Supply Chain Management: Strategy, Planning,

and Operation

Chapter 6

Designing Global Supply Chain

Networks
Impact of Globalization on Supply Chain
Networks (1 of 2)

• Opportunities to simultaneously increase revenues and

decrease costs
• Accompanied by significant additional risk and
uncertainty
• Difference between success and failure often the ability
to incorporate suitable risk mitigation into supply chain
design
• Uncertainty of demand and price drives the value of
building flexible production capacity

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Impact of Globalization on Supply Chain
Networks (2 of 2)

Sources of risk that affect global supply chain performance

- Natural disasters
- Volatilty of fuel prices
- Performance of supply chain partners

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Importance of Total Cost

• Comparative advantage in global supply chains

• Quantify the benefits of offshore production along with
the reasons for the comparative advantage
• Two reasons offshoring fails

1. Focusing exclusively on unit cost rather than total

cost
2. Ignoring critical risk factors

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The Offshoring Decision: Total Cost

• A global supply chain with offshoring increases the length

and duration of information, product, and cash flows
• The complexity and cost of managing the supply chain
can be significantly higher than anticipated
• Quantify factors and track them over time
• Big challenges with offshoring is increased risk and its
potential impact on cost

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Importance of Total Cost
• Key elements of total cost

1. Supplier price
2. Terms: net payment terms and volume discounts
3. Delivery costs
4. Inventory and warehousing
5. Cost of quality: validation, performance drop
6. Customer duties, value added-taxes, local tax incentives
7. Cost of risk, procurement staff, broker fees, infrastructure,
and tooling and mold costs
8. Exchange rate trends and their impact on cost

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Risk Management in Global Supply Chains (1 of 6)

• Risks include supply disruption, supply delays, demand

fluctuations, price fluctuations, and exchange-rate
fluctuations
• Critical for global supply chains to be aware of the
relevant risk factors and build in suitable mitigation
strategies

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Risk Management in Global Supply Chains (2 of 6)

Table 6-3 Supply Chain Risks to Be Considered During Network

Design

Category Risk Drivers

Disruptions Natural disaster, war, terrorism Labor disputes
Supplier bankruptcy

Delays High capacity utilization at supply source Inflexibility

of supply source Poor quality or yield at supply
source
Systems risk Information infrastructure breakdown System
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 Information distortion

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Risk Management in Global Supply Chains (3 of 6)

Table 6-3 [Continued]

Category Risk Drivers

Intellectual property risk Vertical integration of supply chain Global
outsourcing and markets
Procurement risk Exchange-rate risk Price of inputs Fraction
purchased from a single source Industry-wide
capacity utilization
Receivables risk Number of customers Financial strength of
customers
Inventory risk Rate of product obsolescence Inventory holding cost
Product value Demand and supply uncertainty
Capacity risk Cost of capacity Capacity flexibility

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Risk Management in Global Supply Chains (4 of 6)

• Good network design can play a significant role in

mitigating supply chain risk
• Every mitigation strategy comes at a price and may
increase other risks
• Global supply chains should generally use a combination
of rigorously evaluated mitigation strategies along with
financial strategies to hedge uncovered risks

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Network Design using Decision Trees

• Several different decisions

– 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?

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Discounted Cash Flows

• Supply chain decisions should be evaluated as a

sequence of cash flows over time
• Discounted cash flow (DCF) analysis evaluates the
present value of any stream of future cash flows and
allows managers to compare different cash flow streams
in terms of their financial value
• Based on the time value of money – a dollar today is
worth more than a dollar tomorrow

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Discounted Cash Flow Analysis

1
discount factor 
1 k
t
T
 1 
NPV  C0     Ct
t 1  1  k 

Where

C0, C1,…,CT is stream of cash flows over T periods

NPV = net present value of this stream

K = rate of return

• Compare NPV of different supply chain design options

• The option with the highest NPV will provide the greatest financial return

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Trips Logistics Example (1 of 3)

