Supply Chain Management

Subject Code: 18ME653

Module-1: Introduction to Supply Chain Management
What is Supply Chain Management?
The supply chain encompasses all activities involved in the transformation of goods from the raw
material stage to the final stage, when the goods and services reach the end customer. Supply chain
management involves planning, design and control of flow of material, information and finance
along the supply chain to deliver superior value to the end customer in an effective and efficient
manner. A typical supply chain is represented in Figure 1.1.

As can be seen from the definition, the supply chain not only includes manufacturers, suppliers
and distributors but also transporters, warehouses and customers themselves. Of late, firms have
realized that it is not the firms themselves but their supply chains that vie with each other in the
marketplace. Thus, it is not Hindustan Unilever (HUL) versus Procter & Gamble (P&G). Rather,
the supply chains of both these firms compete against each other. The customer is interested only
in the price, availability and quality of the product at the neighborhood retail outlet, where they
actually come into contact with products supplied by HUL and P&G. If customers observe
inefficiency on account of non-availability, damaged packaging, etc. at the retail end with regard
to HUL’s products, they attribute inefficiency to HUL and not to its chain partners. The customer
is only interested in getting the desired product at the right place, at the right time and at the right
price. For a simple product like soap, the HUL supply chain involves ingredient suppliers,
transporters; the company’s manufacturing plants, carrying and forwarding agents, wholesalers,
distributors and retailers. Obviously, HUL does not own all these entities, but the HUL brand name
is at stake and it has to be ensured that the entire chain delivers value to the end customer. HUL
cannot afford to focus only on those parts of the chain that are owned by it and ignore the other
parts of chain. Firms need to realize that the performance of the chain is determined by its weakest
link.
The supply chains of automobile companies (Maruti, Tata Motors and TVS) and other companies
like BPL, LG and Whirlpool, dealing in consumer durables, will be very similar to the one depicted
in Figure 1.1. On the other hand, companies in the consumer non-durables business—for example,
HUL, P&G, Godrej Soaps and Nestlé—have to work with supply chains that are likely to be much
longer and more complex. The term chain is a little misleading because it gives the impression
that there is only one entity at each stage of the supply chain. In reality, as seen in Figure 1.1,
multiple entities are involved at each stage: a manufacturer receives material from several suppliers
and, in turn, distributes the products through multiple distributors. The more appropriate term
probably will be either supply networks or supply web. However, the term supply chain has been
widely accepted by both practitioners and academicians; hence, we will continue to use the same
throughout the book.

Evolution of Supply Chain Management

The First Revolution (1910–1920): Vertical Integrated Firms Offering Low
Variety of Products
There have been three major revolutions along this journey, and we examine each of them in the
context of the broader evolution in the economic environment.
The first major revolution was staged by the Ford Motor Company where they had managed to
build a tightly integrated chain. The Ford Motor Company owned every part of the chain— right
from the timber to the rails. Through its tightly integrated chain, it could manage the journey from
the iron ore mine to the finished automobile in 81 hours. However, as the famous saying goes, the
Ford supply chain would offer any colour, as long as it was black; and any model, as long as it was
Model T. Ford innovated and managed to build a highly efficient, but inflexible supply chain that
could not handle a wide product variety and was not sustainable in the long run. General Motors,
on the other hand, understood the demands of the market place and offered a wider variety in terms
of automobile models and colours. Ford’s supply chain required a long time for set-up changes
and, consequently, it had to work with a very high inventory in the chain.
Till the second supply chain revolution, all the automobile firms in Detroit were integrated firms.
Even traditional firms in India, like Hindustan Motors, were highly integrated firms where the bulk
of the manufacturing was done in-house.

