Slide #

Matching Supply with Demand:

An Introduction to Operations Management

Grard Cachon
ChristianTerwiesch
All slides in this file are copyrighted by Gerard Cachon and Christian
Terwiesch. Any instructor that adopts Matching Supply with
Demand: An Introduction to Operations Management as a required
text for their course is free to use and modify these slides as desired.
All others must obtain explicit written permission from the authors to
use these slides.
Slide #
Assemble-to-order, make-to-order and Quick
Response with reactive capacity
Slide #
The demand-supply mismatch cost
Definition the demand supply mismatch cost includes the cost of left over
inventory (the too much cost) plus the opportunity cost of lost sales (the
too little cost):



For Hammer 3/2:
The maximum profit is the profit without any mismatch costs, i.e., every unit
is sold and there are no lost sales:


The mismatch cost can also be evaluated with


For the Hammer 3/2:
( )
( ) sales lost Expected C
inventory over left Expected C cost Mismatch
u
o
+
=
( ) = c p profit Maximum
Mismatch cost = Maximum profit Expected profit
( ) 680 , 31 $ ) 150 70 ($ 1059 20 $ = + = cost Mismatch
( ) 440 , 223 $ 3192 110 $ 180 $ = = profit Maximum
680 , 31 $ 760 , 191 $ 440 , 223 $ = = cost Mismatch
Slide #
When is the mismatch cost cost high?
Hammer 3/2s mismatch cost as a percentage of the maximum profit is
$31,680/$223,440 = 14.2%

Mismatch cost as a percent of the maximum profit increases as
(1) the coefficient of variability of demand increases
(2) the critical ratio decreases



Coefficient
of variation 0.4 0.5 0.6 0.7 0.8 0.9
0.10 10% 8% 6% 5% 3% 2%
0.25 24% 20% 16% 12% 9% 5%
0.40 39% 32% 26% 20% 14% 8%
0.55 53% 44% 35% 27% 19% 11%
0.70 68% 56% 45% 35% 24% 14%
0.85 82% 68% 55% 42% 30% 17%
1.00 97% 80% 64% 50% 35% 19%
Critical ratio
Slide #
High demand uncertainty gives high mismatch costs
The coefficient of variation, o/, is a better measure of demand uncertainty
than the standard deviation alone:
The probability demand is within 20% of the forecast demand depends
on the coefficient of variation (COV) and not the standard deviation:



Normal demand, = 20, o = 10, COV =0.5
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
0 4 8 12 16 20 24 28 32 36 40
Demand
P
r
o
b
a
b
i
l
i
t
y
31%
20%
Normal demand, = 60
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
10 20 30 40 50 60 70 80 90 100 110
Demand
P
r
o
b
a
b
i
l
i
t
y
95% 31%
o = 10
COV = 10 / 60 = 0.17
o = 30
COV = 30 / 60 = 0.5
20%
Slide #
Reactive capacity
Slide #
Unlimited, but expensive reactive capacity
TEC charges a premium of 20% per unit ($132 vs. $110) in the second
order.
There are no restrictions imposed on the 2
nd
order quantity.
ONeill forecast of total season sales is nearly perfect after observing initial
season sales.
How many units should ONeill order in October?
Slide #
Apply Newsvendor logic even with a 2
nd
order
option
The too much cost remains the same:
C
o
= c v = 110 90 =20.

The too little cost changes:
If the 1
st
order is too low, we cover the difference with the 2
nd
order.
Hence, the 2
nd
order option prevents lost sales.
So the cost of ordering too little per unit is no longer the gross margin, it
is the premium we pay for units in the 2
nd
order.
C
u
= 132 110 = 22

Critical ratio:


Corresponding z-statistic u(0.05)=0.5199, u(0.06)=0.5239, so z = 0.06.




5238 . 0
22 20
22
=
+
=
+
u o
u
C C
C
3263 1181 06 . 0 3192 = + = + = o z Q
Slide #
Profit improvement due to the 2
nd
order option
With a single ordering opportunity:
Optimal order quantity = 4101 units
Expected profit = $191,760
Mismatch cost as % of revenue = 4.9%

The maximum profit is unchanged = $223,440

With a second order option:
Optimal order quantity = 3263 units





Reduction in mismatch cost = 38% (19,774 vs 31,680)
Mismatch cost as % of revenue = 3.1%
( )
( )
( ) ( )
666 , 203 $
437 22 $ 508 20 $ 440 , 223 $
=
=

=
quantity ent replenishm second Expected C
inventory over lef t Expected C - prof it Maximum prof it Expected
u
o
Slide #
Limited reactive capacity
Units in the 2
nd
order are no more expensive than in the 1
st
order
But there is limited capacity for a 2
nd
order
Slide #
Sample of wetsuits
1
st
order must be at least 10,200 suits so that there is enough capacity for
the 2
nd
order.

