Chapter 6: Supply Chain Aggregation

1. Supply Aggregation in Supply Chain (review)

Order/
¨ Aggregating multiple products in single order supply/
¨ Safety Inventory with Supply Uncertainty shipment

2. Impact of aggregation on safety inventory WH

3. Supplier integration into new product development

Reference:
• Chapter 12, Sunil Chopra, Peter Meindl – Supply chain management: Strategy,
Planning and Operation, 6th ed, Pearson.
• Chapter 8, Simchi-Levi, D., Kaminsky, P., and Simchi-Levi, E. (2008). Designing
and Managing the Supply Chain: Concepts, Strategies and Case Studies. Boston:
McGraw-Hill/ Irwin.

1
 1. Supply Aggregation in Supply Chain

Receiving Benefit?
Operations Management Distribution System

Raw Materials
RM Inventory
Suppliers Manufacturing FGs Inventory
Transportation Transportation
Transportation Transportation
Warehouse Factory 1 Warehouse A

Warehouse Factory 2 Warehouse B

Warehouse Factory 3 Warehouse C

Market

2
1.1. Aggregating Multiple Products in
a Single Order (review)

¨Major fixed cost is transportation

¨Aggregate multiple products originating from the
same supplier
¨To have single delivery coming from multiple
suppliers or to have a single truck delivering to
multiple retailers
 Reduce lot size for individual product
 Lot Sizing with Multiple Products or
Customers
¨Variety of products or pickup points: Fixed costs:
ordering, transportation, receiving  optimal lot
sizes?
¨ Di: annual demand for product i
¨ S: order cost independent of the variety of
products included in the order (transportation)
¨ si: additional order cost incurred if product i is
included in the order.
 Lot Sizing Strategies

1. Lots are ordered and delivered independently

for each product
2. Lots are ordered and delivered jointly for all
products
3. Lots are ordered and delivered jointly for
selected subset of the products
 S1: Lots are ordered and delivered
independently for each product

This scenario is equivalent to applying the EOQ

formula to each product when evaluating the lot
sizes
 Example
¨ Best Buy sells three models of computers, the Litepro, the
Medpro, and the Heavypro. Annual demands for the three
products are DL = 12,000 for the Litepro, DM = 1,200 units for
the Medpro, and DH = 120 units for the Heavypro. Each model
costs Best Buy $500. A fixed transportation cost of $4,000 is
incurred each time an order is delivered. For each model
ordered and delivered on the same truck, an additional fixed
cost of $1,000 per model is incurred for receiving and storage.
Best Buy incurs a holding cost of 20 percent. Evaluate the lot
sizes that the Best Buy manager should order if lots for each
product are ordered and delivered independently. Also
evaluate the annual cost of such a policy.
 Solution
¨ Demand, DL = 12,000/year, DM = 1,200/year, DH = 120/year
¨ Fixed Ordering cost: a separate truck delivers each model
¨ Common order cost, S = $4,000
¨ Product-specific order cost, sL = $1,000, sM = $1,000, sH = $1,000
¨ Holding cost, h = 0.2
¨ Unit cost, CL = $500, CM = $500, CH = $500
 S2:Lots are ordered and delivered
jointly for all products
¨All products are ordered and delivered on the same
truck each time an order is placed.
¨The combined fixed order cost per order:

¨Let n be the number of orders placed per year  Total

annual cost:
¨If the capacity of the truck is considered, then:
n*= Di/Capacity for each product
 Example
¨W.W. Grainger sources from hundreds of suppliers
and is considering the aggregation of inbound
shipments to lower costs. Truckload shipping costs
$500 per truck along with $100 per pickup. Average
annual demand from each supplier is 10,000 units.
Each unit costs $50 and Grainger incurs a holding
cost of 20 percent. What is the optimal order
frequency and order size if Grainger decides to
aggregate four suppliers per truck? What is the
optimal order size and frequency if each truck has a
capacity of 2,500 units?
 Solution
¨ Demand per product, Di = 10,000
¨ Holding cost, h = 0.2
¨ Unit cost per product, Ci = $50
¨ Common order cost, S = $500
¨ Supplier-specific order cost, si = $100
¨ The combined order cost from four suppliers is given by: S* =
S + s1 + s2 + s3 + s4 = $ 900 per order
¨ The optimal order frequency is
¨ If the capacity of truck is 2,500 units  capacity for each
supplier is 2,500/4 = 625<10,000/14.91 = 671  n* =
10,000/625 = 16
S3: Lots are ordered and delivered jointly for
selected subset of the products
¨ Step 1: identify the most frequently ordered product, assuming
each product is ordered independently

