ISOM3770 Tutorial 5
Risk Pooling
KLF Electronics is an American manufacturer of electronic equipment. The company has a single
manufacturing facility in San Jose, California. KLF Electronics distributes its products through five
regional warehouses located in Atlanta, Boston, Chicago, Dallas, and Los Angeles. In the current
distribution system, the United States is partitioned into five major markets, each of which is served by a
single regional warehouse. Customers, typically retail outlets, receive items directly from the regional
warehouse in their market. That is, in the current distribution system, each customer is assigned to a
single market and receives deliveries from one regional warehouse.
The warehouses receive items from the manufacturing facility. Typically, it takes about two weeks to
satisfy an order placed by any of the regional warehouses. Currently, KLF provides their customers with
a service level of about 90 percent. In recent years, KLF has seen a significant increase in competition
and huge pressure from their customers to improve the service level and reduce costs. To improve the
service level and reduce costs, KLF would like to consider an alternative distribution strategy in which
the five regional warehouses and replaced with a single, central warehouse that will be in charge of all
customer orders. This warehouse should be one of the existing warehouses. The company CEO insists
that whatever distribution strategy is used, KLF will design the strategy so that service level is increased
to about 97.72 percent.
Table 2-11
Historical Data
Week
1 2 3 4 5 6 7 8 9 10 11 12
Atlanta 33 45 37 38 55 30 18 58 47 37 23 55
Boston 26 35 41 40 46 48 55 18 62 44 30 45
Chicago 44 34 22 55 48 72 62 28 27 95 35 45
Dallas 27 42 35 40 51 64 70 65 55 43 38 47
Los 32 43 54 40 46 74 40 35 45 38 48 56
Angeles
Table 2-12
Transportation Costs Per Unit Product
Warehouse Inbound Outbound
Atlanta 12 13
Boston 11.50 13
Chicago 11 13
Dallas 9 13
Los Angeles 7 13
Table 2-13
Transportation Costs Per Unit In Centralized System
Warehouse Atlanta Boston Chicago Dallas Los Angeles
Atlanta 13 14 14 15 17
Boston 14 13 8 15 17
Chicago 14 8 13 15 16
Dallas 15 15 15 13 8
Los Angeles 17 17 16 8 13
Answer the following three questions:
a. A detailed analysis of customer demand in the five market areas reveals that the demand in the five
regions is very similar; that is, it is common that if weekly demand in one region is above average, so is
the weekly demand in the other regions. How does this observation affect the attractiveness of the new
system?
b. To perform a rigorous analysis, you have identified a typical product, Product A. Table 2-11 provides
historical data and includes weekly demand for this product for the last 12 weeks in each of the market
areas. An order (placed by a warehouse to the factory) costs $5,550 (per order), and holding inventory
costs $1.25 per unit per week. In the current distribution system, the cost of transporting a product from
the manufacturing facility to a warehouse is given in Table 2-12 (see the column “Inbound”). Table 2-12
also provides information about transportation cost per unit from each warehouse to the stores in its
market area (see the column “Outbound”). Finally, Table 2-13 provides information about
transportation costs per unit product from each existing regional warehouse to all other market areas,
assuming this regional warehouse becomes the central warehouse.
Suppose you are to compare the two systems for Product A only; what is your recommendation? To
answer this question, you should compare costs and average inventory levels for the two strategies
assuming demands occur according to the historical data. Also, you should determine which regional
warehouse will be used as the centralized warehouse.
c. It is proposed that in the centralized distribution strategy, that is, the one with a single warehouse,
products will be distributed using UPS Ground Service, which guarantees that products will arrive at the
warehouse in three days (0.5 week). Of course, in this case, transportation cost for shipping a unit
product from a manufacturing facility to the warehouse increases. In fact, in this case, transportation
costs increase by 50 percent. Thus, for instance, shipping one unit from the manufacturing facility to
Atlanta will cost $18. Would you recommend using this strategy? Explain your answer.