<ul><li>Managing the Supply Chain </li></ul><ul><ul><ul><li>Key to matching demand with supply </li></ul></ul></ul><ul><ul...
Corporate Finance <ul><li>Inventories represent about 34% of current assets for a typical US company; 90% of working capit...
The Supply Chain The Procurement or supply system The Operating System The Distribution System Raw Material supply points ...
Key Financial Indicators of Supply Chain Performance <ul><li>Return on Assets </li></ul><ul><li>Net Present Value </li></u...
Costs of not Matching Supply and Demand <ul><li>Cost of overstocking  </li></ul><ul><ul><li>liquidation, obsolescence, hol...
Accurately Matching Demand with Supply is the Key Challenge: Inventories <ul><li>... by 1990  Wal-Mart  was already winnin...
A Key to Matching Supply and Demand <ul><li>When would you rather place your bet? </li></ul>A B C D A: A month before star...
Where is the Flow Time? Buffer Operation Waiting Processing
Why do Buffers Build? Why hold Inventory? <ul><li>Economies of scale </li></ul><ul><ul><li>Fixed costs associated with bat...
Pal ü  Gear : Retail Inventory  Management & Economies of Scale <ul><li>Annual jacket revenues at a  Pal ü  Gear  retail s...
Economies of Scale:  Inventory Build-Up Diagram <ul><li>R :  Annual demand  rate , </li></ul><ul><li>Q : Number of jackets...
Costs Associated with Batches <ul><li>Order costs (S) </li></ul><ul><ul><li>Changeover of production line </li></ul></ul><...
Pal ü  Gear : evaluation of current policy of ordering  Q  = 1500 units each time <ul><li>What is average inventory  I ? <...
Find most economical order quantity:  Spreadsheet for a  Pal ü  Gear  retailer
Economies of Scale:  Economic Order Quantity  EOQ <ul><li>R : Demand per year, </li></ul><ul><li>S : Setup or Order Cost (...
Optimal Economies of Scale:  For a  Pal ü  Gear  retailer <ul><li>R   = 3077 units/ year C  = $ 250 / unit </li></ul><ul><...
Learning Objectives:  Batching & Economies of Scale <ul><li>Average inventory for a batch size of  Q  is  Q /2.  </li></ul...
Role of Leadtime  L :   Pal ü  Gear   cont. <ul><li>The lead time from when a  Pal ü  Gear  retailer places an order to wh...
Demand uncertainty and forecasting <ul><li>Forecasts are usually (always?) wrong. </li></ul><ul><li>A good forecast has at...
Pal ü  Gear : Service levels & inventory management  <ul><li>In reality, a  Pal ü  Gear   store’s demand fluctuates from w...
Example: say we increase ROP to 140 (and keep order size at Q = 520) <ul><li>On average, what is the stock level when the ...
Safety Stocks Q Time  t ROP L order order order mean demand during supply lead time:   =  R L safety stock  I s Inventor...
1. How to find service level (given ROP)? 2. How to find re-order point (given SL)? <ul><li>L = Supply lead time, </li></u...
The standard normal distribution  F(z) <ul><li>Transform  X = N(  )  to  z = N(0,1) </li></ul><ul><li>z =  ( X  -   ) ...
Pal ü  Gear : Determining the required Safety Stock for 95% service <ul><li>DATA: </li></ul><ul><li>R   = 59 jackets/ week...
Comprehensive Financial Evaluation: Inventory Costs of  Pal ü  Gear <ul><li>1.  Cycle Stock (Economies of Scale) </li></ul...
Learning Objectives  safety stocks <ul><li>Levers to decrease s afety stock  without hurting level of service:  </li></ul>...
Improving Supply Chain Performance: 1. The Effect of Pooling/Centralization
Pal ü  Gear’s  Internet restructuring: Centralized inventory management <ul><li>Weekly demand per store = 59 jackets/ week...
Pal ü  Gear’s  Internet restructuring: comprehensive financial inventory evaluation <ul><li>1.  Cycle Stock (Economies of ...
Improving Supply Chain Performance:  2. Postponement & Commonality (HP Laserjet) Generic Power Production Unique Power Pro...
Learning Objectives: Supply Chain Performance <ul><li>Pooling of stock reduces the amount of inventory </li></ul><ul><ul><...
