Chapters 17 and 18 Business Dynamics by John D. Sterman

Chapters 17 and 18 Business Dynamics by John D. Sterman
Supply Chains and the Origin of Oscillations 9/20/2018 Chapters 17 and 18 in Sterman

Chapters 17 and 18 in Sterman
Chapter outline What is a supply chain? Supply Chains in Business and Beyond The Stock Management Problem The Stock Management Structure Origin of Oscillations Summary 9/20/2018 Chapters 17 and 18 in Sterman

Homework: Work through the METROPOLITAN AREA DYNAMICS problem in the homework collection Work the challenge questions on pages 674 and 675—questions 1 through 7 9/20/2018 Chapters 17 and 18 in Sterman

§ What is a supply chain? A supply chain (SC) is the set of structures and processes an organization uses to deliver an output to a customer tangible or intangible product Typically, supply chains consist of Stock and flow structures for the acquisition of the inputs to the processes, and Management policies governing the various flows 9/20/2018 Chapters 17 and 18 in Sterman

Why study SC Dynamics? SCs often exhibit persistent and costly instability Many business and social systems are notorious for producing counter intuitive behavior (Forrester, Sterman) Understanding the behavior of SCs under important contexts is imperative for better management (Recall–Mental Models’ limitations- first week’s lesson) 9/20/2018 Chapters 17 and 18 in Sterman

The bane of Supply Chains—Uncertainty
Uncertainty in the forecast Uncertainty in procurement details lead time Procurement amount Procurement product quality 9/20/2018 Chapters 17 and 18 in Sterman

How to deal with the Uncertainty—buffer it with INVENTORY or reduce it with IT
What is IT? But this totally changes the dynamics of the SC System Information Technology 9/20/2018 Chapters 17 and 18 in Sterman

Without VISIBILITY… Supply chains exhibit a behavior called simply the hockey-stick phenomenon 9/20/2018 Chapters 17 and 18 in Sterman

Approach-some premises
Stock management structure is used to explain origin of oscillation Preconditions for oscillation are-negative feedbacks and time delays present in the system (recall-desired inventory model) Delays are simple enough to notice, yet are often omitted in decision making (experimental evidence supports) 9/20/2018 Chapters 17 and 18 in Sterman

§ SCs in Business and Beyond
SC extend beyond the boundaries of a firm (organization) and include the suppliers, distribution channels, and the customers (Recall-definition of a SC) SD models need to include these players as well, to the extent the flows and rules within the firm cause feedback from these players giving rise to further dynamics in behavior of stocks SCs are not limited to business--consider human body- supply of glucose for energy-consumption-food ingestion-digestion-storage-consumption etc forms one big supply chain 9/20/2018 Chapters 17 and 18 in Sterman

SC-what to expect? SC-to provide right output at right time As requirements change, adjustments in flow rates are initiated-and the negative feedback loop is at work! Production and inventories chronically overshoot and undershoot (17.1) Due to time delays-SCs are prone to oscillate Amplitude of fluctuations increases as they propagate from customer to supplier- each upstream stage lags behind its customer Oscillation, amplification, and phase lag are pervasive in SCs 9/20/2018 Chapters 17 and 18 in Sterman

SC Dynamics Understanding Process
Understand the internal dynamics and structure within the firm Understand the dynamics and structure outside the firm 9/20/2018 Chapters 17 and 18 in Sterman

§ Stock Management Problem
Consider a single firm structure Desired versus actual state-of stock Typically, outflow rate is independent Managers need to regulate inflow to keep the stock level close to desired level We all deal with such feedback loops- adjust temperature in shower, manage checking account balance, credit card account balance, etc 9/20/2018 Chapters 17 and 18 in Sterman

The problem Two parts: Structure and Rules If there is no delay in acquisition (instantaneous replenishments) Stock to be controlled S is the accumulation of AR and LR S=INTEGRAL(AR-LR, Sto) (17-1 pp 668) 9/20/2018 Chapters 17 and 18 in Sterman

We have studied this structure before…
9/20/2018 Chapters 17 and 18 in Sterman

This is just a Balancing Loop…

It gave us Balancing Loop behavior that looked like this…
Called Exponential Goal-Seeking 9/20/2018 Chapters 17 and 18 in Sterman

We can re-arrange this model ….
Without changing behavior… Here, AS = (S* - S) / SAT and AR = AS 9/20/2018 Chapters 17 and 18 in Sterman

We still get the same exact behavior…

Now, we add a Loss Rate Akin to a Sales Rate, a Depreciation Rate or whatever… 9/20/2018 Chapters 17 and 18 in Sterman

Now we see the problem…. 9/20/2018 Chapters 17 and 18 in Sterman

Let examine the Acquisition Rate…

How does the Acquisition Rate look in relation to the Loss Rate?