The Second Revolution (1960–1970): Tightly Integrated Supply Chains

Offering Wide Variety of Products
Towards the end of the first revolution, the manufacturing industry saw many changes, including
a trend towards a wide product variety. To deal with these changes, firms had to restructure their
supply chains to be flexible and efficient. The supply chains were required to deal with a wider
product variety without holding too much inventory. The Toyota Motor Company successfully
addressed all these concerns, thereby ushering in the second revolution.
The Toyota Motor Company came up with ideas that allowed the final assembly and
manufacturing of key components to be done in-house. The bulk of the components was sourced
from a large number of suppliers who were part of the keiretsu system. Keiretsu refers to a set of
companies with interlocking business relationships and shareholdings.
The Toyota Motor Company had long-term relationships with all the suppliers. These suppliers
were located very close to the Toyota assembly plants. Consequently, set-up times, which
traditionally used to take a couple of hours, were reduced to a couple of minutes. This combination
of low set-up times and long-term relationships with suppliers was the key feature that propelled
the second revolution—and it was a long journey from the rigidly integrated Ford supply chain.
The principles followed by Toyota are more popularly known as lean production systems.
The Toyota system, involving tight linkages, did get into some problems in the later part of the
century. Gradually, when Toyota and other Japanese firms tried to set up assembly plants in
different parts of the world, they realized that they would have to take their suppliers also along
with them. Further, they found that some of the suppliers in keiretsu had become com-placent and
were no longer cost competitive. With the advent of electronic data interchange (EDI), which
facilitated electronic exchange of information between firms, it was possible for a firm to integrate
with the suppliers without forcing them to locate their plants close to the manufacturers’ plant.
In actual practice, the Toyota supply chain also had certain rigidities, such as a permanent relation
with suppliers, which could become a liability over a period of time. This, in turn, led to the third
revolution spearheaded by couple of progressive companies like Dell Computers, Apple Inc., and
Bharti Airtel, which offered, its customers the luxury of customization with loosely held supplier
networks.

The Third Revolution (1995–2020): Virtually Integrated Global Supply

Networks Offering Customized Products and Services
Technology, especially information technology, which is evolving faster than enterprises can find
applications for some of the innovations, is the fuel for the third revolution in supply chain. It will
probably take at least couple of years before we can fully understand the IT-enabled model that
has emerged and begin to apply it to all industries. However, we have enough information to get a
reasonably good understanding of the contours of the third revolution. We will illustrate key
characteristics of the third revolution using the example of Dell computers, Apple Inc., and Bharti
Airtel. The first is a product company, the second combines product and service, and third is a
pure service organization. In each of these organisations, we will see different aspects of the third
revolution.
Dell computers allows customers to configure their own laptops (in terms of processors, video
cards, screen sizes, memory, etc.) and track the same in their production and distribution systems.
Apple offers personal digital devices to its customers and iPod is a classic example. However, it
is not just about the product. Apple allows the consumer to have a personalized user experience
through the features and services. Users can personalize the music and other media content on their
device through the various features available on iPod. Similarly, Bharti Airtel allows services like
My Airtel through which customer can have unique personalized experience.
As one can see we have moved to the stage where firms offer a bundle of goods that leads to
personalized experiences, which would be of great value to individual customer. Value is unique
to each customer, and therefore, each customer would wish a customized experience to be fully
satisfied with the value delivered to him or her. In summary, we have moved from single product
(Model T black colour) to wide variety as offered by Toyota to customization as offered by
companies such as Dell computers, Apple, and Bharti Airtel. Businesses can no longer be content
in providing select product variety to customers.
Organizations have moved from offering products to offering user experiences, which are a bundle
of goods and services selected by the user. This has changed the way supply chains are configured
to deliver value.
Let us begin with Dell. To make sure its customers get the completely customized product, Dell
has built a strong network of vendors who are cost and technology leaders. These medium term
relationships are based on the understanding that the vendors will adhere to a high benchmark on
cost and technology leadership which in turn will reflect in Dell’s products.
Apple Inc. brings together a product and a user experience in a revolutionary new way. Similar to
Dell, Apple has global partners with which it maintains medium term relationships based on cost
and technology benchmarking to fulfil its product manufacturing requirements. However, for
creating a better user experience, it has gone a step further by creating a platform that enables
anyone to contribute to the Apple user experience. Take the example of Apple iTunes and App
Store. At the first level, iTunes made it possible for Apple to provide all the music in the world to
its users through a seamless and tightly integrated platform. While this was only about
entertainment, the App Store took it to the next level

