9

Supply Chain Design

Supply Chain Design

The goal is to reduce costs as well increase

performance.
Supply chain encompasses all the facilities,
functions and activities involved in producing and
delivering a product or service from suppliers to
customers.
Facilities include plants, warehouses, distribution
centres, service centres and retail outlets.
A supply chain strategy is essential for service as
well as manufacturing firms.

Supply Chain
Supply chain: The network of services, material,
and information flows that link a firms customer
relationship, order fulfillment, and supplier
relationship processes to those of its supplier and
customers.
Supply chain management: Developing a
strategy to organize, control, and motivate the
resources involved in the flow of services and
materials within the supply chain.
Supply chain strategy: Designing a firms supply
chain to meet the competitive priorities of the
firms operations strategy.

Supply Chain Design

Total costs

Inefficient
supply chain
operations

Area of
improved
operations

Reduce costs
New supply chain
efficiency curve with
changes in design
and execution
Improve
performance
Supply chain performance

Figure 9.1 Supply Chain Efficiency Curve

Supply
Chains
Every firm or organization is a member of some supply chain
Services

Provide support for the essential elements of various

services the firm delivers

Manufacturing

Control inventory by managing the flow of materials

Suppliers identified by position in supply chain tiers

Suppliers and customers

Supply Chains
Flowers:
Local/International

Packaging

Maintenance
services

FedEx delivery
service

Arrangement
materials

Local delivery
service

Flowers-on-Demand florist

Home
customers

Figure 9.2 Supply Chain for a Florist

Commercial
customers

Internet
service

Supply Chains
Tier 3

Poland

Tier 2

Germany

Tier 1

USA

Canada

Mexico

Germany

Australia

USA

Malaysia

China

Mexico

East Coast

Assembly

Ireland

West Coast

East Europe

Figure 9.2 Supply Chain for a Manufacturing Firm

Components

Major
subassemblies

USA

Manufacturer
Ireland

USA

Raw
materials

West Europe

Distribution
centers

Retail

Inventory and Supply Chains

Creation of Inventory
Inventory: A stock of materials used to satisfy customer demand or to support the
production of services or goods.

Input flow of materials

Inventory level

Figure 9.4 Creation of

Inventory

Scrap flow
Output flow of materials

Inventory and Supply Chains

Balance the advantages and
disadvantages
Pressures for small inventories
Inventory holding cost
Cost of capital
Storage and handling costs
Taxes, insurance, and shrinkage

Inventory and Supply Chains

Pressures for large inventories
Customer service
Ordering cost
Setup cost
Labor and equipment utilization
Transportation cost
Payments to suppliers

Types of Inventory
Three aggregate categories
Raw materials
Work-in-process
Finished goods

Classified by how it is created

Cycle inventory

Safety stock inventory

Anticipation inventory

Pipeline inventory

Types of Inventory
Three types of inventory:
Raw materials (RM) are the inventories that are
needed for the production of services or goods. They
are considered to be inputs to the transformation
processes of the firm, whether they produce a service
or a product.
Work-in-process (WIP) consists of items, such as
components or assemblies, needed for a final product
in manufacturing.
Finished goods (FG) in manufacturing plants,
warehouses, and retail outlets are the items sold to
the firms customers. The finished goods of one firm
may actually be the raw materials for another.

Types of Inventory

Figure 9.5 Inventory at Successive Stocking Points

Cycle Inventory
Lot sizing principles
1. The lot size, Q, varies directly with the elapsed
time (or cycle) between orders.
2. The longer the time between orders for a given
item, the greater the cycle inventory must be.
Q+0
Q
Average cycle inventory = 2 = 2

Cycle Inventory
Pipeline inventory
Average demand during lead time = DL
Average demand per period = d
Number of periods in the items lead time = L
Pipeline inventory = DL = dL

Estimating Inventory Levels

EXAMPLE 9.1
A plant makes monthly shipments of electric drills to a
wholesaler in average lot sizes of 280 drills. The
wholesalers average demand is 70 drills a week, and the
lead time from the plant is 3 weeks. The wholesaler must
pay for the inventory from the moment the plant makes a
shipment. If the wholesaler is willing to increase its
purchase quantity to 350 units, the plant will give priority to
the wholesaler and guarantee a lead time of only 2 weeks.
What is the effect on the wholesalers cycle and pipeline
inventories?