The problem is Stock S…. Will never reach the Desired Stock S*, but will always differ from it by a significant amount—600 units in this case Notice that, in steady state, the Acquisition Rate settles down to the Loss Rate 9/20/2018 Chapters 17 and 18 in Sterman

Loss Rate - LR Loss Rate -outflow rate- may arise from usage (material or wip) or decay (depreciation) and must depend on stock itself (also to prevent negative draining) LR may depend on exogenous variables X LR may depend on endogenous variables U LR = ƒ (S, X, U) … (17-2 pp 668) 9/20/2018 Chapters 17 and 18 in Sterman

The Loss Rate… LR = IF THEN ELSE( Stock S > 0 , Variables XU , 0 ) 9/20/2018 Chapters 17 and 18 in Sterman

How can we fix the problem we just observed….
Namely, that the Stock S will always differ from the Desired Stock S* by the amount of the Loss Rate LR???? This will make inventory managers very unhappy because they cannot achieve their targeted service levels—many customers will arrive to buy but no stock will be available 9/20/2018 Chapters 17 and 18 in Sterman

A way to fix the problem Create a new variable called the DAR—Desired Acquisition Rate… DAR = Adjustment for Stock + Loss Rate DAR = AS + LR 9/20/2018 Chapters 17 and 18 in Sterman

Here DAR = AS + LR 9/20/2018 Chapters 17 and 18 in Sterman

A better way… 9/20/2018 Chapters 17 and 18 in Sterman

We can always… Reconstruct the information created in a rate elsewhere without having to take information directly from a rate, as Sterman does here 9/20/2018 Chapters 17 and 18 in Sterman

Now let’s look at Behavior…

Acquisition Rate - AR Typically production requires use of resources, hiring requires efforts-or time delays If no such delays- refer to model (pp 669) AR=MAX(0, DAR) (17-3 pp 668) Max function coupled with 0 ensures positive or zero AR-prevents –ve AR If excess units are returnable, that needs to me modeled separately and not by –ve AR 9/20/2018 Chapters 17 and 18 in Sterman

If Desired stock changes
Adjustment for stock AS needs to change Consider example STOCKMGT.MDL from chapter 17 or 17-4 on pp 669 Desired acquisition rate formulation can depend on several factors- this needs to be modeled based on information available to managers- typically managers use heuristic rules (falls under ‘Bounded Rationality’ domain) DAR=EL+AS (17-4 pp 670) EL=expected loss (= LR here) AS=Desired-actual/time delay (=0 here) 9/20/2018 Chapters 17 and 18 in Sterman

EL and AS formulations Actual Loss is difficult to measure-prone to change-hence EL-avg In certain situations LR may not be directly observable or measurable-must be estimated-introducing measurement, reporting and perception delays- think about trend in sales Creates a negative Stock control feedback loop- simplest form-linear AS = (S* - S)/SAT (17-5 pp 671) SAT= Stock adjustment time S* =desired stock level-(could be a CONSTANT or variable) 9/20/2018 Chapters 17 and 18 in Sterman

§ Steady State Error Omission of EL in DAR leads to Steady State error- stock differs with desired value even in equilibrium Production=(DI-I)/IAT …(17-6 pp671) Equilibrium condition: Production=shipments Production=(DI-I)/IAT=shipments… (17-7) I=DI-Shipments*IAT … (17-8) When in equilibrium the Inventory will be lower than Desired Inventory 9/20/2018 Chapters 17 and 18 in Sterman

Fix for Steady State Error
Including the EL in the production decision will fix this steady state error Production=AvgOR+(DI-I)/IAT…(17-6a) Equilibrium: Avg Orders= Actual Orders, I=DI, and Orders=Shipments Avg OR- to smooth out sharp spikes- and avoid costly changes in production Evidence suggests that managers do include EL in production decisions 9/20/2018 Chapters 17 and 18 in Sterman

Managing a Stock: Behavior
Consider example-Plant & Equipment Avg life time = 8yrs Delays in reporting negligible EL=AL Adjustment time = 3 yrs (Senge, 1978) Desired Capital stock=exogenous; it depends on demand for firm’s products Net Change in Capital Stock= (S*-S)/SAT (17-9)- the first order linear negative feedback system 9/20/2018 Chapters 17 and 18 in Sterman

System response to a change
Step (1, .20) produces changes in AR Amplification in AR-for a mere 20% increase in desired stock 19.2/12.5%= 53% at peak Amplification - temporary- disequilibrium stage If stock is to increase then AR>LR Since AR=receipts from suppliers- a 20% increase in the operations impacts supplier more than the firm (although temporarily) Try at least 3 tests suggested on page 674 (#4 in particular) 9/20/2018 Chapters 17 and 18 in Sterman

BOT Chart of Stock 9/20/2018 Chapters 17 and 18 in Sterman

BOT Chart of rates 9/20/2018 Chapters 17 and 18 in Sterman

§ The Stock Mgmt Structure
Delay between order and acquisition Capital stock-construction/delivery time Workforce-hiring /training time Supply Line introduced-refer model (pp 676) SL=INTEGRAL(OR-AR, SLto )…(17-10 pp 675) AR=L(SL, AL) …(17-11 pp 675) AL =ƒ(SL, X, U) …(17-12 pp 675) L() denotes the material delay Typically average acquisition lag is relatively constant until requisition rate exceeds capacity 9/20/2018 Chapters 17 and 18 in Sterman