Decisions in a Supply Chain

Successful supply chain management involves several decisions with varying time frames. We can
broadly classify them as design decisions and supply chain operations decisions.
Design Decisions
Supply chain design (network design) or strategic decisions involve the following critical issues:

• What activities should be carried out by the nodal firm and what should be outsourced?
• How to select entities/partners to perform outsourced activities and what should be the nature of
the relationship with those entities? Should the relationship be transactional in nature or should it
be a long-term partnership?

• Decisions pertaining to the capacity and location of the various facilities. The decisions
pertaining to location and capacity are for those facilities that are owned by the nodal firm. In
addition to manufacturing locations and capacities, the firm has also to worry about locations and
capacities for warehouses (depots). Supply chain design decisions are made for the long term
(usually a couple of years) and are very expensive to alter at short notice.
Operations Decisions
Once supply chain design decisions are in place, the firm has to take decisions regarding the
management of supply chain operations for shorter horizons. This involves tactical decisions,
which have a horizon of about three months to a year; and operations decisions, which usually
have a horizon ranging from a day to a month. Both tactical and operations decisions involve the
following areas:

• Demand forecasting
• Procurement planning and control
• Production planning and control
• Distribution planning and control
• Inventory management
• Transportation management
• Customer order processing
• Relationship management with partners in the chain
Given the demand forecast and the business strategy of the firm, decisions related to procurement,
production, planning, distribution and transportation have to be integrated with customer order
processing and inventory management decisions. Relationship management essentially involves
the alignment of incentives to the various entities in the chain so that the overall supply chain
performance meets customer requirements at the lowest cost. Though not so obvious, the supply
chain has also to be integrated with other important functions of the firm, for example, customer
relationship management and new product development. Since customer relationship creates
demand, the supply chain must ensure that it is in a position to fulfil the demand created by
customer relationship management in a profitable way. Well-managed firms integrate their
customer relationship and supply chain activities. Similarly, while designing new products, well-
managed firms ensure that supply chain issues are kept in mind at the design stage. Firms have to
find a way in which the new products can use the existing product platforms and components, so
as to minimize the supply chain costs for the product family as a whole. Traditionally, terms like
integrated logistics or business logistics have been used synonymously with the term supply chain
management. In some firms, traditional logistics professionals have taken up the responsibility of
integrating supply chain activities within the firm under the banner of integrated logistics. In some
other firms where this integration is quite weak, the top management has taken on the responsibility
of developing the supply chain culture within the organization. Since both these approaches are
prevalent in the industry, a lot of practitioners and academicians refer to this body of knowledge
as logistics and supply chain management.

The Importance of the Supply Chain

In the past, customers were not very demanding and competition was not really intense. As a
result, firms could afford to ignore issues pertaining to the supply chain. Today, firms that do
not manage their supply chain will incur huge inventory costs and eventually end up losing a lot
of customers because the right products are not available at the right place and time. The following
are the five major trends that have emerged to make supply chain management a critical success
factor in most industries.
Proliferation in product lines. Companies have realized that more and more product variety is
needed to satisfy the growing range of customer tastes and requirements. This is evident from the
fact that every time a customer walks into a neighbourhood store, he or she is bound to discover a
couple of items on the shelf that he or she had not seen during his or her last visit and that he or
she has more varieties to choose from now. Every time you walk into a neighbourhood store, do
not be surprised to find that even a simple product like toilet soap has 50-odd varieties. We define
stock-keeping unit (SKU) as a unit of variety. For example, the same brand of soap may be offered
in varying colours and sizes. Each variety is treated as a separate SKU. Companies like HUL, in
their personal care products, manage, on an average, 1,200 SKUs. Chains like Foodworld manage
about 6,000 SKUs. With increasing product variety, it becomes rather difficult to forecast
accurately. Hence, retailers and other organizations involved in the business are forced to either
maintain greater amount of inventories or lose customers.