Estimating Inventory Levels

SOLUTION
The wholesalers current cycle and pipeline inventories are
Q
Cycle inventory = 2 = 140 drills
Pipeline inventory = DL = dL = (70 drills/week)(3 weeks)
= 210 drills

Estimating Inventory Levels

1. Enter the average lot size, average demand during a period,
and the number of periods of lead time:
Average lot size

350

Average demand

70

Lead time

2. To compute cycle inventory, simply divide average lot size

by 2. To compute pipeline inventory, multiply average
demand by lead time
Cycle inventory

175

Pipeline inventory

140

Inventory Reduction Tactics

Cycle inventory

Reduce the lot size

Reduce ordering and setup costs and allow Q to be
reduced
Increase repeatability to eliminate the need for
changeovers

Safety stock inventory

Place orders closer to the time when they must be

received

Improve demand forecasts

Cut lead times

Reduce supply chain uncertainty

Rely more on equipment and labor buffers

Inventory Reduction Tactics

Anticipation inventory

Match demand rate with production rates

Add new products with different demand cycles
Provide off-season promotional campaigns
Offer seasonal pricing plans

Pipeline inventory

Reduce lead times

Find more responsive suppliers and select new carriers

Change Q in those cases where the lead time depends on

the lot size

Inventory Placement
Where to locate an inventory of finished goods?
Centralized placement: Keeping all the inventory
at one location such as a firms manufacturing plant
or a warehouse and shipping directly to customers.
Inventory pooling is a reduction in inventory and
safety stock because of the merging of variable
demands from customers.
A higher than expected demand from one customer can
be offset by a lower-than-expected demand from another.

Forward placement is locating stock closer to

customers at a warehouse, wholesaler, or retailer.

Measures of Supply Chain

Performance
Inventory measures
Average
Number of
aggregate
units of item
=
inventory
A typically
value
on hand

Weeks of supply =

Number of
Value of
units of item
each unit +
B typically
of item A
on hand

Value of
each unit
of item B

Average aggregate inventory value

Weekly sales (at cost)

Annual sales (at cost)

Inventory turnover = Average aggregate inventory value

Calculating Inventory Measures

EXAMPLE 9.2
The Eagle Machine Company averaged $2 million in inventory last
year, and the cost of goods sold was $10 million. Figure 9.7 shows
the breakout of raw materials, work-in-process, and finished goods
inventories. The best inventory turnover in the companys industry
is six turns per year. If the company has 52 business weeks per
year, how many weeks of supply were held in inventory? What was
the inventory turnover? What should the company do?

Calculating Inventory Measures

Figure 9.7 Calculating Inventory Measures

Using Inventory Estimator Solver

Calculating Inventory Measures

SOLUTION
The average aggregate inventory value of $2 million
translates into 10.4 weeks of supply and 5 turns per year,
calculated as follows:
Weeks of supply =

$2 million
= 10.4 weeks
($10 million)/(52 weeks)

$10 million
Inventory turns =
= 5 turns/year
$2 million

Application 9.1

A recent accounting statement showed total inventories

(raw materials + WIP + finished goods) to be $6,821,000.
This years cost of goods sold is $19.2 million. The
company operates 52 weeks per year. How many weeks
of supply are being held? What is the inventory turnover?
Weeks of supply =

Average aggregate inventory value

Weekly sales (at cost)

$6,821,000
=
= 18.5 weeks
($19,200,000)/(52 weeks)

$19,200,000
Inventory turnover =
= 2.8 turns
$6,821,000

Measures of Supply Chain

Performance
Financial measures
Total revenue
Cost of goods sold
Operating expenses
Cash flow
Working capital
Return on assets

Financial Measures
Total Revenue: Increasing the percent of on-time deliveries to
customers increases total revenue because satisfied customers
will buy more services and products.
Cost of Goods Sold: Buying materials at a better price, or
transforming them more efficiently, improves a firms cost of
goods sold measure and ultimately its net income.
Operating Expenses: Selling expenses, fixed expenses, and
depreciation are considered operating expenses
Cash Flow: Cash-to-cash is the time lag between paying for
the services and materials needed to produce a service or
product and receiving payment for it.
The shorter the time lag, the better the cash flow position of the firm
because it needs less working capital.

