10 inventory cost & decision tree - copy

Cost Calcualtions in Losgistics

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EVALUATING NETWORK DESIGN DECISIONS

DECISION TREES

A manager makes several different decisions when designing a supply chain network. For instance:

• Should the firm sign a long-term contract for warehousing space or get space from the spot market as needed?

• What should the firm's mix of long-term and spot market be in the portfolio of transportation capacity?

• How much capacity should various facilities have? What fraction of this capacity should be flexible?

If uncertainty is ignored, a manager will always sign long-term contracts (because they are typically cheaper) and avoid all flexible capacity (because it is more expensive). Such decisions, however, can hurt the firm if future demand or prices are not as forecast at the time of the decision.


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During network design, managers thus need a methodology that allows them to estimate the uncertainty in their forecast of demand and price and then incorporate this uncertainty in the decision-making process.

Such a methodology is most important for network design decisions because these decisions are hard to change in the short term.

It cab be seen that accounting for uncertainty can have a significant impact on the value of network design decisions.

A decision tree is a graphic device used to evaluate decisions under uncertainty. Decision trees with DCFs can be used to evaluate supply chain design decisions given uncertainty in prices, demand, exchange rates, and inflation.

The decision tree analysis methodology is as follows

1. Identify the duration of each period (month, quarter, etc.)

and the number of periods T over which the decision is

to be evaluated.

2. Identify factors such as demand, price, and exchange

rate whose fluctuation will be considered over the next T

periods.

3. Identify representations of uncertainty for each factor;

that is, determine what distribution to use to model the

uncertainty.


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The decision tree analysis methodology is as follows

4. Identify the periodic discount rate k for each period.

5. Represent the decision tree with defined states in each

period as well as the transition probabilities between

states in successive periods.

6. Starting at period T, work back to Period 0 identifying the

optimal decision and the expected cash flows at each

step. Expected cash flows at each state in a given

period should be discounted back when included in the

previous period.

The manager must decide whether to lease warehouse space for the coming three years and the quantity to lease.

The long-term lease is currently cheaper than the spot market rate for warehouse space.

The manager anticipates uncertainty in demand and spot prices for warehouse space over the coming three years.

The long term lease is cheaper but could go unused if demand is lower than anticipated.

The long-term lease may also end up being more expensive if future spot market prices come down.

In contrast, spot market rates are high and warehouse space from the spot market will be expensive if future demand is high.

Lease decision facing the general manager at Trips Logistics


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The manager is considering three options

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 charge that

allows variable usage of warehouse space up to a

limit with additional requirement from the spot

market.


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A restaurant owner has determined that she needs to expand her facility. The alternatives are to expand large now and risk smaller demand, or expand on a smaller scale now knowing that she might need to expand again in three years. Which alternative would be most attractive?

• The likelihood of demand being high is .70• The likelihood of demand being low is .30• Large expansion yields profits of Rs300K(high demand) or

Rs50k(low demand)• Small expansion yields profits of Rs80K if demand is low• Small expansion followed by high demand and later expansion

yield a profit of Rs200K at that point. No expansion at that point yields profit of Rs150K

Example Using Decision Trees:

Example of Decision Tree Problem: Add our possible states of nature, probabilities, and payoffs

A

B

Rs.200k

Rs. 80k

Rs. 300k

Rs. 50k

1

Expand small

Expand Large

Expand

Not Expand

High demand (.7)

Low demand (.3)

Rs.200k

Rs.150k2

High demand (.7)

Low demand (.3)

0.7 X 200 + 0.3 X 80Rs.164K

0.7 X 200 + 0.3 X 80Rs.225K


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Evaluating the Decision Tree

• At decision point 2, choose to expand to maximize profits (Rs200,000 > Rs150,000)

• Calculate expected value of small expansion:– EVsmall = 0.30(80,000) + 0.70(200,000) = Rs164,000

• Calculate expected value of large expansion:– EVlarge = 0.30(50,000) + 0.70(300,000) = Rs225,000

• At decision point 1, compare alternatives & choose thelarge expansion to maximize the expected profit:– Rs225,000 > Rs164,000

• Choose large expansion despite the fact that there is a 30% chance it’s the worst decision:– Take the calculated risk!

RISK MANAGEMENT AND NETWORK DESIGN

A global supply chain network is exposed to a variety of risks, including supply disruption, supply delays, demand fluctuations, price fluctuations, and exchange-rate fluctuations.