• Shorter product life cycles. With increased competition, product life cycles across all industries
are becoming shorter. For example, technology leaders like Apple works with a life cycle as short
as 6 months. So a firm like Apple , which has, on an average, just 5 days of inventory, as compared
to the industry average of 35 days, does not have to worry about product and component
obsolescence. Its competitors with higher inventories end up writing off huge amounts of stocks
every year as obsolete. In the past, in developing countries where inflation was a way of life, higher
inventories used to be a major source of profits for the firm. With inflation in control and shorter
product life cycles, firms have had to change the way they manage their inventories. Also, with
shorter product life cycles, there is not much data available for demand forecasting. Most of the
technology firms find that 50 per cent of their revenue comes from products that were introduced
in the last three years.

• Higher level of outsourcing. As discussed in the section on “Evolution of Supply Chain

Management”, firms increasingly focus on their core activities and outsource non-core activities
to other competent players. Michael Dell, the CEO of Dell Computers, had mentioned that if his
company was vertically integrated, it would need five times as many employees and would suffer
from a drag effect. Apart from primary activities in the value chain, even support activities that
were usually done inhouse are outsourced in a big way now. Bharti Tele-Ventures, India’s number
one private telecom service provider, has outsourced network-management services, IT services
and call centre operations. This trend towards outsourcing is irreversible but a higher level of
outsourcing makes supply chains more vulnerable, thereby forcing firms to develop different types
of supply chain capabilities within the organization.
Shift in power structure in the chain. In every industry, the entities closer to customers are
becoming more powerful. With increasing competition, a steadily rising number of products are
chasing the same retail shelf space. Retail shelf space has not increased at the pace at which product
variety has increased. So there have been cases of retailers asking for slotting allowance when
manufacturers introduce new products in the market place. Savvy firms have started talking about
trade marketing and treating dealers and retailers as their customers while simultaneously trying
to woo the retailers aggressively. There is a clear shift in the power structure. Retailers have
realized that they are powerful entities in the chain and hence expect the manufacturers to be more
responsive to their needs and demands. Discount retailers like Wal-Mart have been asking their
suppliers to replenish the supplies on a daily basis based on actual sales data from their point-of-
sales systems. In general, manufacturers are forced to respond more quickly to the customers’
demands, because of changes in the power structure within the chain.

• Globalization of manufacturing. Over the past decade, tariff levels have come down significantly.
Many companies are restructuring their production facilities to be at par with global standards.
Unlike in the past, when firms use to source components, produce goods and sell them locally,
now firms are integrating their supply chain for the entire world market. For example, companies
like ABB have developed some global centres of excellence for each of their product lines that
take care of the global market. General Motors is talking about a world car and has been designing
a few cars for global markets. In the telecommunications and electronics industry, companies
usually get their chips from Taiwan, test them in Europe and finally integrate them with other
products in the United States of America to sell in the international market. This has made
managing supply chains extremely complicated. Unlike information and finance flow, which can
be managed electronically, materials and products have to move physically, and as this movement
can even be across continents, managing supply chains is now an extremely complex issue.

Enablers of Supply Chain Performance

As mentioned in the previous section, managing supply chains is becoming increasingly complex.
Despite this, firms have actually managed to reduce their logistics costs. For example, in a country
like the United States of America, logistics costs used to account for 15 per cent of the gross
domestic product (GDP) in the 1980s. Today, because of innovations in technology and
management practices, logistics costs account for about 8.5 per cent of their GDP. Three major
enablers that have helped firms and nations in reducing supply chain costs are briefly discussed
below.