Financial Measures
Working Capital: Money used to finance ongoing
operations.
Weeks of inventory and inventory turns are reflected in
working capital.
Decreasing weeks of supply or increasing inventory turns
reduces the working capital.

Return on Assets (ROA): is net income divided by

total assets.
Managing the supply chain so as to reduce the aggregate
inventory investment will reduce the total assets portion of
the firms balance sheet.

Measures of Supply Chain

Performance
Figure 9.8 How Supply Chain Decisions
Can Affect ROA

Total revenue
Increase sales through
better customer service

Cost of goods sold

Net income

Reduce costs of
transportation and
purchased materials

Improve profits with

greater revenue and
lower costs

Operating expenses
Reduce fixed expenses by
reducing overhead
associated with supply
chain operations

Return on assets
(ROA)
Increase ROA with
higher net income and
fewer total assets

Working capital
Net cash flows
Improve positive cash flows
by reducing lead times and
backlogs

Reduce working capital

by reducing inventory
investment, lead times,
and backlogs

Fixed assets
Inventory
Increase inventory turnover

Reduce the number of

warehouses through
improved supply chain
design

Total assets
Achieve the same or
better performance
with fewer assets

Mass Customization

Mass Customization: A strategy whereby a firms

flexible processes generate a wide variety of
personalized services or products at reasonably low
costs.
Competitive advantages:
Managing customer relationships. It requires
detailed inputs from customers so that the ideal
service or product can be produced.
Eliminating finished goods inventory. Producing to a
customers order eliminates finished goods
inventory.
Increasing perceived value. It increases the
perceived value of services or products.

Mass Customization
Supply chain design for mass customization
Assemble-to-order strategy involves two stages:
Initially, standardized components are produced or
purchased and held in stock. In the second stage
the firm assembles these standard components to a
specific customer order.
Modular design requires careful attention to
service/product designs so that the final service or
product can be assembled from a set of
standardized modules economically and fast in
response to a customer order.
Postponement is when some of the final activities
in the provision of a service or product are delayed
until the orders are received.

Outsourcing Processes
Make-or-buy decision
Vertical integration
Backward integration
Forward integration

Outsourcing
Offshoring
Benefits to outsourcing
Pitfalls to outsourcing

Outsourcing Processes
A Make-or-buy decision is a managerial choice
between whether to outsource a process or do it
in-house.
Outsourcing: Paying suppliers and distributors to
perform processes and provide needed services and
materials.
Backward integration is a firms movement upstream
toward the sources of raw materials, parts, and
services through acquisitions.
Forward integration is acquiring more channels of
distribution, such as distribution centers (warehouses)
and retail stores, or even business customers.

Outsourcing
Offshoring is a supply chain strategy that
involves moving processes to another country.
Factors that influence the offshoring decision
include:
Comparative labor costs
Logistics costs
Labor Laws and Unions

Tariffs and Taxes

Internet

Pitfalls of offshoring include:

Pulling the plug too quickly. Not making a good-faith
effort to fix the existing process
Technology transfer
Difficulties integrating processes

Using Break-Even Analysis

EXAMPLE 9.3
Thompson manufacturing produces industrial scales for the
electronics industry. Management is considering outsourcing
the shipping operation to a logistics provider experienced in
the electronics industry. Thompsons annual fixed costs of the
shipping operation are $1,500,000, which includes costs of the
equipment and infrastructure for the operation. The estimated
variable cost of shipping the scales with the in-house
operation is $4.50 per ton-mile. If Thompson outsourced the
operation to Carter Trucking, the annual fixed costs of the
infrastructure and management time needed to manage the
contract would be $250,000. Carter would charge $8.50 per
ton-mile. What is the break-even quantity?