• Demand = 100,000 units

• 1,000 sq. ft. of space for every 1,000 units of demand
• Revenue = $1.22 per unit of demand
• Sign a three-year lease or obtain warehousing space on
the spot market?
• Three-year lease cost = $1 per sq. ft.
• Spot market cost = $1.20 per sq. ft.
• k = 0.1

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Trips Logistics Example (2 of 3)

Expected annual profit if = (100,000 × $1.22)

Warehousing space is obtained − (100,000 × $1.20)
from spot market = $2,000

C1 C2
NPV(No lease)  C0  
1 k 1 k 2

2,000 2,000
 2,000   2
 $5,471
1.1 1.1

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Trips Logistics Example (3 of 3)

Expected annual profit with = (100,000 × $1.22)

Three year lease − (100,000 × $1.00)
Blank = $22,000

C1 C2
NPV(Lease)  C0  
1 k 1 k 2
22,000 22,000
 22,000   2
 $60,182
1.1 1.1
• NPV of signing lease is $60,182 − $5,471 = $54,711 higher
than spot market

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Basics of Decision Tree Analysis

• A decision tree is a graphic device used to evaluate

decisions under uncertainty
– Identify the number and duration of time periods that
will be considered (T)
– Identify factors that will affect the value of the decision
and are likely to fluctuate over the next T periods
– Evaluate decision using a decision tree

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Decision Tree Methodology
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 whose fluctuation will be considered
3. Identify representations of uncertainty for each factor
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

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Decision Tree – Trips Logistics (1 of 3)

• Three warehouse lease 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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Decision Tree – Trips Logistics (2 of 3)
• 1000 sq. ft. of warehouse space needed for 1000 units of demand
• Current demand = 100,000 units per year
• Binomial uncertainty: Demand can go up by 20% with
p = 0.5 or down by 20% with 1 − p = 0.5
• Lease price = $1.00 per sq. ft. per year
• Spot market price = $1.20 per sq. ft. per year
• Spot prices can go up by 10% with p = 0.5 or down by 10% with 1 −
p = 0.5
• Revenue = $1.22 per unit of demand
• k = 0.1

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Decision Tree (1 of 2)

Figure 6-2 Decision Tree for Trips Logistics, Considering Demand

and Price Fluctuation
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Evaluating the Spot Market Option (1 of 9)
• Analyze the option of not signing a lease and using the spot market
• Start with Period 2 and calculate the profit at each node

For D = 144, p = $1.45, in Period 2:

C(D = 144, p = 1.45,2) = 144,000 × 1.45
= $208,800
P(D = 144, p = 1.45,2) = 144,000 × 1.22
− C(D = 144, p = 1.45, 2)
= 175,680 − 208,800
= −$33,120
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Evaluating the Spot Market Option (2 of 9)
Table 6-5 Period 2 Calculations for Spot Market Option

Cost Profit
Blank Revenue C(D =, p =, 2) P(D =, p =, 2)
D = 144, p = 1.45 144,000 × 1.22 144,000 × 1.45 −$33,120
D = 144, p = 1.19 144,000 × 1.22 144,000 × 1.19 $4,320
D = 144, p = 0.97 144,000 × 1.22 144,000 × 0.97 $36,000
D = 96, p = 1.45 96,000 × 1.22 96,000 × 1.45 −$22,080
D = 96, p = 1.19 96,000 × 1.22 96,000 × 1.19 $2,880
D = 96, p = 0.97 96,000 × 1.22 96,000 × 0.97 $24,000
D = 64, p = 1.45 64,000 × 1.22 64,000 × 1.45 −$14,720
D = 64, p = 1.19 64,000 × 1.22 64,000 × 1.19 $1,920
D = 64, p = 0.97 64,000 × 1.22 64,000 × 0.97 $16,000

