Supply Chain Transportation

Coordination

Book: Supply Chain Management, Chopra, Meindl, & Kalra,

[6th Ed]
Chapter 14: Transportation in a Supply Chain
Chapter 10: Coordination in a Supply Chain

Indranil Biswas
Operations Management Group
Office: Chintan, Room No. 211, Tel. 6663
Email: indranil@iiml.ac.in
Supply Chain Transportation: Trade off through inventory aggregation
Q 14-3: HighMed is a manufacturer of medical equipment based out of Madison, USA and directly
sells her products to the doctors in USA.
The company divides USA in 24 territories, each with its own sales team.
The products sold fall into 2 categories: HighVal and LowVal
Territory-wise demand and other details of the products are given below:
HighVal: Weekly Demand μH = 2, σH = 5, weight = 0.1 lbs, cost = $200
LowVal: Weekly Demand μL = 20, σL = 5, weight = 0.04 lbs, cost = $30
Cycle Service Level = 0.997, Holding Cost = 25% of price
Product inventories are maintained locally and replenished every 4 weeks (i.e. Reorder Interval, T =
4 weeks) by UPS.
Details of UPS delivery are: Lead Time = 1 week, Per lb Cost = $(0.66 + 0.26x) where x is the
number of lb shipped/ required to be shipped.
In addition to the current arrangement, the management is also considering the following 2 options.
Option A. Keep the current structure but replenish inventory once a week rather than once every
four weeks by UPS.
Option B. Eliminate inventories in the territories, aggregate all inventories in a finished-goods
warehouse at Madison, and replenish the warehouse once a week by FedEx. Details of FedEx
delivery are: Lead Time = overnight, Per lb Cost = $(5.53 + 0.53x). The factory requires 1 week
lead time to replenish goods at Madison and after aggregation, average customer order for HighVal
is 1 and that of LowVal is 10.
What should HighMed do?
 In this case we calculate reorder level (ROL)
ROL = lead time demand + safety stock
 ROL =D × L + sD × sqrt (L)
In this case, the service level is calculated as:
Service level =
Pr (LT×D < ROL) = Pr (LT<ROL/D)

In this case we calculate

Target Stock Level
In this case, it is the target stock (also
known as Order-up-to Level) that we
attempt to maintain.
OUL is chosen such that over a fixed
time window the service level is
maintained
 Periodic Review Policy of Inventory
(Recapitulation of Pre-Mid Term Concepts )

On-hand inventory = the number of units physically in inventory ready to serve demand.
Backorder = the total amount of demand that has not been satisfied:
(All backordered demand is eventually filled, i.e., there are no lost sales.)
Inventory level = On-hand inventory – Backorder
On-order inventory / pipeline inventory = the number of units that have been ordered but have
not been received.
Inventory position = On-order inventory + Inventory level
Order up-to level (S)
It is the maximum inventory position we allow.
Sometimes called the base stock level.
This is the target inventory level we want to have in each period before starting to deal with that
period’s demand.
Note: Inventory position incorporates the On-order/ pipeline inventory in the decision making as
well, which Inventory level does not.
Periodic Review Policy of Inventory
Order-up-to Level (OUL): It is the maximum inventory position or target
inventory level or base stock level.

(T+L) Protection Level/ Service Level

Time window

Periodic Review Policies: Lot size determined by pre-specified order-up-to level (OUL)
D: Average demand per period ; sD: Standard deviation of demand per period
L: Average lead time for replenishment; T: Review interval; CSL: Desired cycle service level
Periodic Review Policy of Inventory (contd.)