Using Break-Even Analysis

SOLUTION
From Supplement A, Decision Making, the formula for the
break-even quantity yields
Fm Fb
Q=
cb cm

1,500,000 250,000
=
8.50 4.50
= 312,500 ton-miles

Solved Problem 1
A distribution center experiences an average weekly demand of
50 units for one of its items. The product is valued at $650 per
unit. Average inbound shipments from the factory warehouse
average 350 units. Average lead time (including ordering delays
and transit time) is 2 weeks. The distribution center operates 52
weeks per year; it carries a 1-week supply of inventory as safety
stock and no anticipation inventory. What is the value of the
average aggregate inventory being held by the distribution center?

Solved Problem 1
SOLUTION
Type of
Inventory
Cycle
Safety stock
Anticipation
Pipeline

Calculation of Average Inventory

Q
350
=
2
2

= 175 units

1-week supply = 50 units

None
dL = (50 units/week)(2 weeks) = 100 units
Average aggregate inventory = 325 units
Value of aggregate inventory = $650(325)
= $211,250

Solved Problem 2

A firms cost of goods sold last year was $3,410,000, and the firm
operates 52 weeks per year. It carries seven items in inventory:
three raw materials, two work-in-process items, and two finished
goods. The following table contains last years average inventory
level for each item, along with its value.
a. What is the average
aggregate inventory
value?
b. How many weeks of
supply does the firm
maintain?
c. What was the
inventory turnover
last year?

Category
Raw materials

Work-in-process
Finished goods

Part
Number

Average
Level

Unit
Value

15,000

$ 3.00

2,500

5.00

3,000

1.00

5,000

14.00

4,000

18.00

2,000

48.00

1,000

62.00

Solved Problem 2
SOLUTION
a.

Part Number

Average Level

Unit Value

Total Value

15,000

$ 3.00

2,500

5.00

3,000

1.00

5,000

14.00

4,000

18.00

2,000

48.00

1,000

62.00

Average aggregate inventory value =

Solved Problem 2
SOLUTION
a.

Part Number

Average Level

Unit Value

Total Value

15,000

$ 3.00

$ 45,000

2,500

5.00

12,500

3,000

1.00

3,000

5,000

14.00

70,000

4,000

18.00

72,000

2,000

48.00

96,000

1,000

62.00

62,000

Average aggregate inventory value =

$360,500

Solved Problem 2
b. Average weekly sales at cost = $3,410,000/52 weeks
= $65,577/week
Average aggregate inventory value
Weeks of supply =
Weekly sales (at cost)
$360,500
=
= 5.5 weeks
$65,577
Annual sales (at cost)
c. Inventory turnover = Average aggregate inventory value
$3,410,000
=
= 9.5 turns
$360,500

Supply Chain Integration

10

Supply Chain Integration

The effective coordination of supply chain processes
through the seamless flow of information up and
down the supply chain.

A river that flows from raw material

suppliers to consumers
Upstream
Downstream

Mitigating the effects of supply chain disruptions

is an important benefit of supply chain integration.
Information flows, both upstream and downstream,
provide visibility to supply chain members regarding
supplies, capacities and plans. Cash flows move
upstream and are affected by pricing, promotional
programs, and supply contracts.

Supply Chain Integration

Upstream

Downstream

Tier 3

Tier 2

Tier 1

Tomato
suppliers

Tomato
grading
stations

Tomato
paste
factories

Ketchup
factory

Information flows
Cash flows

Figure 10.1 Supply Chain for a Ketchup Factory

Retail
sales

Consumers

Supply Chain Dynamics

Bullwhip effect
Upstream members must react to the demand
Slightest change in customer demand can
ripple through the entire chain
External causes
Internal causes

Supply Chain Dynamics

Supply chain dynamics can wreak havoc on
supply chain performance measures.
Actions of downstream supply chain members
can affect the operations of upstream members.

The bullwhip effect: The phenomenon in

supply chains whereby ordering patterns
experience increasing variance as you
proceed upstream in the chain.

