.1)0 = + + = $ 60,182 Chapter 1

Example: Net Present Value SYST 4050 Slides 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 Chapter 1

Binomial Representation of Uncertainty SYST 4050 Slides Binomial Representation of Uncertainty Multiplicative binomial Pu5 p Pu4 p Pu3 1-p p Pu4d Pu2 1-p p Pu3d Pu p 1-p P Pu2d Pu3d2 1-p Pud Pu2d2 1-p Pd Pud2 Value of interest (e.g., P = price) Changes from period to period Up by a factor u with probability p Down by a factor d with probability 1-p Models Multiplicative: Pu, Pd Additive: P + u, P - d Pu2d3 Pd2 Pud3 Pd3 Pud4 Pd4 Pd5 Chapter 1

Binomial Representation of Uncertainty SYST 4050 Slides Binomial Representation of Uncertainty Additive binomial P+5u p P+4u p P+3u 1-p p P+4u-d P+2u 1-p p P+3u-d P+u p 1-p P P+2u–d P+3u-2d 1-p P+u-d P+2u-2d 1-p P-d P+u-2d P+2u-3d P-2d P+u-3d P-3d P+u-4d P-4d P-5d Chapter 1

SYST 4050 Slides Decision Trees P Chapter 1

SYST 4050 Slides Decision Trees A decision tree is a graphic device used to evaluate decisions under uncertainty 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 Decisions: 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? Multi-period decisions when uncertainty resolves after each period Sources of uncertainty: Prices Demand Inflation rate Exchange rates Chapter 1

Example: Decision Tree Analysis SYST 4050 Slides 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) Chapter 1

Example: Decision Tree Analysis SYST 4050 Slides 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 Chapter 1

Example: Decision Tree Analysis SYST 4050 Slides 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 Chapter 1

Example: Decision Tree Analysis SYST 4050 Slides 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 Chapter 1

SYST 4050 Slides Example Represent the tree, identifying all states as well as all transition probabilities Period 2 P = 120*85+(0.6*12240+0.4*8160)/1.1 = 19844 P = 12240 Period 1 D=144 0.6 Period 0 D=120 0.6 0.4 P = 8160 D=100 D=96 0.6 P = 100*85+ (0.6*19844+0.4*13229)/1.1 = 24135 0.4 D=80 0.4 P = 5440 D=64 P = 80*85+(0.6*8160+0.4*5440)/1.1 = 13229 Chapter 1

Example: Decision Tree Analysis SYST 4050 Slides Example: Decision Tree Analysis Three options for Trips Logistics 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 Chapter 1