<ul><li>Pal ü  Gear’s  is planning to offer a special line of winter jackets, especially designed as gifts for the Christm...
In reality, you do not know demand for sure… Impact of uncertainty if you order the expected  Q =  2000
What happens if you change your order level to hedge against uncertainty?  Performance for all possible  Q  using Excel <u...
Towards the newsboy model  S uppose you placed an order of 2000 units but you are not sure if you should order more. What ...
Accurate response: Find optimal  Q  from newsboy model   <ul><li>Cost of overstocking by one unit =  C o </li></ul><ul><ul...
Where else do you find newsboys? <ul><li>Deciding on economic service level </li></ul><ul><li>Benefits: Flexible Spending ...
Goal of a Supply Chain Match Demand with Supply It is hard … Why? Hard to Anticipate Demand Forecasts are wrong… why? Ther...
Implications: Is z (service level appropriate) Reduce Lead time Reduce   R Where does   R  come from? Information Uncert...
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    1. 1. <ul><li>Managing the Supply Chain </li></ul><ul><ul><ul><li>Key to matching demand with supply </li></ul></ul></ul><ul><ul><ul><li>Cost and Benefits of inventory </li></ul></ul></ul><ul><li>Economies of Scale </li></ul><ul><ul><ul><li>Factors affecting optimal batch size: EOQ </li></ul></ul></ul><ul><ul><ul><li>Levers for improvement </li></ul></ul></ul><ul><li>Safety Stock </li></ul><ul><ul><ul><li>Factors affecting level of safety stock: ROP </li></ul></ul></ul><ul><ul><ul><li>Levers for reducing safety stock </li></ul></ul></ul><ul><li>Improving Performance </li></ul><ul><ul><ul><li>Centralization & Pooling efficiencies </li></ul></ul></ul><ul><ul><ul><li>Postponement </li></ul></ul></ul><ul><ul><ul><li>Accurate Response </li></ul></ul></ul>Operations Management: Supply Chain Management Module
    2. 2. Corporate Finance <ul><li>Inventories represent about 34% of current assets for a typical US company; 90% of working capital. </li></ul><ul><li>For each dollar of GNP in the trade and manufacturing sector, about 40% worth of inventory was held. </li></ul><ul><li>Average logistics cost = 21c/sales dollar = 10.5% of GDP </li></ul>
    3. 3. The Supply Chain The Procurement or supply system The Operating System The Distribution System Raw Material supply points Movement/ Transport Raw Material Storage Movement/ Transport Movement/ Transport STORAGE STORAGE STORAGE PLANT 1 PLANT 2 PLANT 3 WAREHOUSE WAREHOUSE WAREHOUSE Movement/ Transport MARKETS Manufacturing Finished Goods Storage A B C
    4. 4. Key Financial Indicators of Supply Chain Performance <ul><li>Return on Assets </li></ul><ul><li>Net Present Value </li></ul><ul><li>… </li></ul><ul><li>… </li></ul><ul><li>These are LAGGING indicators. What must the supply chain do to achieve this? </li></ul>
    5. 5. Costs of not Matching Supply and Demand <ul><li>Cost of overstocking </li></ul><ul><ul><li>liquidation, obsolescence, holding </li></ul></ul><ul><li>Cost of under-stocking </li></ul><ul><ul><li>lost sales and resulting lost margin </li></ul></ul>
    6. 6. Accurately Matching Demand with Supply is the Key Challenge: Inventories <ul><li>... by 1990 Wal-Mart was already winning an important technological war that other discounters did not seem to know was on. “Wal-Mart has the most advanced inventory technology in the business and they have invested billions in it”. (NYT, Nov. 95). </li></ul><ul><li>WSJ, Aug. 93: Dell Computer stock plunges. The company was sharply off in forecast of demand resulting in inventory writedowns. </li></ul><ul><li>BW 1997: </li></ul>
    7. 7. A Key to Matching Supply and Demand <ul><li>When would you rather place your bet? </li></ul>A B C D A: A month before start of Derby B: The Monday before start of Derby C: The morning of start of Derby D: The winner is an inch from the finish line