¨ Step 2:For all products i ≠ i*, evaluate the ordering frequency:

¨ Step 3: For all i i*, evaluate the frequency of product i relative
to the most frequently ordered product i* to be:
 Joint Order for a Selected Subset of
the Products (cont.)
¨ Step 4:Having decided the ordering frequency of each product
i, recalculate the ordering frequency of the most frequently
ordered product i* to be:

¨ Step 5: evaluate an order frequency of ni = n/mi and the total

cost of such an ordering policy
 Example

¨Consider the Best Buy data. Product managers

have decided to order jointly, but to be selective
about which models they include in each order.
Evaluate the ordering policy and costs using the
procedure discussed previously.
 Solution
¨ Step 1:; 3.5; 
¨ Step 2: we first obtain: =7.7;
¨ Step 3: we have and
¨ Step 4: recalculate the ordering frequency of the most frequently ordered model as
=11.47
¨ Step 5: ordering frequency for each product will be:
nL = 11.47/year, nM = 11.47/ 2 = 5.74/year, and nH = 11.47/5 = 2.29/year
¨ The annual holding cost of this policy is $65,383.50.
¨ The annual order cost is nS + nLsL + nMsM + nHsH = $ 65,383.50
¨ The total annual cost is thus equal to $130,767  cost reduction of $5,761 (4%) compared
with the joint ordering of all models. The cost reduction results because each model-specific
fixed cost of $1,000 is not incurred with every order.
Solution Summary
 1.2. Safety Inventory with Supply Uncertainty
¨ Supply uncertainty arises because of many factors:
¨ Production delays
¨ Transportation delays
¨ Quality problems
¨ Supply uncertainty  lead time uncertainty
¨ Assume:
¨ Demand per period  normal distribution
¨ Replenishment lead time  normal distribution
¨ Notations:
¨ D: average demand per period
¨ D: standard deviation of demand per period
¨ L: average lead time for replenishment
¨ SL: standard deviation of lead time
 Safety Inventory Supply Uncertainty (cont.)
¨If demand during the lead time> ROP  stock-
out
¨Assume demand during the lead time is normally
distributed with:

And with given CSL, we have:

𝑠𝑠 = 𝑁𝑂𝑅𝑀𝑆𝐼𝑁𝑉 (𝐶𝑆𝐿 )𝜎 𝐿
 Example
Daily demand for tablets at Amazon is normally distributed, with a
mean of 2,500 and a standard deviation of 500. The tablet supplier
takes an average of L = 7 days to replenish inventory at Amazon.
Amazon is targeting a CSL of 90 percent (providing a fill rate close
to 100 percent) for its tablet inventory. Evaluate the safety inventory
of tablets that Amazon must carry if the standard deviation of the
lead time is seven days. Amazon is working with the supplier to
reduce the standard deviation to zero. Evaluate the reduction in
safety inventory that Amazon can expect as a result of this initiative.
 Solution
¨ We have:
¨ Average demand per period, D = 2,500
¨ Standard deviation of demand per period, D = 500
¨ Average lead time for replenishment, L = 7 days
¨ Standard deviation of lead time, sL = 7 days
¨ We first evaluate the distribution of demand during the lead time.
¨ Mean demand during lead time, DL = D * L = 2,500 * 7 = 17,500
¨ Standard deviation of demand during lead time, =17,550
¨ The required safety inventory is
ss = NORMSINV(CSL) * L = NORMSINV(0.90) * 17,550 = 22,491 tablets
=
 2. Impact of Aggregation on Safety Inventory
How to reduce the supply chain costs by supply chain design/arrangement ?
¨ Inventory Centralization (Physical Aggregation)  WH combination
¨ Non-physical aggregations: information centralization, specialization, product
substitution.
¨ Postponement/delayed differentiation
¨ Resequencing
¨ Component commonality
¨ Modularity
¨ Standardization