What should we produce in the 1
st
order?
Sport Model
o o /
Price Margin Discount
DIVE DIVE COMP 3/2 FULL 1100 660 0.60 120 38% 65%
DIVE WMS 7000X 7MM FULL 600 360 0.60 275 38% 65%
SURF EPIC 5/3 W/HD 800 296 0.37 225 38% 50%
SURF HEAT 3/2 1200 444 0.37 110 38% 50%
SURF HEATWAVE 4/3 700 259 0.37 140 38% 50%
SURF ZEN-ZIP 4/3 3100 1147 0.37 165 38% 50%
TRIATHLON TRIATHLON 4/3 FULL 2600 1690 0.65 210 45% 65%
WAKE-BOARD REACTOR 3/2 1500 750 0.50 150 45% 65%
WINDSURF CYCLONE 4/3 950 665 0.70 325 45% 65%
WINDSURF WMS EVOLUTION 4/3 850 595 0.70 275 45% 65%

= expected demand
o
= standard deviation of demand
Price = wholesale price
Margin = gross margin as a % of price
Discount = anticipated end of season discount as % of price to sell left over inventory

Slide #
Profit and mismatch with only 1 ordering
opportunity
Use the Newsvendor model to evaluate the optimal order quantity, expected
profit, maximum profit and mismatch cost










A suits produced in the 1
st
order earns the Newsvendor profit but a suit
produced in the 2
nd
order earns the maximum profit.
Sport Model
Order
quantity
Expected
profit
Maximum
profit
Mismatch
cost
DIVE DIVE COMP 3/2 FULL 1241 $30,086 $50,160 $20,074
DIVE WMS 7000X 7MM FULL 677 $37,608 $62,700 $25,092
SURF EPIC 5/3 W/HD 1009 $58,048 $68,400 $10,352
SURF HEAT 3/2 1514 $42,568 $50,160 $7,592
SURF HEATWAVE 4/3 883 $31,604 $37,240 $5,636
SURF ZEN-ZIP 4/3 3910 $164,953 $194,370 $29,417
TRIATHLON TRIATHLON 4/3 FULL 3449 $164,582 $245,700 $81,118
WAKE BOARD REACTOR 3/2 1877 $75,536 $101,250 $25,714
WINDSURF CYCLONE 4/3 1284 $89,538 $138,938 $49,399
WINDSURF WMS EVOLUTION 4/3 1149 $67,788 $105,188 $37,399
Total 16993 $762,311 $1,054,105 $291,794

Slide #
Produce safer products early, produce risky
products with reactive capacity
Sort items by their mismatch cost to order quantity ratio.
Fill the 1
st
order up to the minimum quantity (10,200) with the items that
have the lowest mismatch quantity ratio











The mismatch cost is reduced by 66%!
Model
Order
quantity
Newsvendor
expected
profit
Mismatch
cost
Mismatch cost-
order quantity
ratio
First order
quantity Profit
HEAT 3/2 1514 $42,568 $7,592 5.0 1514 $42,568
HEATWAVE 4/3 883 $31,604 $5,636 6.4 883 $31,604
ZEN-ZIP 4/3 3910 $164,953 $29,417 7.5 3910 $164,953
EPIC 5/3 W/HD 1009 $58,048 $10,352 10.3 1009 $58,048
REACTOR 3/2 1877 $75,536 $25,714 13.7 1877 $75,536
DIVE COMP 3/2 FULL 1241 $30,086 $20,074 16.2 1241 $30,086
TRIATHLON 4/3 FULL 3449 $164,582 $81,118 23.5 0 $245,700
WMS EVOLUTION 4/3 1149 $67,788 $37,399 32.6 0 $105,188
WMS 7000X 7MM FULL 677 $37,608 $25,092 37.1 0 $62,700
CYCLONE 4/3 1284 $89,538 $49,399 38.5 0 $138,938
Total 16993 $762,311 $291,794 10434 $955,320