    8. 8. Where is the Flow Time? Buffer Operation Waiting Processing
    9. 9. Why do Buffers Build? Why hold Inventory? <ul><li>Economies of scale </li></ul><ul><ul><li>Fixed costs associated with batches </li></ul></ul><ul><ul><li>Quantity discounts </li></ul></ul><ul><ul><li>Trade Promotions </li></ul></ul><ul><li>Uncertainty </li></ul><ul><ul><li>Information Uncertainty </li></ul></ul><ul><ul><li>Supply/demand uncertainty </li></ul></ul><ul><li>Seasonal Variability </li></ul><ul><li>Strategic </li></ul><ul><ul><li>Prices, availability </li></ul></ul>Cycle/Batch stock Safety stock Seasonal stock Strategic stock
    10. 10. Pal ü Gear : Retail Inventory Management & Economies of Scale <ul><li>Annual jacket revenues at a Pal ü Gear retail store are roughly $1M. Pal ü jackets sell at an average retail price of $325, which represents a mark-up of 30% above what Pal ü Gear paid its manufacturer. Being a profit center, each store made its own inventory decisions and was supplied directly from the manufacturer by truck. A shipment up to a full truck load, which was over 3000 jackets, was charged a flat fee of $2,200. Stores typically ordered 1500 jackets at a time, twice a year. ( Pal ü ’s cost of capital is approximately 20%.) </li></ul><ul><li>What order size would you recommend for a Pal ü store in current supply network? </li></ul>retailer manufacturer
    11. 11. Economies of Scale: Inventory Build-Up Diagram <ul><li>R : Annual demand rate , </li></ul><ul><li>Q : Number of jackets per replenishment order </li></ul><ul><li>Number of orders per year = R / Q. </li></ul><ul><li>Average number of jackets in inventory = Q /2 . </li></ul>Q Time t Inventory Profile : # of jackets in inventory over time. R = Demand rate Inventory
    12. 12. Costs Associated with Batches <ul><li>Order costs (S) </li></ul><ul><ul><li>Changeover of production line </li></ul></ul><ul><ul><li>Transportation </li></ul></ul><ul><ul><li>Receiving </li></ul></ul><ul><li>Holding costs (H = rC) </li></ul><ul><ul><li>Physical holding cost </li></ul></ul><ul><ul><li>Cost of capital </li></ul></ul><ul><ul><li>Cost of obsolescence </li></ul></ul>
    13. 13. Pal ü Gear : evaluation of current policy of ordering Q = 1500 units each time <ul><li>What is average inventory I ? </li></ul><ul><ul><li>I = Q/2 = </li></ul></ul><ul><ul><li>Annual cost to hold one unit H = </li></ul></ul><ul><ul><li>Annual cost to hold I = Holding cost × Inventory </li></ul></ul><ul><li>How often do we order? </li></ul><ul><ul><li>Annual throughput R = </li></ul></ul><ul><ul><li># of orders per year = Throughput / Batch size </li></ul></ul><ul><ul><li>Annual order cost = Order cost × # of orders </li></ul></ul><ul><li>What is total cost? </li></ul><ul><ul><li>TC = Annual holding cost + Annual order cost = </li></ul></ul><ul><li>What happens if order size changes? </li></ul>
    14. 14. Find most economical order quantity: Spreadsheet for a Pal ü Gear retailer
    15. 15. Economies of Scale: Economic Order Quantity EOQ <ul><li>R : Demand per year, </li></ul><ul><li>S : Setup or Order Cost ($/setup; $/order), </li></ul><ul><li>H : Marginal annual holding cost ($/per unit per year), </li></ul><ul><li>Q : Order quantity. </li></ul><ul><li>C : Cost per unit ($/unit), </li></ul><ul><li>r+h : Holding cost % (%/yr), </li></ul><ul><li> H = ( r+h) C . </li></ul>Batch Size Q Total annual costs H Q/2: Annual holding cost S R /Q: Annual setup cost EOQ
    16. 16. Optimal Economies of Scale: For a Pal ü Gear retailer <ul><li>R = 3077 units/ year C = $ 250 / unit </li></ul><ul><li>r = 0.20/year S = $ 2,200 / order </li></ul><ul><li>Unit annual holding cost = H = </li></ul><ul><li>Optimal order quantity = Q = </li></ul><ul><li>Number of orders per year = R / Q = </li></ul><ul><li>Time between orders = Q / R = </li></ul><ul><li>Annual order cost = ( R / Q ) S = $13,008.87/yr </li></ul><ul><li>Average inventory I = Q /2 = </li></ul><ul><li>Annual holding cost = ( Q /2) H = $13,008.87/yr </li></ul><ul><li>Average flow time T = I/R = </li></ul>