If appropriate mitigation plans are not in place, these risks can significantly hurt supply chain performance


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Supply Chain Risks to Be Considered During Network Design

Category Risk Drivers

Disruptions Natural disaster, war, terrorismLabor disputesSupplier bankruptcy

Delays High capacity utilization at supply sourceInflexibility of supply sourcePoor quality or yield at supply source

Systems risk Information infrastructure breakdownSystem integration or extent of systems being networked



Forecast risk Inaccurate forecasts due to long lead times, seasonality, product variety, short life cycles, small customer base, Bullwhip effect or information distortion

Intellectual property risk Vertical integration of supply chainGlobal outsourcing and markets

Procurement risk Exchange-rate riskFraction purchased from a single sourceIndustry-wide capacity utilization


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Receivables risk Number of customersFinancial strength of customers

Inventory risk Rate of product obsolescenceInventory holding costProduct valueDemand and supply uncertainty

Capacity risk Cost of capacityCapacity flexibility

MAKING SUPPLY CHAIN DESIGN DECISIONS UNDER UNCERTAINTY IN PRACTICE

Combine strategic planning and financial planning during network design.

In most organizations, financial planning and strategic planning are performed independently.

Strategic planning tries to prepare for future uncertainties but often without rigorous quantitative analysis, whereas financial planning performs quantitative analysis but assumes a predictable or well-defined future.

The various options should be evaluated in the context of future uncertainty.


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Use multiple metrics to evaluate supply chain networks.

As one metric can give only part of the picture, it is beneficial to examine network design decisions using multiple metrics such as firm profits supply chain profits, customer service levels, and response times.

Good decisions perform well along most relevant metrics.


Use financial analysis as an input to decision making, not as the decision making process.

Financial analysis is a great tool in the decision-making process, as it often produces an answer and an abundance of quantitative data to back up that answer.

However, financial methodologies alone do not provide a complete picture of the alternatives, and other non-quantifiable inputs should also be considered.



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Use estimates along with sensitivity analysis.

One of the best ways to speed the process along and arrive at a good decision is to use estimates of inputs when it appears that finding a very accurate input would take an inordinate amount of time, using estimates is fine when the estimates are backed up by sensitivity analysis.

It is almost always easier to come up with a range for an input than it is to come up with a single point. By performing sensitivity analysis on the input's range, managers can often show that no matter where the true input lies within the range, the decision remains the same.

To make supply chain design decisions effectively, managers need to make estimates of inputs and then test all recommendations with sensitivity analysis.

A grocery store pays Rs100 for each delivery of milk from the dairy. They sell 200 liters per week. Each liter costs thestore Rs20, and they sell it for Rs30. They earn a 15% return on cash that is invested in milk. They have a large refrigerator that holds up to 100 liters. It costs them Rs10,000 per year to maintain. What should be their ordering lot size?

M ~ 200(52)

Example

Q* = 833 �� Roughly one replenishment every 4 weeks?!?!

Cc ~ 15% = 0.15 Co ~ Rs100 s ~ Rs20= 10,400 liters per year.


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The refrigerator held only 100 liters. How much would it be worth to expand capacity to 200 liters?

2100

3 55010Rs=,100

40010100 +)( =100TC

5005Rs2

2003 =200

400,10100 +)200( =TC

�Rs.5050 per year in operational savings from doublingfreezer size.

A Truck delivers 200 fridge per day from a warehouse. The truck charges per trip is Rs20 and the waiting cost per min is Rs.0.20. The truck carries 6 fridge per trip. It works for 10 hrs in a day. Calculate the total cost. How can you reduce this cost?Co = Rs20 Cc = 0.20x60x10 = Rs.120/day M= 200/dayQ = 6 i.e. 200/6 = 33 delivery/dayi.e. 10/33 = 0.3 hrs i.e. every 18 min one delivery is sent.

EOQ = √ 2x20x200/120 = 8 nosThe truck should carry approximately 8 order per deliveryi.e 200/8 = 25 delivery/ day against 33 at presenti.e. 10/24 = 0.4 hrs i.e. every 24 minute one delivery to go outTC = 20x200/8 + 120x8/2 = Rs980

Savings of Rs1026.67 – Rs980 = Rs.46.67/dayAnswer: Savings of Rs.46.67 per day can be achieved if the truck carries 8 order per delivery as against 6 at present.

Total Cost = (20x200)/6 + (120x6)/2 = Rs.1026.67Answer: Total Cost is Rs.1026.67


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10 inventory cost & decision tree - copy

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