Improvement in Communication and IT

Computing power has become cheaper and communication costs too have come down. This has
helped firms in coordinating global supply chains in a cost-effective manner. Advances in
enterprise resource planning (ERP) systems have helped firms in automating several business
processes resulting in seamless information flow throughout the company across different
functions. The way ERP systems have changed the nature of information flow within organization,
Internet technology is likely to change the nature of information flow in interfirm transactions. In
the past, only large companies could integrate with partner firms using expensive EDI
technologies. Now, even small firms can communicate with their chain partners using the
worldwide web at a fraction of the earlier cost. Companies are realizing that they can replace
physical inventory by information. To really exploit their IT investments, companies need to re-
engineer their supply chain and other supporting organizational processes and try to replace
physical inventory with information. Unfortunately, many Indian companies have invested in
information systems but have not made the corresponding changes in their supply chain systems
and processes, which has resulted in the company failing to exploit the information system to its
full potential. For example, a company with multiple plants can work with a common pool of
safety stock of raw materials and does not need to have safety stocks for each individual plant.
Similarly, on the order-processing side, companies can offer greater customization as compared to
the past because their order-processing system can be designed to handle customized orders and
their manufacturing and distribution system would allow them to track these customized products
in the system. In the absence of an information system, this would not have been possible at all.
But unfortunately a significant number of companies have used IT to just automate the existing
supply chain systems and processes. Companies that have successfully exploited IT have made
major changes in their supply chain structure, systems, processes and strategy.

Emergence of Third-party Logistics Providers

Traditionally, many firms have been managing their logistics activities internally. Lately,
companies have realized that they need to focus their energies on managing core business
activities, and hence have been exploring the possibility of outsourcing logistics activities to third-
party logistics (3PL) service providers. In developed countries, almost 90 per cent of the logistics
activities are outsourced and are managed by 3PL companies. Apart from bringing in the much
needed professionalism to the field, 3PL companies have economies of scale as they are able to
pool demand across customers. In developed markets, global firms would like leading 3PL
companies to go beyond the traditional role and play the role of a fourth-party logistics (4PL)
company that can integrate the capabilities, resources and technology so as to provide
comprehensive supply chain solutions to its customers. Currently, the 3PL industry in India is still
evolving. Two sets of companies have emerged in this field. One set of companies involves
traditional transporters, shippers, warehouse service providers and freight forwarders, who want
to offer value-added services and would like to see if they can develop competencies and become
a 3PL company. The second set of service providers comprises international 3PL companies that
have come to India along with their global MNC customer. For example, when Toyota wanted to
set up a manufacturing plant in India, it asked its logistics service provider Mitsui and Co. to come
to India to take care of its logistics requirements. Currently, not many companies in India employ
the services of other 3PL companies. However, with the evolution of the Indian market, new MNCs
and progressive Indian companies operating in the mid-volume, mid-variety segment have started
using the services of 3PL companies. Over a period, the 3PL companies would not only develop
the competence required to function smoothly in the Indian context but also take care of the
logistics requirements of the bulk of the industries in India as well.

Enhanced Inter-firm Coordination Capabilities

Successful coordination across a global network of companies has been a comparatively new
phenomenon in the corporate world. It has been realized that for a network to function
meaningfully one needs a firm to play the role of the strategic centre. Many companies, like Apple,
Nike, Benetton, Nintendo, Sun and Toyota, have successfully managed complex networks, played
the part of the strategic centre and, hence, have emerged as role models to other companies. While
each company in the network focuses on its core competencies, the strategic centres function as a
leading and orchestrating system. Consequently, supply chains become more efficient and
responsive. However, there have been a large number of failures also, where firms within the chain
could not align their interests, and as a result the network could not function effectively. The
industry is still on the learning curve in this matter, but better understanding and coordination of
issues would greatly help in diffusing the third supply chain revolution across all industries.