Supply Chain Dynamics

Manufacturers
weekly orders to
package supplier

Order quantity

9,000

Package suppliers
weekly orders to
cardboard supplier

Retailers daily
orders to
manufacturer

7,000
Consumers
daily
demands

5,000
3,000
0

Day 1

Day 30 Day 1

Day 30 Day 1
Month of April

Figure 10.2 Supply Chain Dynamics for Facial Tissue

Day 30 Day 1

Day 30

Supply Chain Dynamics

External Causes
Volume changes.
Customers may change ordered quantity or
delivery date.

Service and product mix changes.

Customers may change the mix of ordered items.

Late deliveries.
Late deliveries can force a switch in production
schedules.

Underfilled shipments.
Partial shipments can cause a switch in
production schedule or quantity produced.

Supply Chain Dynamics

Internal Causes
Internally generated shortages of parts. A shortage of parts
manufactured by a firm may occur because of machine
breakdowns or inexperienced workers.
Engineering changes to the design of services or products
can have a direct impact on suppliers.
Order batching. Suppliers may offer a quantity discount, which
gives an incentive to firms to purchase large quantities of an
item less frequently, thereby raising the variability in orders to
the suppliers.
New service or product introductions disrupt the supply
chain and may require a new supply chain.
Service or product promotions may create a demand spike
that is felt throughout the supply chain.
Information errors such as demand forecast errors, faulty
inventory counts, or miscommunication with suppliers.

First-Tier Supplier

Service/Product Provider

Support Processes

Support Processes

New service/
product
development
process

Supplier
relationship
process

Businessto-business
(B2B)
customer
relationship
process

Order
fulfillment
process

Figure 10.3 External Supply Chain Linkages

New service/
product
development
process

Supplier
relationship
process

Businessto-business
(B2B)
customer
relationship
process

Order
fulfillment
process

External Consumers

External Suppliers

Supply Chain Dynamics

New Service or Product Development

Design
Service or
product not
profitable

Analysis

Need to rethink
the new offering
or production
process

Development
Post-launch
review

Figure 10.4 New Service/Product Development Process

Full Launch

Supplier Relationship Process

Sourcing

Supplier selection
Material costs equal annual requirements (D)
multiplied by the price per unit, p.
Annual material costs = pD

Freight costs. The costs of transporting the product or the equipment

and personnel who will perform the service can vary greatly depending
on the location of the supplier, the size of shipments, the no. of
shipments per year, and the mode of transportation.

Inventory costs. The shipping quantity, Q, will determine the cycle

inventory the buyer must maintain until the next shipment of the product.

Cycle inventory = Q/2

The lead time, L, and the average requirements per day (or week), d
Pipeline inventory = dL
Annual inventory costs = (Q/2 + dL)H, where H is the annual holding cost per unit.

Administrative costs

Supplier Relationship Process

The total annual cost for a supplier is the
sum of these costs:
Total Annual Cost = pD + Freight costs
+ (Q/2 + dL)H
+ Administrative costs
Other

supplier selection criteria

Green

purchasing: The process of identifying,

processing, and managing the flow of environmental
waste and finding ways to reduce it and minimize its
impact on the environment.

Supplier

certification and evaluation.

Total Cost Analysis

EXAMPLE 10.1
Compton Electronics manufactures laptops for major
computer manufacturers. A key element of the laptop is the
keyboard. Compton has identified three potential suppliers
for the keyboard, each located in a different part of the
world. Important cost considerations are the price per
keyboard, freight costs, inventory costs, and contract
administrative costs. The annual requirements for the
keyboard are 300,000 units. Assume Compton has 250
business days a year. Managers have acquired the
following data for each supplier.
Which supplier provides the lowest annual total cost to
Compton?