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Evaluating the Spot Market Option (3 of 9)

• Expected profit at each node in Period 1 is the profit

during Period 1 plus the present value of the expected
profit in Period 2
• Expected profit EP(D =, p =, 1) at a node is the expected
profit over all four nodes in Period 2 that may result from
this node
• PVEP(D =, p =, 1) is the present value of this expected
profit and P(D =, p =, 1), and the total expected profit, is
the sum of the profit in Period 1 and the present value of
the expected profit in Period 2

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Evaluating the Spot Market Option (4 of 9)
• From node D = 120, p = $1.32 in Period 1, there are four
possible states in Period 2
• Evaluate the expected profit in Period 2 over all four states
possible from node D = 120, p = $1.32 in Period 1 to be

EP(D = 120, p = 1.32,1) = 0.2 × [P(D = 144, p = 1.45,2)

+ P(D = 144, p = 1.19,2)
+ P(D = 96, p = 1.45,2)
+ P(D = 96, p = 1.19,2)
= 0.25 × [−33,120 + 4,320
− 22,080 + 2,880]
= −$12,000
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Evaluating the Spot Market Option (5 of 9)

• The present value of this expected value in Period 1 is

EP (D  120, p  1.32,1)
 PVEP D  120, p  1.32,1 
(1  k )
$12, 000

1.1
 $10, 909

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Evaluating the Spot Market Option (6 of 9)

• The total expected profit P(D = 120, p = 1.32,1) at node D

= 120, p = 1.32 in Period 1 is the sum of the profit in
Period 1 at this node, plus the present value of future
expected profits possible from this node

P (D = 120, p  1.32,1)  120,000  1.22  – 120,000  1.32 

PVEP (D  120, p  1.32,1)
 –$12,000 – $10,909  – $22, 909

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Evaluating the Spot Market Option (7 of 9)
Table 6-6 Period 1 Calculations for Spot Market Option

P(D =, p =, 1)
= D × 1.22 – D x p + start fraction E P at left parenthesis D =, p =,
1 right parenthesis over left parenthesis 1 + k right parenthesis end fraction

EP (D  , p  ,1)
Node EP(D =, p =, 1) 1  k 
D = 120, p = 1.32 −$12,000 −$22,909

D = 120, p = 1.08 $16,000 $32,073

D = 80, p = 1.32 −$8,000 −$15,273

D = 80, p = 1.08 $11,000 $21,382

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Evaluating the Spot Market Option (8 of 9)

• For Period 0, the total profit P(D = 100, p = 120,0) is the

sum of the profit in Period 0 and the present value of the
expected profit over the four nodes in Period 1

EP(D = 100, p = 1.20,0) = 0.25 × [P(D = 120, p = 1.32,1)

+ P(D = 120, p = 1.08,1)
+ P(D = 96, p = 1.32,1)
+ P(D = 96, p = 1.08,1)]
= 0.25 × [−22,909 + 32,073
− 15,273) + 21,382]
= $3,818
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Evaluating the Spot Market Option (9 of 9)

EP  D  100, p  1.20,0 
PVEP (D  100, p  1.20,1) 
1  k 
$3,818
  $3,471
1.1
P(D = 100, p = 1.20,0) = (100,000 × 1.22) − (100,000 × 1.20)+ P V
E P(D = 100, p = 1.20,0)
= $2,000 + $3,471 = $5,471
• Therefore, the expected NPV of not signing the lease and obtaining
all warehouse space from the spot market is given by NPV (Spot
Market) = $5,471

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Evaluating the Fixed Lease Option (1 of 5)
Table 6-7 Period 2 Profit Calculations at Trips Logistics for Fixed Lease Option