    17. 17. Learning Objectives: Batching & Economies of Scale <ul><li>Average inventory for a batch size of Q is Q /2. </li></ul><ul><li>Increasing batch size of production (or purchase) increases average inventories (and thus cycle times). </li></ul><ul><li>The optimal batch size trades off setup cost and holding cost. </li></ul><ul><li>To reduce batch size, one has to reduce setup cost (time). </li></ul><ul><li>Square-root relationship between Q and ( R , S ): </li></ul><ul><ul><li>If demand increases by a factor of 4, it is optimal to increase batch size by a factor of 2 and produce (order) twice as often. </li></ul></ul><ul><ul><li>To reduce batch size by a factor of 2, setup cost has to be reduced by a factor of 4. </li></ul></ul>
    18. 18. Role of Leadtime L : Pal ü Gear cont. <ul><li>The lead time from when a Pal ü Gear retailer places an order to when the order is received is two weeks. If demand is stable as before, when should the retailer place an order? </li></ul><ul><li>I-Diagram: </li></ul><ul><li>The two key decisions in inventory management are: </li></ul><ul><ul><li>How much to order? </li></ul></ul><ul><ul><li>When to order? </li></ul></ul>
    19. 19. Demand uncertainty and forecasting <ul><li>Forecasts are usually (always?) wrong. </li></ul><ul><li>A good forecast has at least 2 numbers (includes a measure of forecast error, e.g., standard deviation). </li></ul><ul><li>The forecast horizon must at least be as large as the lead time. The longer the forecast horizon, the less accurate the forecast. </li></ul><ul><li>Aggregate forecasts tend to be more accurate. </li></ul>
    20. 20. Pal ü Gear : Service levels & inventory management <ul><li>In reality, a Pal ü Gear store’s demand fluctuates from week to week. In fact, weekly demand at each store had a standard deviation of about 30 jackets  assume roughly normally distributed. Recall that average weekly demand was about 59 jackets; the order lead time is two weeks; fixed order costs are $2,200/order and it costs $50 to hold one jacket in inventory during one year. </li></ul><ul><li>Questions: </li></ul><ul><ul><li>If the retailer uses the ordering policy discussed before, what will the probability of running out of stock in a given cycle be? </li></ul></ul><ul><ul><li>The Pal ü retailer would like the stock-out probability to be smaller. How can she accomplish this? </li></ul></ul><ul><ul><li>Specifically, how does it get the service level up to 95%? </li></ul></ul>
    21. 21. Example: say we increase ROP to 140 (and keep order size at Q = 520) <ul><li>On average, what is the stock level when the replenishment arrives? </li></ul><ul><li>What is the probability that we run out of stock? </li></ul><ul><li>How do we get that stock-out probability down to 5%? </li></ul>
    22. 22. Safety Stocks Q Time t ROP L order order order mean demand during supply lead time:  = R L safety stock I s Inventory on hand I ( t ) Q I s 0 L R L
    23. 23. 1. How to find service level (given ROP)? 2. How to find re-order point (given SL)? <ul><li>L = Supply lead time, </li></ul><ul><li>D =N ( R   R ) = Demand per unit time is normally distributed </li></ul><ul><li> with mean R and standard deviation  R , </li></ul><ul><li>D L =N (  ) = Demand during the lead time </li></ul><ul><li>where  = RL and  R  L </li></ul><ul><li>Given ROP, find SL = Cycle service level = P (no stock out) </li></ul><ul><li>= P (demand during lead time < ROP ) </li></ul><ul><li>= F ( z*= ( ROP-  )/  ) [use table] </li></ul><ul><li>= NORMDIST ( ROP ,  ,  , True) [or Excel] </li></ul><ul><li>Given SL, find ROP =  + I s </li></ul><ul><li>=  + z*   [use table to get z* ] </li></ul><ul><li>=  + NORMSINV (SL)*  [or Excel] </li></ul><ul><li>Safety stock I s = z*   Reorder point ROP =  + I s </li></ul>