The Stock Mgmt Structure…
Typically, OR=Max(0,IO) …(17-13) Cancellations of orders need to be modeled as distinct outflows from SL IO=DAR+ASL … (17-14) ASL=(SL*-SL)/SLAT similar to AS ..(17-15) SL*=EAL * DAR …(17-16) Managers use SL*=EAL*EL …(17-16a) not sophisticated- instead use avg loss rate Revised DAR=MAX(0,EL+AS) …(174a) To ensure a non negative DAR 9/20/2018 Chapters 17 and 18 in Sterman

Oscillations—how do we get them??
Oscillations require delays, which involve additional stocks (states) Negative Feedback systems without delays will not oscillate Delays between corrective actions and their effects create a supply line of corrections that have been initiated but not yet had their impact 9/20/2018 Chapters 17 and 18 in Sterman

More on oscillations To oscillate the time delay must be at least partially ignored Managers must continue to initiate corrective actions in response to the perceived gap between the desired and actual state of the system, even after sufficient corrections to close the gap are in the pipeline 9/20/2018 Chapters 17 and 18 in Sterman

The Beer Distribution Game
Originally developed by Forrester in the 1950’s Consists of a supply chain of four entities Retailer Wholesaler Distributor Factory Each entity has the same exact structure 9/20/2018 Chapters 17 and 18 in Sterman

One person assumes the role of each entity At each stage there are order processing and shipping delays Each player’s objective is to minimize holding costs and stock costs Holding costs run $.50 per case per week Stockout costs run $1.00 per case per week 9/20/2018 Chapters 17 and 18 in Sterman

Incoming orders deplete inventory Players must try to maintain a ‘desired’ inventory Pattern for customer demand is: Starting from equuilibrium, there is a small unannounced one-time increase in customer orders from 4 to 8 cases per week. 9/20/2018 Chapters 17 and 18 in Sterman

Beer Distribution Game Behavior
Most players develop a backlog—meaning negative actual inventory Eventually inventories throughout the supply chain start to rise But then all entities inventories overshoot See page 687 9/20/2018 Chapters 17 and 18 in Sterman

Beer Distribution Game Behavior
Most players ignore the delays and order the difference between their desired inventory and their actual inventory This creates a huge overshoot in actual inventory when it all arrives 9/20/2018 Chapters 17 and 18 in Sterman

Why Do We Ignore the Supply line—the Delays??
Examples of situations where we ignore delays appear on page 695 9/20/2018 Chapters 17 and 18 in Sterman

Boom and Bust in real Estate Markets
Real Estate markets exhibit large amplitude cycles of 10 to 20 years Booms are often accompanied by periods of intense speculation involving expansion of credit and banking activity When the bubble bursts, the resulting bad loans, defaults, and unemployment can throw an entire region into recession or even depression 9/20/2018 Chapters 17 and 18 in Sterman

Recent Real Estate Boom/Bust Cycles
North American and European Property markets boomed in the 1980’s, but then crashed in the early 1990’s Similar behaviro was observed in Japan 9/20/2018 Chapters 17 and 18 in Sterman

How does the cycle begin?
See Figure 17-15—another adaptation of the stock management structure Interest and mortgage rates do down to stimulate the economy Employment goes up Vacancy rates go down as employment goes up Rents go up as do market values Developers see an opportunity and initiate construction This causes construction starts to increase and go higher 9/20/2018 Chapters 17 and 18 in Sterman

What happens next? High profits attract new developers and investors Many new projects are started, swelling the supply line of buildings under development After a long delay—2 to 5 years—the supply of buildings rises, rents start to fall, as vacancy rates go up, dragging down market values Meanwhile there is still a huge supply of new construction starts underway 9/20/2018 Chapters 17 and 18 in Sterman

What should developers do?
They should assess the profitability of a potential new development and forecast the future vacanyy rate by projecting the growth of demand and supply In other words they should develop a structure like that in figure and take the feedback structure of the market into account 9/20/2018 Chapters 17 and 18 in Sterman

What else? Developers and bankers should consider the supply line of buildings under development taken in relation to the growth of demand Banks, in particular, should assume a leading role This means using SD models to assess demand taken in relation to supply. And giving specific attention to the pipeline and construction delays 9/20/2018 Chapters 17 and 18 in Sterman

What else? Regulatory agencies should establish a regulatory environment the forces banks to behave in a more fiscally responsible way. The HERD instinct is wrong and will should be avoided at all costs 9/20/2018 Chapters 17 and 18 in Sterman

Basic Stock Management Structure

Stock Management Structure Applied to Capital Investment

Chapters 17 and 18 Business Dynamics by John D. Sterman

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Chapters 17 and 18 Business Dynamics by John D. Sterman

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