¨ Economic packaging and transportation

¨ Concurrent and parallel processing
¨ Push-pull
 2.1. Centralized Inventory
¨ Consider k regions, with demand in each region
normally distributed with
¨ Di: mean weekly demand in region i, i = 1,…,k
¨ i: standard deviation of weekly demand in region i, i =
1, 2,…, k.
¨ ij: Correlation of weekly demand for regions i, j; 1≤ i ≠ j
≤k
¨ L: replenishment lead time
¨ CSL: desired cycle service level
𝑘
¨ Decentralized safety inventory: ∑
𝑠𝑠= 𝐹 𝑆 (𝐶𝑆𝐿)𝜎 𝑖−1
√
𝑖=1
 Centralized Inventory (cont.)
¨ The aggregate demand is normally distributed with:
𝑘 𝑘
𝐷 =∑ 𝐷𝑖 ;𝑣𝑎𝑟 𝐷 =∑ 𝜎 𝑖 +¿ ∑ 𝜌 𝑖𝑗 𝜎 𝑖 𝜎 𝑗 ;𝜎 𝐷= √ 𝑣𝑎𝑟 (𝐷 )¿
𝐶
( 𝐶
) 2 𝐶 𝐶

𝑖=1 𝑖=1 𝑖> 𝑗

¨ If all k regions have demand that is identically distributed with mean
D and standard deviation D, and  then:
𝐶
(*) 𝜌 → 𝜎 →  𝐷
¨ The required safety inventory on aggregation is
(**)
¨ Holding cost savings on aggregation per unit sold =
𝐹 ( 𝐶𝑆𝐿 ) 𝐻 √ 𝐿
( )
−1 𝑘
𝑆

𝐷
𝐶
× ∑ 𝜎𝑖 − 𝜎 𝐶
𝐷
𝑖=1
 Insights
¨ Characteristics:
¨ The safety inventory savings on aggregation increase with the desired
cycle service level CSL.
¨ The safety inventory savings on aggregation increase with the
replenishment lead time L.
¨ The safety inventory savings on aggregation increase with the holding
cost H.
¨ The safety inventory savings on aggregation increase with the
coefficient of variation (/D) of demand.
¨ The safety inventory savings on aggregation decrease as the
correlation coefficients increase
¨ Disadvantages:
¨ Increase in response time to customer order
¨ Increase in transportation cost to customer
 Example 1: Impact of Inventory
Aggregation
A BMW dealership has k = 4 retail outlets serving the entire Chicago area
(disaggregate option). Weekly demand at each outlet is normally
distributed, with a mean of D = 25 cars and a standard deviation of D = 5.
The lead time for replenishment from the manufacturer is L = 2 weeks.
Each outlet covers a separate geographic area, and the correlation of
demand across any pair of areas is . The dealership is considering the
possibility of replacing the four outlets with a single large outlet (aggregate
option). Assume that the demand in the central outlet is the sum of the
demand across all four areas. The dealership is targeting a CSL of 0.90.
Compare the level of safety inventory needed in the two options as the
correlation coefficient  varies between 0 and 1.
 Solution
¨ We provide a detailed analysis for the case when demand in each area is independent
(i.e.,  = 0). For each retail outlet we have:
¨ Standard deviation of weekly demand, D = 5
¨ Replenishment lead time, L = 2 weeks
¨ The required safety inventory in the decentralized option for CSL = 0.90 is

¨ Consider the aggregate option:

¨ Standard deviation of weekly demand at central outlet:

¨ For a CSL of 0.90 and  = 0, safety inventory required for the aggregated option is:

Safety inv saving = 36.25 -18.12 = 18 cars

 Example 2: Trade-Offs of Physical
Centralization
¨ An online retailer is debating whether to serve the United States through
four regional distribution centers or one national distribution center. Weekly
demand in each region is normally distributed, with a mean of 1,000 and a
standard deviation of 300. Demand experienced in each region is
independent, and supply lead time is four weeks. The online retailer has a
holding cost of 20 percent and the cost of each product is $1,000. The
retailer promises its customers next-day delivery. With four regional
distribution centers, the retailer can provide next-day delivery using ground
transportation at a cost of $10/unit. With a single national distribution
center, the retailer will have to use a more expensive mode of transport
that will cost $13/unit for next-day service. Building and operating four
regional DCs costs $150,000 per year more than building and operating
one national distribution center. What distribution network do you
recommend? Assume a desired CSL of 0.95.
 Solution
¨ D = 1,000pcs/week, D= 300, L = 4 weeks
¨ Given the desired CSL = 0.95, the required safety inventory across all four regional
distribution centers:

¨ Aggregate Option: Because demand in all four areas is independent,  = 0

For a CSL of 0.95, safety inventory required for the aggregate option:

¨ The effects of the changes in inventory, transportation, and facility costs on aggregation as
follows:
 2.2. Non-Physical Aggregation
Save inv. cost
¨ Information Centralization
¨ Specialization of Inventory Based on Product Type: The higher the
coefficient of variation of an item, the greater is the reduction in safety
inventories as result of centralization (Root cause: aggregation improves
forecast accuracy significantly)  Example 3