Service Level for (any) Review Policy of Inventory is governed by the following principle:
Service Level = Pr (No Shortage) = Pr (Demand ≤ Inventory)
Cycle Service Level = %age of a cycle without stock-out.
In the fixed period review cycle: Probability(demand during L + T ≤ OUL) = CSL
Therefore, the relevant formula of Periodic Review are calculated below:
DT  L  (T  L) D
Q  DT  D  T
s T L  s D T  L
OUL  DT  L  ss ss  FS–1 (CSL)  s D  L  NORMSINV (CSL)  s T  L
Supply Chain Transportation: Trade off through inventory aggregation
Observation: Transportation cost can be reduced by quantity aggregation as the cost structures of both
UPS and FedEx exhibit economies of scale.
However, the question is, how can we understand that?
Proof: The cost function is of the form: c(x) = a + bx
𝑑𝐶(𝑥)
The average cost is: AC(x) = c(x)/x = (a/x) + b and marginal cost is: MC(x) = =𝑏
𝑑𝑥
𝑀𝐶(𝑥) 𝑏
Therefore, = 𝑎 < 1 𝑎𝑠 𝑎 > 0 𝑎𝑛𝑑 𝑥 > 0 ⇒ 𝑀𝐶 𝑥 < 𝐴𝐶(𝑥)
𝐴𝐶(𝑥) 𝑏+
𝑥
From the aforementioned inequality we can say that economies of scale exists in the cost structures of
both UPS and FedEx.
Evaluation of the current scenario
Solving this problem requires application of the concepts discussed in (Fixed) Periodic Review Policy
of Inventory.
Part A: Calculation of Inventory Carrying Cost for HighMed
Number of territories (n): 24. Territory-wise demand and subsequent calculations are as follows:
HighVal: Weekly Demand μH = 2, σH = 5, 𝑤𝐻 = 0.1 lbs, 𝑝𝐻 = $200, ℎ𝐻 = 𝛼𝑝𝐻 = 0.25x$200 = $50
LowVal: Weekly Demand μL = 20, σL = 5, 𝑤𝐿 = 0.04 lbs, 𝑝𝐿 = $30, ℎ𝐿 = 𝛼𝑝𝐿 = 0.25x$30 = $7.5
Cycle Service Level (CSL) = 0.997, (Fixed) Reorder Interval T = 4 weeks, Lead Time, l = 1 week
Average Lot Size(s): HighVal: QH =T x μH = 4x2= 8; LowVal: QL =T x μL = 4x20= 80
Safety Inventories:
HighVal: ssH = 𝐹 −1 𝐶𝑆𝐿 × 𝑇 + 𝑙 × 𝜎𝐻 =NORMSINV(0.997)× 4 + 1 × 5 = 30.7 𝑎𝑝𝑝𝑟𝑜𝑥
LowVal: ssL = 𝐹 −1 𝐶𝑆𝐿 × 𝑇 + 𝑙 × 𝜎𝐿 =NORMSINV(0.997)× 4 + 1 × 5 = 30.7 (𝑎𝑝𝑝𝑟𝑜𝑥)
Supply Chain Transportation: Trade off through inventory aggregation
Part A: Calculation of Inventory Carrying Cost for HighMed (contd.)
Cycle Inventories: HighVal: CIH =QH /2 = 8/2 = 4; LowVal: CIL =QL /2 = 80/2 = 40
Total Inventories:
HighVal: TIH = CIH + ssH = 4 + 30.7 = 34.7; LowVal: TIL = CIL + ssL = 40 + 30.7 = 70.7
Total Inventory Carrying Cost(s):
HighVal: ICCH = hH x TIH = $50 x 34.7 = $1735; LowVal: ICCL = hL x TIL = $7.5 x 70.7 = $530.25
Therefore, across all 24 territories we have,
Annual Inventory Holding Cost = ($1735 + $530.25) x 24 = $ 54,366
Part B: Calculation of Shipment Cost for HighMed
Average Replenishment Orders:
This value is equal to Average Lot Sizes. Therefore we have,
HighVal: QH =T x μH = 4x2= 8; LowVal: QL =T x μL = 4x20= 80
Total weight of the shipment: QH x wH + QL x wL = (8 x 0.1 + 80 x 0.04) lbs = 4 lbs
Shipping Cost per Replenishment Orders: $(0.66 + 0.26 x 4) = $ 1.70
As Reorder Interval, T = 4 weeks, therefore in 1 year Total Number of Shipments = 52/ 4 = 13
Such Shipment has to happen across all 24 territories.
Thus, Annual Shipment Cost = $ 1.70 x 13 x 24 = $ 530.4