Profit P(D =, p =, 2)
Warehouse Space = D × 1.22 − (100,000 ×
Node Leased Space at Spot Price (S) 1 + S x p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880
D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320
D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000
D = 96, p = 1.45 100,000 sq. ft. 0 sq. ft. $17,120
D = 96, p = 1.19 100,000 sq. ft. 0 sq. ft. $17,120
D = 96, p = 0.97 100,000 sq. ft. 0 sq. ft. $17,120
D = 64, p = 1.45 100,000 sq. ft. 0 sq. ft. −$21,920
D = 64, p = 1.19 100,000 sq. ft. 0 sq. ft. −$21,920
D = 64, p = 0.97 100,000 sq. ft. 0 sq. ft. −$21,920

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Evaluating the Fixed Lease Option (2 of 5)
Table 6-8 Period 1 Profit Calculations at Trips Logistics for Fixed Lease Option

Warehouse P(D =, p =, 1)
Space = D x 1.22−(100,000 x 1 +
at Spot Price S x p) + EP(D =, p = ,1)(1
Node EP(D =, p =, 1) (S) + k)
D = 120, p = 1.32 0.25 × [P(D = 144, p = 1.45,2) + P(D 20,000 $35,782
= 144, p = 1.19,2) + P(D = 96, p =
1.45,2) + P(D = 96, p = 1.19,2)] =
0.25 × (11,880 + 23,320 + 17,120 +
17,120) = $17,360

D = 120, p = 1.08 0.25 × (23,320 + 33,000 + 17,120 + 20,000 $45,382

17,120) = $22,640
D = 80, p = 1.32 0.25 × (17,120 + 17,120−21,920 − 0 −$4,582
21,920) = −$2,400
D = 80, p = 1.08 0.25 × (17,120 + 17,120 − 21,920 0 −$4,582
−21,920) = −$2,400

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Evaluating the Fixed Lease Option (3 of 5)

• Using the same approach for the lease option, NPV

(Lease) = $38,364

EP(D = 100, p = 1.20,0) = 0.25 × [P(D = 120, p = 1.32,1) +

P(D = 120, p = 1.08,1) + P(D =
80, p = 1.32,1) + P(D = 80, p =
1.08,1)]
= 0.25 × [35,782 + 45,382 − 4,582
− 4,582]
= $18,000

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Evaluating the Fixed Lease Option (4 of 5)

EP  D  100, p  1.20,1
PVEP (D  100, p  1.20,1) 
1  k 
$18,000
  $16,364
1.1

P(D = 100, p = 1.20,0) = (100,000 × 1.22) − (100,000 × 1)

+ PVEP(D = 100, p = 1.20,0)
= $22,000 + $16,364 = $38,364

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Evaluating the Fixed Lease Option (5 of 5)

• Recall that when uncertainty was ignored, the NPV for

the lease option was $60,182
• However, the manager would probably still prefer to sign
the three-year lease for 100,000 sq. ft. because this
option has the higher expected profit

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Evaluating the Flexible Lease Option (1 of 2)
Table 6-9 Period 2 Profit Calculations at Trips Logistics with Flexible
Lease Contract

Profit P(D =, p =, 2)
Warehouse Space Warehouse Space = D × 1.22 − (W× 1
Node at $1 (W) at Spot Price (S) + S × p)
D = 144, p = 1.45 100,000 sq. ft. 44,000 sq. ft. $11,880
D = 144, p = 1.19 100,000 sq. ft. 44,000 sq. ft. $23,320
D = 144, p = 0.97 100,000 sq. ft. 44,000 sq. ft. $33,000
D = 96, p = 1.45 96,000 sq. ft. 0 sq. ft. $21,120
D = 96, p = 1.19 96,000 sq. ft. 0 sq. ft. $21,120
D = 96, p = 0.97 96,000 sq. ft. 0 sq. ft. $21,120
D = 64, p = 1.45 64,000 sq. ft. 0 sq. ft. $14,080
D = 64, p = 1.19 64,000 sq. ft. 0 sq. ft. $14,080
D = 64, p = 0.97 64,000 sq. ft. 0 sq. ft. $14,080