¨ Product Substitution.
¨ Manufacturer-driven one-way substitution
¨ Customer-driven two-way substitution
 Example 3
¨ Assume that W.W. Grainger, a supplier of MRO products, has 1,600
stores distributed throughout the United States. Consider two products—
large electric motors and industrial cleaner. Large electric motors are high-
value items with low demand, whereas the industrial cleaner is a low-value
item with high demand. Each motor costs $500 and each can of cleaner
costs $30. Weekly demand for motors at each store is normally
distributed, with a mean of 20 and a standard deviation of 40. Weekly
demand for cleaner at each store is normally distributed, with a mean of
1,000 and a standard deviation of 100. Demand experienced by each
store is independent, and supply lead time for both motors and cleaner is
four weeks. W.W. Grainger has a holding cost of 25 percent. For each of
the two products, evaluate the reduction in safety inventories that will
result if they are removed from retail stores and carried only in a
centralized DC. Assume a desired CSL of 0.95.
Solution
 2.3. Postponement/Delayed Differentiation
¨ A concept in supply chain management where the
manufacturing process starts by making a generic or family
product that is later differentiated into a specific end-product.
¨ A widely used method, especially in industries with high
demand uncertainty, and can be effectively used to address
the final demand even if forecasts cannot be improved.
¨ Implementing delayed differentiation:
¨Resequencing
¨Commonality
¨Modularity
¨Standardization
 A. Resequencing
¨Modifying the order of product manufacturing steps so
that those operations that result in the differentiation
of specific items or products are postponed as much
as possible.
Example:
Consumer preferences
change rapidly

=> Leave little flexibility to respond to the changing taste of the

customers
Postponement of dyeing process

=> Improve forecasts, lower surplus inventory, higher sales

 B. Commonality

Common components Customization

In some cases, the concepts of resequencing and commonality allow
some of final manufacturing steps to be completed at distribution
centers or warehouses instead of at the factory. => Advantage when
DCs are nearer to the market, customer service will be better.

Kelogg, Kraft  DKSH

 Example
Assume that Dell is to manufacture 27 servers with three distinct
components: processor, memory, and hard drive. Under the disaggregate
option, Dell designs specific components for each server, resulting in 3 * 27
= 81 distinct components. Under the common-component option, Dell
designs servers such that three distinct processors, three distinct memory
units, and three distinct hard drives can be combined to create 27 servers.
Each component is thus used in nine servers. Monthly demand for each of
the 27 servers is independent and normally distributed, with a mean of 5,000
and a standard deviation of 3,000. The replenishment lead time for each
component is one month. Dell is targeting a CSL of 95 percent for
component inventory. Evaluate the safety inventory requirements with and
without the use of component commonality. Also evaluate the change in
safety inventory requirements as the number of finished products of which a
component is a part varies from one to nine.
 Solution
¨ We first evaluate the disaggregate option, in which components are specific to a server.
For each component, we have:
Standard deviation of monthly demand = 3,000
¨ Given a lead time of one month and a total of 81 components across 27 servers, we
obtain:
Total safety inventory required = 81 * NORMSINV(0.95)* * 3,000 = 399,699 units
¨ In the case of component commonality, each component ends up in nine finished
products. Therefore, the demand at the component level is the sum of demand across
nine products. Using Equations (*) and (**), the safety inventory required for each
component is thus
Safety inventory per common component = NORMSINV(0.95)***3,000~ 14,804 units
¨ With component commonality, there are a total of nine distinct components. The total
safety inventory across all nine components is thus
Total safety inventory required = 9 * 14,803.68 = 133,233
¨ Thus, having each component common to nine products results in a reduction in safety
inventory for Dell from 399,699 to 133,233 units.
Benefit of Component Commonality
 C. Modularity
The degree to which a system's components may be separated and
recombined, often with the benefit of flexibility and variety in use

Example:

Color kit

Example: tire= wheel +rubber tire

 D. Standardization
• Replace a family of products by a standard product.

• Build in several of the possible options that particular customers

might need.