Therefore, Total Cost to HighMed due to current Replenishment & Transportation Policy:
$ 54,366 + $ 530.4 = $ 54,896.4
Supply Chain Transportation: Trade off through inventory aggregation
Evaluation of Option B
Solving this problem requires application of the concepts discussed in (Fixed) Periodic Review
Policy of Inventory and Inventory Pooling.
Part A: Calculation of Inventory Carrying Cost for HighMed
In this case, all the items are stocked centrally at Madison.
Therefore, Number of territories (n): 1. Demand and subsequent calculations are required to be done
on aggregate basis for the entire country.
Other relevant information are:
Cycle Service Level (CSL) = 0.997, (Fixed) Reorder Interval T = 1 week, Lead Time, l = 1 week
HighVal: Weekly Countrywide Calculation:
μH = 2x24 = 48, σH = 5x sqrt (24) = 24.49, 𝑤𝐻 = 0.1 lbs, 𝑝𝐻 = $200, ℎ𝐻 = 𝛼𝑝𝐻 = 0.25x$200 = $50
LowVal: Weekly Countrywide Calculation:
μL = 20x24 = 480, σL = 5x sqrt (24) = 24.49, 𝑤𝐿 = 0.04 lbs, 𝑝𝐿 = $30, ℎ𝐿 = 𝛼𝑝𝐿 = 0.25x$30 = $7.5
Average Lot Size(s): HighVal: QH =T x μH = 1x48= 48; LowVal: QL =T x μL = 1x480= 480
Safety Inventories:
HighVal: ssH = 𝐹 −1 𝐶𝑆𝐿 × 𝑇 + 𝑙 × 𝜎𝐻 =NORMSINV(0.997)× 1 + 1 × 24.49 = 95.2 𝑎𝑝𝑝𝑟𝑜𝑥
LowVal: ssL = 𝐹 −1 𝐶𝑆𝐿 × 𝑇 + 𝑙 × 𝜎𝐿 =NORMSINV(0.997)× 1 + 1 × 24.49 = 95.2 (𝑎𝑝𝑝𝑟𝑜𝑥)
Cycle Inventories: HighVal: CIH =QH /2 = 48/2 = 24; LowVal: CIL =QL /2 = 480/2 = 240
Total Inventories:
HighVal: TIH = CIH + ssH = 24 + 95.2 = 119.2; LowVal: TIL = CIL + ssL = 240 + 95.2 = 335.2
Supply Chain Transportation: Trade off through inventory aggregation
Total Inventory Carrying Cost(s):
HighVal: ICCH = hH x TIH = $50 x 119.2 = $5960
LowVal: ICCL = hL x TIL = $7.5 x 335.2 = $2514
Therefore, Annual Inventory Holding Cost = ($5960 + $2514) = $ 8,474
Part B: Calculation of Shipment Cost for HighMed
Average Replenishment Orders:
This value is equal to actual customer order. From the question we have,
HighVal: ROH = 1; LowVal: ROL = 10
Total weight of the shipment: ROH x wH + ROL x wL = (1 x 0.1 + 10 x 0.04) lbs = 0.5 lbs
Shipping Cost per Replenishment Orders: $(5.53 + 0.53 x 0.5) = $ 5.795
To meet weekly demands (2 and 20) number of shipments required in a week is = 2/1 = 2
As Reorder Interval, T = 1 week, and in 1 week number of required shipment is 2, therefore in 1
year Total Number of Shipments (for 1 location) = (52/ 1) x 2 = 52 x 2 = 104
Such 104 shipments are required across all 24 territories, hence Total Number of Shipments
required for HighMed = 104 x 24 = 2496
Thus, Annual Shipment Cost = $ 5.795 x 2496 = $ 14,464.32
Therefore, Total Cost to HighMed due to current Replenishment & Transportation Policy:
$ 8,474 + $ 14,464.32 = $ 22938.32
Supply Chain Transportation: Trade off through inventory aggregation