Supply Chain Performance in India

Supply chain performance measures involve multiple dimensions and they are discussed in detail
in the subsequent chapters. In this section, the focus is on performance, both in terms of inventory
turnover ratio at the organizational level and logistics costs at the economy level. Logistics costs
include inventory-carrying costs, transportation costs and logistics administration costs. As can be
seen in Table 1.1, logistics costs in India are quite high when compared with other countries. Of
course, one could argue that since customer service expectations are not the same across countries,
logistics costs may not be strictly comparable. However, as tariff levels have been coming down
with globalization, logistics costs do become comparable to a significant extent. Higher logistics
costs definitely affect the competitiveness of the Indian industry. Firms often argue that
inefficiency in the transport and warehousing sector makes it difficult for them to compete in the
global market. For example, the cost of sending an export cargo to Mumbai from Punjab and that
of shipping it further to London from Mumbai are the same. Further, variable transit time and in-
transit damages make transportation in India a very expensive affair We now analyse the
performance of the supply chains of Indian firms using inventory turnover ratio as a measure of
performance. When we look at the performance of the Indian manufacturing sector in last decade
(Figure 1.2), we find that performance has gradually improved in the time period between 2003
and 2008. After 2008, the inventory turn has dropped significantly and subsequently improving
gradually. Impact of global financial crisis had deep impact on Indian manufacturing, and even
after five years, Indian manufacturing has not reached level of performance achieved in 2008. Over
a decade, Indian manufacturing industry has more or less maintained the performance and has
shown only marginal improve-ment.

Though there is evidence of moderate improvement, this rate of improvement has to be sustained.
On the other hand, the best international firms have improved at much faster rates in the past
decade when compared to the best Indian firms. The sector-wise performance of Indian firms is
shown in Figure 1.3.

We find that most sectors show performance trend similar to the overall manufacturing sector
except consumer goods, construction, and chemicals. Unlike other sectors, consumer goods and
construction sector have maintained inventory levels in last decade, whereas chemical industry
had shown significant improvements in the last few years. To compete successfully in the global
market the Indian firms need to improve their performance in managing their inventory and keep
their logistics costs low. Let us now look at the challenges that Indian firms face when it comes to
supply chain management. Many of these challenges—which arise due to the economic
environment; taxation structures and the geography of India—are unique to the Indian scenario.
 Module-2
Strategic Sourcing Outsourcing

Make Vs. buy:

 Production units are identified mostly with their decision to make or buy. In other words, do
they wish to produce the desired product on their own or do they want to purchase it from the
foreign market.
 This decision is critical because the third-party suppliers especially in countries like Eastern
Europe, China, and other low-cost parts of the world hold out the promise of essential
beneficiaries, which the developed nations fail to offer.
 The decision of a firm to perform its activities internally or get those activities done from an
independent firm is known as the make versus buy decision. This make versus buy issue is
strategic in nature and involves the following key decisions: What activities should be carried
out by the firm and what activities should be outsourced? How to select the entities/partners to
carry out outsourced activities and what should be the nature of the relationship with those
entities? Should the relationship be transactional in nature or should it be a long-term
partnership?
 The make versus buy decision evaluates the contribution of each activity. Using the value chain
framework developed by Michael Porter, we classify all supply chain activities as primary
activities and support activities. Primary activities consist of inbound logistics, operations,
outbound logistics, sales and service. Secondary activities involve procurement, technology
development, human resource management and firm infrastructure management.
 The make versus buy decisions look at each of these activities critically and ask the question:
Should this activity be done internally or can it be outsourced to an external party? Once the
decision to outsource has been taken, the firm has to choose among competing suppliers and
also decide on the nature of the relationship it would like to establish with the supplier firm.

Identifying Core Processes

 The identification of core processes is a crucial decision. If this is driven by short-term benefits
such as re-engineering of balance sheets and improved return on investments, then the long-
term business sustainability is endangered. Instead of becoming the best in the chosen category
(represented by core processes), the firm runs the risk of ending up as a mere hollow
corporation.
 The mere decision to focus the resources on core activities to match capabilities with the best-
in-class performance is not enough; firms must strive to be the best in the world in that specific
area.
 In these areas they can invest in people, equipments and R&D. Such a focus will also help the
firm in attracting the best talent from that field. Many corporations have realized that they can
never hope to attract the best talent in IT; hence, they have decided to depend on their outside
partners for the IT support required for business application.
 Thus, the first step for a firm is to develop the capability to distinguish between core activities
and commodity activities. Even among core activities, it has to keep certain activities in-house,
and for all outsourced critical activities, it has to maintain some knowledge so that it can manage
an effective relationship with its outsourcing partner.
The two ways through which one can identify a firm’s core processes are the business process
route and the product architecture route.
 The Business Process Route:
 For any firm, three core and high-level business processes include customer relationship,
product innovation and supply chain management. Customer relationship focuses on acquiring
new customers and building relationships with existing customers.
 Product innovation focuses on developing new products and services, while supply chain
management focuses on fulfilment of customer orders. It is possible to un-bundle the three
business processes and a firm can afford to outsource two of these business processes. A firm
must identify and ensure that it builds core capabilities in-house in at least one of these areas.