    24. 24. The standard normal distribution F(z) <ul><li>Transform X = N(  ) to z = N(0,1) </li></ul><ul><li>z = ( X -  ) /  . </li></ul><ul><li>F ( z ) = Prob( N (0,1) < z ) </li></ul><ul><li>Transform back, knowing z* : </li></ul><ul><li>X* =  + z*  . </li></ul>F(z) z 0
    25. 25. Pal ü Gear : Determining the required Safety Stock for 95% service <ul><li>DATA: </li></ul><ul><li>R = 59 jackets/ week  R = 30 jackets/ week </li></ul><ul><li>H = $50 / jacket, year </li></ul><ul><li>S = $ 2,200 / order L = 2 weeks </li></ul><ul><li>QUESTION: What should safety stock be to insure a desired cycle service level of 95%? </li></ul><ul><li>ANSWER: </li></ul><ul><li>1. Determine  lead time demand = </li></ul><ul><li>2. Required # of standard deviations z* = </li></ul><ul><li>3. Answer: Safety stock I s = </li></ul>
    26. 26. Comprehensive Financial Evaluation: Inventory Costs of Pal ü Gear <ul><li>1. Cycle Stock (Economies of Scale) </li></ul><ul><li>1.1 Optimal order quantity = </li></ul><ul><li>1.2 # of orders/year = </li></ul><ul><li>1.3 Annual ordering cost per store = $13,009 </li></ul><ul><li>1.4 Annual cycle stock holding cost. = $13,009 </li></ul><ul><li>2. Safety Stock (Uncertainty hedge) </li></ul><ul><li>2.1 Safety stock per store = 70 </li></ul><ul><li>2.2 Annual safety stock holding cost = $3,500 . </li></ul><ul><li>3. Total Costs for 5 stores = 5 (13 ,009 + 13,009 + 3,500) </li></ul><ul><li>= 5 x $29,500 = $147.5K . </li></ul>
    27. 27. Learning Objectives safety stocks <ul><li>Levers to decrease s afety stock without hurting level of service: </li></ul><ul><li>Decrease demand variability or forecast error, </li></ul><ul><li>Decrease delivery lead time, </li></ul><ul><li>Decrease delivery lead time variability. </li></ul>
    28. 28. Improving Supply Chain Performance: 1. The Effect of Pooling/Centralization
    29. 29. Pal ü Gear’s Internet restructuring: Centralized inventory management <ul><li>Weekly demand per store = 59 jackets/ week </li></ul><ul><li>with standard deviation = 30 / week </li></ul><ul><li>H = $ 50 / jacket, year </li></ul><ul><li>S = $ 2,200 / order </li></ul><ul><li>Supply lead time L = 2 weeks </li></ul><ul><li>Desired cycle service level F(z*) = 95%. </li></ul><ul><li>Pal ü Gear now is considering restructuring to an Internet store. </li></ul><ul><li> = </li></ul><ul><li> = </li></ul>
    30. 30. Pal ü Gear’s Internet restructuring: comprehensive financial inventory evaluation <ul><li>1. Cycle Stock (Economies of Scale) </li></ul><ul><li>1.1 Optimal order quantity = </li></ul><ul><li>1.2 # of orders/year = </li></ul><ul><li>1.3 Annual ordering cost of e-store = $29,089 </li></ul><ul><li>1.4 Annual cycle stock holding cost = $29,089 </li></ul><ul><li>2. Safety Stock (Uncertainty hedge) </li></ul><ul><li>2.1 Safety stock for e-store = </li></ul><ul><li>2.2 Annual safety stock holding cost = $7,800 . </li></ul><ul><li>3. Total Costs for consolidated e-store = 29 ,089 + 29,089 + 7,800 </li></ul><ul><li>= $65,980 . </li></ul>
    31. 31. Improving Supply Chain Performance: 2. Postponement & Commonality (HP Laserjet) Generic Power Production Unique Power Production Process I: Unique Power Supply Europe N. America Europe N. America Transportation Process II: Universal Power Supply Make-to-Stock Push-Pull Boundary Make-to-Order
    32. 32. Learning Objectives: Supply Chain Performance <ul><li>Pooling of stock reduces the amount of inventory </li></ul><ul><ul><li>physical </li></ul></ul><ul><ul><li>information </li></ul></ul><ul><ul><li>specialization </li></ul></ul><ul><ul><li>substitution </li></ul></ul><ul><ul><li>commonality/postponement </li></ul></ul><ul><li>Benetton: Tailored response (e.g., partial postponement) can be used to better match supply and demand </li></ul>Single product Multi product