Current Scenario Option A Option B

Number of stocking locations 24 24 1
Reorder interval (weeks) 4 1 1
HighVal Cycle inventory 96 24 24
HighVal safety inventory 737.3 466.3 95.2
HighVal inventory 833.3 490.3 119.2
LowVal cycle inventory 960 240 240
LowVal safety inventory 737.3 466.3 95.2
LowVal inventory 1697.3 706.3 335.2
Annual inventory cost $ 54,395 $ 29,813 $ 8,473
Shipment type Replenishment Replenishment Customer order
Shipment size
Highval 8 2 1
LowVal 80 20 10
Shipment weight (lbs) 4 1 0.5
Number of shipments / year 13 52 2496
Annual transport cost $ 530 $ 1,148 $ 14,464
Total Annual Cost $ 54,926 $ 30,961 $ 22,938
Supply Chain Transportation: Trade off through inventory aggregation
Extension Problem:
If HighMed can convince the customers to order according to weekly average demand of one
territory (i.e. ordering 2 HighVal instead of 1 and 20 LowVal instead of 10), how does it change
your optimal cost calculation?
Answer:
Annual inventory cost remains unchanged.
Therefore, Annual Inventory Holding Cost = ($5960 + $2514) = $ 8,474
Calculation of Shipment Cost for HighMed changes and it is given below:
Average Replenishment Orders:
This value is equal to weekly average demand from each territory. From the question we have,
HighVal: ROH = 2; LowVal: ROL = 20
Total weight of the shipment: ROH x wH + ROL x wL = (2 x 0.1 + 20 x 0.04) lbs = 1.0 lbs
Shipping Cost per Replenishment Orders: $(5.53 + 0.53 x 1) = $ 6.06
To meet weekly demands (2 and 20) number of shipments required in a week is = 1
As Reorder Interval, T = 1 week, and in 1 week number of required shipment is 1, therefore in 1
year Total Number of Shipments (for 1 location) = (52/ 1) x 1 = 52 x 1 = 52
Such 104 shipments are required across all 24 territories, hence Total Number of Shipments
required for HighMed = 52 x 24 = 1248
Thus, Annual Shipment Cost = $ 6.06 x 1248 = $ 7,562.88
Therefore, Total Cost to HighMed due to current Replenishment & Transportation Policy:
$ 8,474 + $ 7,562.88 = $ 16,036.88
 Transportation in Supply Chain: Cross Docking

Amazon’s China subsidiary has received United States approval to ship ocean
freight for other companies. That could make it cheaper and easier for sellers on
Amazon to move goods from Chinese factories to Amazon’s American
warehouses.
With this move Amazon China could start “cross-docking” goods in United States
ports “for direct injection into Amazon’s courier network.”
–NY Times Report (January 14, 2016)

Wal-Mart receives goods from its vendors at loading docks and its massive
fleet of trucks take these to the warehouses, which are usually located in the
range of 130 miles from the stores.
For distribution purposes, Wal-Mart uses the technique of cross-docking to
reduce or (in some cases) eliminate the intermediate storage costs.
– (Too many articles have reported this news!)
Cross Docking – Points to remember
Cross-docking refers to the direct transfer of goods from vendor end (incoming
shipments) to warehouses (via outgoing vehicles) without any storage in between.

This practice can serve different goals:

(i) Consolidation of shipments (Capacity utilization of vehicles)
(ii) Shorter delivery lead time
(iii) Reduction of total costs (Delivery + ICC)
(iv) Usage of entire capacity of the truck ensures less emission
Note: Cross-docking is probably not the best strategy in every case and in all
circumstances.
Two major factors influence the decision of cross docking and they are as follows:

(1) Product Demand Rate: If there is an imbalance between the incoming load and
the outgoing load, cross-docking will not work well.
Hence, goods that are more suitable for cross-docking are the ones that have
demand rates that are more or less stable (e.g. grocery and regularly consumed
perishable food items).
For these products, the warehousing and transportation requirements are much
more predictable, and consequently the planning and implementation of cross-
docking becomes easier.
Cross Docking – Points to remember (contd.)
(2) Unit Stock-out Cost: As cross-docking minimizes the level of inventory at
the warehouse, the probability of stock-out situations is higher.