Total Cost Analysis

Annual Freight Costs
Shipping Quantity (units/shipment)
Supplier

10,000

20,000

30,000

Belfast

$380,000

$260,000

$237,000

Hong Kong

$615,000

$547,000

$470,000

Shreveport

$285,000

$240,000

$200,000

Keyboard Costs and Shipping Lead Times

Annual Inventory Shipping Administrative
Supplier

Price/Unit

Carrying Cost/Unit

Lead Time (days)

Costs

$100

$20.00

15

$180.000

Hong Kong

$96

$19.20

25

$300.000

Shreveport

$99

$19.80

$150.000

Belfast

Total Cost Analysis

SOLUTION
The average requirements per day are
d = 300,000/250 = 1,200 keyboards
Each option must be evaluated with consideration for the
shipping quantity using the following equation:
Total Annual Cost = Material costs + Freight costs
+ Inventory costs + Administrative costs
= pD + Freight costs + (Q/2 + dL)H + Administrative costs

Total Cost Analysis

For example, consider the Belfast option for a shipping
quantity of Q = 10,000 units. The costs are
Material
($100/unit)(300,000
costs = pD =
units)
= $30,000,000
Freight costs

= $380,000

Inventory costs = (cycle inventory + pipeline inv

= (Q/2 + dL)H
= (10,000 units/2
+ 1200 units/day(15 days))$20/unit/year
= $460,000
Administrative costs

= $180,000

$30,000,000
+ $380,000=
Total
Annual Cost
+ $460,000 + $180,000 = $31,020,000

Total Cost Analysis

The total costs for all three shipping quantity options are
similarly calculated and are contained in the following table.
Total Annual Costs for the Keyboard Suppliers
Shipping Quantity
Supplier
Belfast
Hong Kong
Shreveport

10,000

20,000

30,000

Total Cost Analysis

The total costs for all three shipping quantity options are
similarly calculated and are contained in the following table.
Total Annual Costs for the Keyboard Suppliers
Shipping Quantity
Supplier

10,000

20,000

30,000

Belfast

$31,020,000

$31,000,000

$31,077,000

Hong Kong

$30,387,000

$30,415,000

$30,434,000

Shreveport

$30,352,800

$30,406,800

$30,465,800

Application 10.1
ABC Electric Repair is a repair facility for several major
electronic appliance manufactures. ABC wants to find a lowcost supplier for an electric relay switch used in many
appliances. The annual requirements for the relay switch (D)
are 100,000 units. ABC operates 250 days a year. The
following data are available for two suppliers. Kramer and
Sunrise, for the part:
Freight Costs
Shipping Quantity (Q)
Carrying
Cost/Unit
(H)

Lead Time
(L)(days)

Administrative
Costs

Supplier

2,000

10,000

Price/Unit
(p)

Kramer

$30,000

$20,000

$5.00

$1.00

$10,000

Sunrise

$28,000

$18,000

$4.90

$0.98

$11,000

Application 10.1
SOLUTION
The daily requirements for the relay switch are:
d = 100,000/250 = 400 units
We must calculate the total annual costs for each alternative:
Total annual cost = Material costs + Freight costs
+ Inventory costs + Administrative costs
= pD + Freight costs + (Q/2 + dL)H
+ Administrative costs

Application 10.1
Kramer
Q = 2,000: ($5.00)(100,000) + $30,000
+ (2,000/2 + 400(5))($1) + $10,000 = $543,000
Q = 10,000: ($5.00)(100,000) + $20,000
+ (10,000/2 + 400(5))($1) + $10,000 = $537,000
Sunrise
Q = 2,000: ($4.90)(100,000) + $28,000
+ (2,000/2 + 400(9))($0.98) + $11,000 = $538,508
Q = 10,000: (4.90)(100,000) + $18,000
+ (10,000/2 + 400(9))($0.98) + $11,000 = $527,428
The analysis reveals that using Sunrise and a shipping quantity
of 10,000 units will yield the lowest annual total costs.