    33. 33. <ul><li>Pal ü Gear’s is planning to offer a special line of winter jackets, especially designed as gifts for the Christmas season. Each Christmas-jacket costs the company $250 and sells for $450. Any stock left over after Christmas would be disposed of at a deep discount of $195. Marketing had forecasted a demand of 2000 Christmas-jackets with a forecast error (standard deviation) of 500 </li></ul><ul><li>How many jackets should Pal ü Gear order? </li></ul>Optimal Service Level in Response to Demand Uncertainty when you can order only once: Pal ü Gear 1% 1% 3% 6% 10% 13% 16% 16% 13% 10% 6% 3% 1% 1% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 800 1000 1200 1400 1600 1800 2000 2200 2400 2600 2800 3000 3200 Demand forecast for Christmas jackets
    34. 34. In reality, you do not know demand for sure… Impact of uncertainty if you order the expected Q = 2000
    35. 35. What happens if you change your order level to hedge against uncertainty? Performance for all possible Q using Excel <ul><li> 200 </li></ul>  -55 = F ( Q )
    36. 36. Towards the newsboy model S uppose you placed an order of 2000 units but you are not sure if you should order more. What happens if I order one more unit (on top of Q = 2000)? Sell the extra unit with probability …  = ….. Do not sell the extra unit with probability …  = ….. Expected profit from additional unit E(  ) = So? ... Order more?
    37. 37. Accurate response: Find optimal Q from newsboy model <ul><li>Cost of overstocking by one unit = C o </li></ul><ul><ul><li>the out-of-pocket cost per unit stocked but not demanded </li></ul></ul><ul><ul><li>“ Say demand is one unit below my stock level. How much did the one unit overstocking cost me?” E.g.: purchase price - salvage price. </li></ul></ul><ul><li>Cost of understocking by one unit = C u </li></ul><ul><ul><li>The opportunity cost per unit demanded in excess of the stock level provided </li></ul></ul><ul><ul><li>“ Say demand is one unit above my stock level. How much could I have saved (or gained) if I had stocked one unit more?” E.g.: retail price - purchase price. </li></ul></ul><ul><li>Given an order quantity Q , increase it by one unit if and only if the expected benefit of being able to sell it exceeds the expected cost of having that unit left over. </li></ul><ul><li>Marginal Analysis: Order more as long as F ( Q ) < C u / ( C o + C u ) </li></ul><ul><li>= smallest Q such that service level F ( Q ) > critical fractile C u / ( C o + C u ) </li></ul>
    38. 38. Where else do you find newsboys? <ul><li>Deciding on economic service level </li></ul><ul><li>Benefits: Flexible Spending Account decision </li></ul><ul><li>ATM </li></ul><ul><li>Capacity Mgt </li></ul>
    39. 39. Goal of a Supply Chain Match Demand with Supply It is hard … Why? Hard to Anticipate Demand Forecasts are wrong… why? There is lead time… why there is lead time? Lead time (flow time) = Activity time+ Waiting Time Because there is waiting time.. Why there is waiting time? There is inventory in the SC ( Little’s Law) Why there is Inventory? Economies of Scale There are fixed costs of ordering/production Q*= Uncertainty Forecast Error Safety Stock Is = z  R Seasonality Implications: How fast cycle inventory grows if demand grows. How much to invest in fixed cost reduction to reduce batch size. Implications: Is z (service level appropriate) Reduce Lead time Reduce  R
    40. 40. Implications: Is z (service level appropriate) Reduce Lead time Reduce  R Where does  R come from? Information Uncertainty Balance overstocking and understocking Newsboy Problem … Critical Fractile = 1- P(stockout) Customer Demand Uncertainty Normal Variations… <ul><li>How do we deal with it? </li></ul><ul><li>Aggregation </li></ul><ul><li>Physical </li></ul><ul><li>Information </li></ul><ul><li>Specialization </li></ul><ul><li>Component Commonality </li></ul><ul><li>Postponement </li></ul>

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