If the unit stock-out cost is low, the benefits of cross-docking can outweigh the
increased stock-out cost, and so cross-docking can still be the preferred
strategy.

Product Demand Rate

Stable & Constant Unstable/ Fluctuating
Cross-docking can be
Unit Stock-out

Traditional Distribution
High implemented with proper
preferred
Costs

systems & planning tools

Cross-docking can be
Low Cross-docking preferred implemented with proper
systems & planning tools
It’s OSCAR Time! 
 Supply Chain (Inventory) Coordination
“The more inventory a company has, the less likely they will have what they
need” – Taiichi Ohno
All business entities are worried about their inventory levels.
For most businesses, inventories represent a substantial portion of what the firm owns.
Changes in inventory levels will result in significant changes in both gross as well as net
profit levels.
Changes in inventory levels tend to be indicative of broader business trends and
therefore warrant close attention.
How does Wal-Mart continue to manage Every Day
Low Price (EDLP)?
Due to its large size, Wal-Mart enjoys strong negotiating power over her
vendors.
Wal-Mart offers long-term and high-volume purchase contracts to her vendors,
and is therefore able to negotiate the best prices. Several vendors are entirely
dependent on Wal-Mart for their business, which allows the retailer to squeeze
the best possible agreement from them.
Wal-Mart employs vendor-managed inventory (VMI) method, where her
suppliers are responsible for managing their goods inside the retailer’s (Wal-
Mart) warehouses.
As a result, inventory management becomes stronger and more vendor
specific, which results in 100% order fulfillment.
This strategies prevent the issues of inventory shortage or surplus, which helps
in reducing the cost of goods and services.
Her efficient supply chain has allowed Wal-Mart to become the price leader in
the U.S. retail market.
Forbes Report (September 9, 2014)
 Case 1: Decentralized Supply Chain
[No VMI Agreement between Supplier & Retailer]
Supplier Retailer Final Goods Market
(Produces FG) w (Sells FG) Market Demand: q = a – p

Supplier’s per unit Buyer’s per unit Retail Price: p = a – q

production cost: s cost: c = p(q)

w: Supplier’s per unit selling price

As in this model we are analyzing the effect of VMI on Supply Chain structure, therefore
we are going to explicitly incorporate the associated inventory costs (i.e. Ordering Cost &
Inventory Carrying Cost).
For this purpose, we assume the following: Total Inventory Cost
AS : Setup Cost of the Supplier of the Supplier:
hS : Per unit Inventory Carrying Cost of the Supplier   q   QS  
AB : Ordering Cost of the Retailer TC S QS    AS     hS 
  S Q 2  
h B : Per unit Inventory Carrying Cost of the Retailer Total Inventory Cost
Q S : Economic Order Quantity of the Supplier of the Retailer:
QB : Economic Order Quantity of the Retailer    
Q 
TC B QB    AB 
q
   B hB 
  QB   2  
 Case 1: Decentralized Supply Chain
[No VMI Agreement between Supplier & Retailer] (Contd.)
Supplier Retailer Final Goods Market
(Produces FG) w (Sells FG) Market Demand: q = a – p

Supplier’s per unit Buyer’s per unit Retail Price: p = a – q

production cost: s cost: c = p(q)
2 AS q
We can obtain, EOQ of the Supplier: QS* 
hS
 
Optimal Total Inventory Cost: TCS QS*  2 AS hS q
Similarly we obtain:
QB* 
2 AB q
hB
TCB Q  
*
B 2 AB hB q

If the Supplier orders according to her EOQ then her profit level is given by:
 S  w  s q  TCS QS*   w  s q  2 AS hS q
If the Retailer also orders according to her EOQ then her profit level is given by:
 B  pq  (w  c)q  TCB QB*   pq  (w  c)q  2 AB hB q
Total Profit of the Supply Chain is:  S   B  pq   s  cq   2A h q 
S S 2 AB hB q 
 Case 2: Decentralized Supply Chain
[VMI Agreement between Supplier & Retailer]
Supplier Buyer Final Goods Market
(Produces WIP) w (Produces FG) Market Demand: q = a – p