Example Power supply

110 Switchable
volts
Universal power
220 supply
volts
=> The customer can use the product in different countries.
 Example: Value of Postponement
¨ Consider a paint retailer that sells 100 different colors of paint.
Assume that weekly demand for each color is independent
and is normally distributed with a mean of 30 and a standard
deviation of 10. The replenishment lead time from the paint
factory is two weeks and the retailer aims for a CSL = 0.95.
How much safety stock will the retailer have to hold if paint is
mixed at the factory and held in inventory at the retailer as
individual colors? How does the safety stock requirement
change if the retailer holdpaint (supplied by the paint factory)
and mixes colors on demands base?
 Solution
¨ We first evaluate the disaggregate option without postponement, in which the retailer
holds safety inventory for each color sold. For each color, we have:
D = 30/week, D = 10, L = 2 weeks
¨ Given the desired CSL = 0.95, the required safety inventory across all 100 colors is
obtained using Decentralized Equation to be
Total required safety inventory, ss =
= 100 * NORMSINV(0.95) * SQRT(2) * 10 = 2,326
¨ Now, consider the option whereby mixing is postponed until after the customer orders.
Safety inventory is held in the form of base paint, whose demand is an aggregate of
demand of the 100 colors. Because demand in all 100 colors is independent,  = 0.
Using Equation (*), the standard deviation of aggregate weekly demand of base paint is
Standard deviation of weekly demand of base paint
= SQRT(k)*10=SQRT(100) * 10 = 100
¨ For a CSL of 0.95, safety inventory required for the aggregate option using Equation (**)
is given as:ss = = NORMSINV(0.95) * SQRT(2) * 100 = 233
¨ Observe that postponement reduces the required safety inventory at the paint retailer
from 2,326 units to 233 units.
 2.4. Economic packaging and transportation
Redesign of the products and packaging could help control logistics
costs
¨ Designing products so that they can be efficiently packed and stored

¨ “Well – packed” products (can be stored more compacted ) can help

reduce transportation cost.

¨ Reduce certain components of inventory cost

e.g. Large plastic items in discount store (garbage pails) are designed to
stack => take up less shelf/ floor space in the store.
Rice mill
 Economic packaging and transportation

¨ Shipping goods in bulk & only complete final packaging at the warehouse
or at the retailer
¨ Save transportation cost

E.g. Edible cooking: import palm oil  tanker ferry  filling capping
labeling  distribute

¨ Designing products to facilitate cross – docking

Example: sorter conveyor (youtube) , de-palletizer/palletizer: e-fulfillment

center
2.5. Processes
 A. Concurrent and Parallel Processing

Modifying the manufacturing process – which may also require

modification of product design.

¨ Concurrent and Parallel Processing: involves modifying the

manufacturing process so that steps that were previously
performed in a sequence can be completed at the same time.

⇒ Reduce manufacturing lead time, lower inventory costs, reduce

safety stock requirements
 Example

European Far East

Long production &
transportation lead
time ~ Large safety
stock in Europe

- Decrease lead time

- Serve to further
increase
responsiveness.
 B. The push- pull boundary
¨ In push based system, production decisions are based on
long – term forecast
Overstock, long
=> Take advantage of economies of scale leadtime
¨ In pull based system, production is demand driven.
⇒ Reduce lead time, inventory level, system cost Stockout
The delayed differentiation strategies: combination of push
and pull system?

PUSH SYSTEM PULL SYSTEM

3. Supplier integration into new product development

¨ Benefits from involving suppliers in the design process:

¨Materials costs
¨Material quality
¨Development time, manufacturing cost
¨Final product technology levels
 3.1. The spectrum of supplier integration
¨ None: The supplier is not involved in design. Materials and
subassemblies are supplied according to customer
specifications and design.
¨ White box: This level of integration is informal. The buyer
“consults” with the supplier informally when designing products
and specifications, although there is no formal collaboration.
¨ Grey box: This represents formal supplier integration.
Collaborative teams are formed between the buyer’s and
supplier’s engineers, and joint development occurs 
Ikea/scancom, Decathon/TBS, customers/Jabil
¨ Black box: The buyer gives the supplier a set of interface
requirements and the supplier designs and develops the
required components  iphone
 The spectrum of supplier integration
How to determine the appropriate level of supplier
integration?
- what is going
• Determine internal core competencies to procured
• Determine current and future new product from suppliers
development - what level of
• Identify external development and supplier
manufacturing needs. expertise is
appropriate
 The spectrum of supplier integration

If future products have components

which require expertise that the firm If the separation is
does not posses, and development of not possible
these components can be separated
from other phases of product
development

If the buyer has some design

expertise but wants to
ensure that the supplier can
adequately manufacture the
component
 3.2. Keys to effective supplier integration

¨Select supplier and build relationships with them

¨Align objectives with selected suppliers.