Using a Performance Matrix

The management of Compton Electronics has done a total

cost analysis for three international suppliers of keyboards
(see Example 10.1). Compton also considers on-time
delivery, consistent quality, and environmental stewardship
in its selection process. Each criterion is given a weight
(total of 100 points), and each supplier is given a score (1 =
poor, 10 = excellent) on each criterion. The data are shown
in the following table.
Score
Criterion

Weight

Belfast

Hong Kong

Shreveport

Total Cost

25

On-Time Delivery

30

Consistent Quality

30

Environment

15

Using a Performance Matrix

SOLUTION
The weighted score for
each supplier is
calculated by multiplying
the weight by the score
for each criterion and
arriving at a total. For
example, the Belfast
weighted score is

Score
Weight

Belfast

Hong
Kong

Shreveport

Total Cost

25

On-Time
Delivery

30

Consistent
Quality

30

Environment

15

Criterion

WS = (25 5) + (30 9) + (30 8) + (15 9) = 770

Similarly, the weighted score for Hong Kong is 740, and for
Shreveport, 735. Consequently, Belfast is the preferred
supplier.

Application 10.2
ABC Electric Repair wants to select a supplier based on
total annual cost, consistent quality, and delivery speed.
The following table shows the weights management
assigned to each criterion (total of 100 points) and the
scores assigned to each supplier (Excellent = 5, Poor = 1).
Scores
Criterion

Weight

Kramer

Sunrise

Total annual cost

30

Consistent quality

40

Delivery speed

30

Which supplier should ABC select, given these criteria

and scores?

Application 10.2
SOLUTION
Using the preference matrix
approach, the weighted scores
for each supplier are:

Scores
Criterion

Weight

Kramer

Sunrise

Total annual
cost

30

Consistent
quality

40

Delivery
speed

30

WSKramer = (30 4) + (40 3) + (30 5) = 390

WSSunrise = (30 5) + (40 4) + (30 3) = 400
Based on the weighted scores, ABC should select Sunrise
even though delivery speed performance would be better
with Kramer.

Using Expected Value

EXAMPLE 10.3
Tower Distributors provides logistical services to local
manufacturers. Tower picks up products from the
manufacturers, takes them to its distribution center, and then
assembles shipments to retailers in the region. Tower needs
to build a new distribution center; consequently, it needs to
make a decision on how many trucks to have. The monthly
amortized capital cost of ownership is $2,100 per truck.
Operating variable costs are $1 per mile for each truck
owned by Tower. If capacity is exceeded in any month, Tower
can rent trucks at $2 per mile. Each truck Tower owns can be
used 10,000 miles per month. The requirements for the
trucks, however, are uncertain. Managers have estimated the
following probabilities for several possible demand levels and
corresponding fleet sizes.

Using Expected Value

Requirements (miles/month)

100,000

150,000

200,000

250,000

Fleet Size (trucks)

10

15

20

25

Probability

0.2

0.3

0.4

0.1

Notice that the sum of the probabilities must equal 1.0. If Tower
Distributors wants to minimize the expected cost of operations,
how many trucks should it have?

Using Expected Value

SOLUTION
We use the expected value decision rule to evaluate the
alternative fleet sizes where we want to minimize the expected
monthly cost. To begin, the monthly cost, C, must be
determined for each possible combination of fleet size and
requirements. The cost will depend on whether additional
capacity must be rented for the month. For example, consider
the 10 truck fleet size alternative, which represents a capacity
of 100,000 miles per month.

Using Expected Value

C = monthly capital cost of ownership
+ variable operating cost per month + rental costs if needed
C(100,000 miles/month) = ($2,100/truck)(10 trucks)
+ ($1/mile)(100,000 miles) = $121,000
C(150,000 miles/month) = ($2,100/truck)(10 trucks)
+ ($1/mile)(100,000 miles)
+ ($2 rent/mile)(150,000 miles 100,000 miles)
= $221,000
C(200,000 miles/month) = ($2,100/truck)(10 trucks)
+ ($1/mile)(100,000 miles)
+ ($2 rent/mile)(200,000 miles 100,000 miles)
= $321,000
C(250,000 miles/month) = ($2,100/truck)(10 trucks)
+ ($1/mile)(100,000 miles)
+ ($2 rent/mile)(250,000 miles 100,000 miles)
= $421,000