Supplier’s per unit Buyer’s per unit Retail Price: p = a – q

production cost: s production cost: c = p(q)

1. The Retailer enters into VMI agreement with the supplier. Therefore the supplier maintains
inventory at the Retailer’s end.
2. All the inventory related costs (of the retailer) are carried by the supplier.
3. As the incurred cost level increases, the supplier charges the buyer by a different per unit
wholesale price level
wVMI : Supplier’s per unit wholesale price under VMI agreement
Therefore, assuming supplier & retailer order according to their EOQ, we can calculate
 S VMI  wVMI  sq  2 AS  AB hS  hB q
their profit level(s) as follows:

 B VMI  pq   wVMI  c q

Observe:
1. The Retailer’s profit level does not incorporate inventory cost at all
2. The supplier is carrying the entire inventory cost, as well as the associated risk
3. Such an agreement can be enforced if and only if Retailer holds high bargaining power
Comparison between VMI & Non-VMI Supply Chains
Now, we compare the overall supply chain profits of VMI and non-VMI supply chain.
In order to get into comparable terms we assume that the supplier follows the EOQ of the
*
Retailer, i.e. (Q B )
 S VMI   B VMI    S   B     
2 AB hB q  TCS QS  QB*  2 AS  AB hS  hB q
   q   hS  *  
  2 AB hB q   AS  *    QB    2 AS  AB hS  hB q
   Q B   2   
AB hB q  AS hS   A  h 
     2 AB hB q 1  S 1  S 
2  AB hB   AB  hB 
2
 1 1

1   AS  2  hS  2
 0
 2 AB hB q 1    1  
 

2 AB   hB  
Thus algebraic simplification yields:
 S VMI   B VMI    S   B 
Observe: We have arrived at this conclusion without optimizing either supplier’s profit or
retailer’s profit
Example Problem
A supply chain consists of a supplier and a retailer. The details about ordering costs and
holding costs of these firms, marginal costs of production, annual demand, wholesale
prices are as follows:
AS  45; AB  3; hS  8; hB  1; q  60,000; p  50; s  10; c  5; w  15, wVMI  20
Assume that, without VMI agreement, the supplier follows retailer’s EOQ decision.
Calculate, the increase in profit level by implementing VMI
Comment whether the aforementioned wholesale price (with VMI) is a correct price point.
If we implement VMI, the supply chain profit increases by:
2
1  A h 
2 AB hB q  1  S  1  S  = 300
2  AB hB 

Without VMI
Supplier’s profit: (15 – 10)x60,000 – [45x(60,000/600)+(8/2)x600] = 2,93,100 (as EOQ of
retailer = 600)
Retailer’s profit: {50 – (15+5)}x60,000 – sqrt. (2x3x1x60,000) = 17,99,400
With VMI
Supplier’s profit: (20 – 10)x60,000 – sqrt. [2x(45+3)x(8+1)x60,000] = 5,92,800 (!!!)
Retailer’s profit: {50 – (20+5)}x60,000 = 15,00,000 (!!!)
Now calculate using w(VMI) = 15.005
Supplier’s profit: 2,93,100
Retailer’s profit: 17,99,700 (retailer captures that extra 300!)
Points to remember about VMI

1. VMI will reduce the total inventory-related cost of the whole system
(Retailer and Supplier together).
2. VMI will increase the supplier’s inventory-related costs.
3. In the short-term, the buyer’s profit level will always be increased after
VMI. The supplier’s profit could be decreased. Supplier’s profit level can
increase only if she can enforce a suitable contractual agreement.
4. The purchase quantity of the Retailer with VMI agreement is higher than
that without VMI agreement.
 How to copy the Wal-Mart model?