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Evaluating the Flexible Lease Option (2 of 2)
Table 6-10 Period 1 Profit Calculations at Trips Logistics with Flexible
Lease Contract
Warehouse P(D =, p =, 1)
Warehouse Space = D × 1.22 − (W x 1 +
Space at $1 at Spot Price S x p) + EP(D =,
Node EP(D =, p =, 1) (W) (S) p = ,1)(1 + k)
D = 120, 0.25 × (11,880 + 23,320 + 100,000 20,000 $37,600
p = 1.32 21,120 + 21,120) =
$19,360
D = 120, 0.25 × (23,320 + 33,000 + 100,000 20,000 $47,200
p = 1.08 21,120 + 21,120) =
$24,640
D = 80, 0.25 × (21,120 + 21,120 + 80,000 0 $33,600
p = 1.32 14,080 + 14,080) =
$17,600
D = 80, 0.25 × (21,920 + 21,920 + 80,000 0 $33,600
p = 1.08 14,080 + 14,080) =
$17,600

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Decision Tree – Trips Logistics (3 of 3)
Table 6-11 Comparison of Different Lease Options for Trips Logistics

Option Value
All warehouse space from the spot market $5,471
Lease 100,000 sq. ft. for three years $38,364
Flexible lease to use between 60,000 and 100,000 sq. ft. $46,545

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Onshore or Offshore

• The value of flexibility under uncertainty

– D-Solar demand in Europe = 100,000 panels per year
– Each panel sells for €70
– Annual demand may increase by 20 percent with
probability 0.8 or decrease by 20 percent with
probability 0.2
– Build a plant in Europe or China with a rated capacity
of 120,000 panels

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D-Solar Decision (1 of 5)
Table 6-12 Fixed and Variable Production Costs for D-Solar

European Plant European Plant Chinese Plant Chinese Plant

Fixed Cost Variable Cost Fixed Cost Variable Cost

(euro) (euro) (yuan) (yuan)
1 million/year 40/panel 8 million/year 340/panel

Table 6-13 Expected Future Demand and Exchange Rate

Period 1 Period 1 Period 2 Period 2

Demand Exchange Rate Demand Exchange Rate

112,000 8.64 yuan/euro 125,440 8.2944 yuan/euro

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D-Solar Decision (2 of 5)
• European plant has greater volume flexibility
• Increase or decrease production between 60,000 to 150,000 panels
• Chinese plant has limited volume flexibility
• Can produce between 100,000 and 130,000 panels
• Chinese plant will have a variable cost for 100,000 panels and will
lose sales if demand increases above 130,000 panels
• Yuan, currently 9 yuan/euro, expected to rise 10%, probability of 0.7
or drop 10%, probability of 0.3
• Sourcing decision over the next three years
• Discount rate k = 0.1

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D-Solar Decision (3 of 5)

Period 0 profits = (100,000 × 70) – 1,000,000 − (100,000 × 40) = €2,000,000

Period 1 profits = (112,000 × 70) − 1,000,000 − (112,000 × 40) = €2,360,000

Period 2 profits = (125,440 × 70) − 1,000,000 − (125,440 × 40) = €2,763,200

2,000,000  2,360,000
Expected profit from onshoring 
1.1
2,763,200

1.21
 €6,429,091

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D-Solar Decision (4 of 5)

 8,000,000   100,000  340 

Period 0 profits  100,000  70       €2,333,333
 9   9 
 8,000,000   112,000  340 
Period 1 profits  112,000  70       €2,506,667
 8.64   8.64 
 8,000,000   125,440  340 
Period 2 profits  125,440  70       €2,674,319
 7.9524   7.9524 
2,506,667 2,674,319
Expected profit from off  shoring  2,333,333    €6,822,302
1.1 1.21

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Decision Tree (5 of 5)

Figure 6-3 Decision Tree for D-Solar

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