Using Expected Value

Next, calculate the expected value for the 10 truck fleet size alternative as
follows:
Expected Value (10 trucks) = 0.2($121,000) + 0.3($221,000)
+ 0.4($321,000) + 0.1($421,000) = $261,000
Using similar logic, we can calculate the expected costs for each of
the other fleet-size options:
Expected Value (15 trucks) = 0.2($131,500) + 0.3($181,500)
+ 0.4($281,500) + 0.1($381,000) = $231,500
Expected Value (20 trucks) = 0.2($142,000) + 0.3($192,000)
+ 0.4($242,000) + 0.1($342,000) = $217,000
Expected Value (25 trucks) = 0.2($152,500) + 0.3($302,500)
+ 0.4($252,500) + 0.1($302,500) = $222,500

Application 10.3
Schneider Logistics Company has built a new warehouse in
Columbus, Ohio, to facilitate the consolidation of freight shipments
to customers in the region. How many teams of dock workers he
should hire to handle the cross docking operations and the other
warehouse activities? Each team costs $5,000 a week in wages
and overhead. Extra capacity can be subcontracted at a cost of
$8,000 a team per week. Each team can satisfy 200 labor hours of
work a week. Management has estimated the following
probabilities for the requirements:
Requirements (hours/wk)
Number of teams
Probability

200

400

600

0.20

0.50

0.30

How many teams should Schneider hire?

Application 10.3
SOLUTION
We use the expected value decision rule by first computing the
cost for each option for each possible level of requirements and
then using the probabilities to determine the expected value for
each option. The option with the lowest expected cost is the one
Schneider will implement. We demonstrate the approach using
the one team in-house option.
One Team In-House
C(200) = $5,000
C(400) = $5,000 + $8,000 = $13,000
C(600) = $5,000 + $8,000 + $8,000 = $21,000

Expected Value
(One Team) = 0.20($5,000) + 0.50($13,000) + 0.30($21,000) = $13,800

Application 10.3
A table of the complete results is below.
Weekly Labor Requirements
In-House
One team
Two teams
Three teams

200 hrs

400 hrs

600 hrs

Expected Value

Application 10.3
A table of the complete results is below.
Weekly Labor Requirements
In-House

200 hrs

400 hrs

600 hrs

Expected Value

One team

$5,000

$13,000

$21,000

$13,800

Two teams

$10,000

$10,000

$18,000

$12,400

Three teams

$15,000

$15,000

$15,000

$15,000

Based on the expected value decision rule, Schneider should

employ two teams at the warehouse.

The Customer Relationship Process

Marketing
Electronic Commerce (e-commerce) is the
application of information and communication
technology anywhere along the value chain of
business processes.
Business-to-Consumer Systems (B2C) allows
customers to transact business over the Internet.
Business-to-Business Systems (B2B) involves
commerce between firms.
The biggest growth area, it is currently about 70% of the
regular economy.

The Customer Relationship Process

Order Placement

Cost reduction: Using the Internet can reduce

the costs of processing orders.
Revenue flow increase: Reduction in the time
lag associated with billing the customer or
waiting for checks.
Global Access: Available 24 hours a day.
Price flexibility: Prices can easily be changed
as the need arises.

TABLE 10.1

Performance Measures
|

SUPPLY CHAIN PROCESS MEASURES

Customer Relationship

Order Fulfillment

Supplier Relationship

Percent of orders taken

accurately
Time to complete the
order placement process
Customer satisfaction
with the order placement
process
Customers evaluation of
firms environmental
stewardship

Percent of incomplete
orders shipped
Percent of orders
shipped on-time
Time to fulfill the order
Percent of botched
services or returned
items
Cost to produce the
service or item
Customer satisfaction
with the order fulfillment
process
Inventory levels of workin-process and finished
goods
Amount of greenhouse
gasses emitted into the
air

Percent of suppliers
deliveries on-time
Suppliers lead times
Percent defects in
services and purchased
materials
Cost of services and
purchased materials
Inventory levels of
supplies and purchased
components
Evaluation of suppliers
collaboration on
streamlining and waste
conversion
Amount of transfer of
environmental
technologies to suppliers