Although Wal-Mart’s methodologies are well known to other logistics

providers, just a handful of retailers have achieved them.
Copying the model is not easy because of the high initial costs, huge inventory
levels involved, and assurance of high sales.
Simply, no other chain can attain this scale.
Rank Store 2013 U.S. Sales Sales Growth
(000)
(’13 vs. ’12)
1 Wal-Mart $334,302,000 1.7%
2 Kroger $93,598,000 1.6%
3 Costco $74,740,000 5.2%
4 Target $71,279,000 – 0.9%
5 The Home Depot $69,951,000 6.6%
Data Source(s): Forbes, IBT
How is this relevant in Indian Retail scenario?

Marico's organizational goal of ‘constant innovation’ led it to focus on the

introduction of a large number of newer brands in its supply chain.

The company also anticipated that each of these new products might not get
adequate attention from dealers because of (initial) smaller volumes and
uncertain demand.

Marico solved this problem by introducing Vendor Managed Inventory (VMI)

system whose primary objective was to provide greater support to newer
brands at the dealer end and not solely reduce inventory.

Attempts to replicate this across several sectors like retail, electronics

components, textiles and automobile manufacturing in India have taken place
over the last 10 years with Marico Industries Limited, Shoppers Stop, Future
Group, Nokia India, Maruti Udyog Limited, Mahindra & Mahindra
 Indian Railway Budget 2016

Mission PACE (Procurement and Consumption Efficiency): This mission

aims to improve procurement and consumption practices of Indian Railways to
improve the quality of goods and services.

It will introduce a culture of optimum usage by adopting practices such as

Vendor Managed Inventory, new procedures for identification and disposal of
scrap, etc.

Adoption of new procurement and consumption practices will lead to an

estimated saving of more than Rs 1,500 Crore in 2016-17.
Numerical Problem from Supply Chain Coordination
Question: A retailer faces market demand: q = 100 – 2p, where p is the retail price of the
product. The marginal production cost of the retailer is $1/unit. The retailer procures the
product from a supplier. The supplier has a marginal production cost: $3/ unit and she sells
the product to the retailer at a price point: $5/ unit.
(i) Calculate the optimal retail price.
(ii) Calculate the profits made by the retailer and the supplier.
(iii) Comment whether the wholesale price is optimal.
Answer (i): The retailer’s profit function is: R  p  1  5100  2 p   2 p  650  p 
The optimal retail price set by the retailer is calculated from the first order condition as
follows:  R
 250  p    p  6  0  2 p  56  p*  28
p
Answer (ii): The retailer’s profit:  R  28  6 100  2  28  22  44  968
The supplier’s profit:  S  w  s q  w  s 100  2 p   5  3100  2  28  2  44  88
Answer (iii): The wholesale price ($5/ unit) is not optimal as the optimal wholesale price
should be:
w  a  bs  c   100  2  3  1  1  104  26
1 1
2b 22 4
Under optimality the order quantity should be:
q*  a  bs  c   100  2  3  1   92  23
1 1 1
4 4 4
a  q 100  23
*
p*    38.5
b 2
Numerical Problem from Supply Chain Coordination (contd.)
At p = 38.5 and q = 23, the profits of retailer and supplier are as follows:
R 
1
a  bs  c 2  1 100  2  3  12  264.5
16b 16  2
 S  a  bs  c 2  100  2  3  12  529
1 1
8b 82
Cross verification of the result:
 R  p  w  c q  38.5  26  1 23  264.5  S  w  s q  26  3  23  529
Observation: Though the given wholesale price is not optimal from the point of view of
the supplier, it helped the overall supply chain to gather more profit compared to the
optimal case, as seen.
 DC   S   R  529  264.5  793.5
Previously computed total profit was:  DC   S   R  88  968  1056
The centralized profit in this case is:
 C  a  bs  c 2  100  2  3  12  1058
1 1
4b 42
Observation(s):
(a) If we observe the given problem statement, we can see that, w ≈ s.
(b) It made the supply chain behave (almost) like a centralized supply chain.
(c) As a result the overall supply chain profit increased even compared to an optimal
decentralized supply chain.
(d) However, the profit of the supplier was heavily reduced and that of the retailer
increased compared to an optimal decentralized supply chain.