The Product Architecture Route:

 In the product architecture approach, the focus is on sub-systems and components and the make
or buy decisions are made at that level.
 A product like a car can be divided into sub-systems such as engine, chassis and transmission.
The engine sub-system can be divided into components such as power cylinder, fuel system
and engine electronics.
 In a product, first the sub-systems are classified as strategic and non-strategic. A sub-system is
strategic if it involves technologies that change rapidly, if it requires specialized skills and
technologies and if it can significantly impact the performance of the product on attributes that
are considered important by the customer.
 By keeping theses strategic sub-systems internal, a firm can ensure that it can offer
differentiated products and can avoid being commoditized. Further, within a sub-system, the
same kind of analysis has to be done for all major components.
 All those components where the firm is technologically ahead of potential suppliers or can hope
to achieve a leadership position with some investments are kept internal to the firm.
 In case the suppliers have a huge technological lead, which will be impossible to bridge in the
foreseeable future, or if the time and investments required for catching up may not be worth the
effort, then the component should be outsourced and the supplier should be treated as a strategic
partner (as shown in Figure, view of the overall framework)

The strategic outsourcing process (Ref: Janath shah )

Market Versus Hierarchy
 The make versus buy decision is also known as the market versus hierarchy decision in
economics literature. The key issue here is to coordinate the chain so as to provide a bundle of
goods and services at the lowest cost for a given level of service required by the customer. If a
firm decides to make the relevant component in-house, it may not have the necessary economies
of scale and might have to use internal hierarchy for coordination.
 The costs involved in control and coordination of internal supply is termed agency costs in
economics. When a firm uses market mechanisms to procure the necessary inputs, it may be
able to take advantage of economies of scale and also choose the supplier that supplies goods
and services at lower prices.
 However, there are costs incurred in the control and coordination of the external supplier and
are termed as transaction costs in economics. Costs related to economies of scale are tangible
in nature but the bulk of agency and transaction costs are intangible in nature.

Economies of Scale
There are four major sources of economies of scale, which are briefly discussed here.
1. Higher volume allows a firm to spread its fixed cost over a larger volume of operations.
Any manufacturing or logistics process will involve investments in fixed costs. A firm
with higher volume is able to spread its fixed costs over a higher output and thus has
lower cost of operations.
2. Higher volume allows a firm to choose more efficient technologies.
Higher volume allows a firm to invest in technologies that are capital intensive but
result in lower fixed and variable costs per unit of output. In the semiconductor
industry, capital-intensive technologies capable of handling wafers of diameter 300
millimetres allow firms to obtain twice as many chips per wafer compared to older
technologies, which could handle wafers only with diameters up to 200 millimetres.
This allows a semiconductor manufacturing firm, willing to invest in more capital-
intensive technologies, to bring down the cost per chip.
3. Pooling of buffer capacities and inventories
If firms keep their activities in-house, they have to keep buffer capacities and
inventories to take care of the uncertainties in demand. A supplier, on the other hand,
is able to pool uncertainties over a larger number of customers and as a result needs
much lower levels of buffer capacity and safety inventory. A supplier can also ensure
utilization of high capacity by pooling demand across customers who have different
demand profiles.
4. Learning curve effect.
The learning curve captures the impact of cumulative production on the average cost
of production. The management and the workers are able to improve their performance
based on experience gained through the cumulative production of a firm. In several
industries, it is found that with doubling of cumulative production the average cost
declines by 10 to 20 per cent.
Agency Cost
 A firm with its own fleet of trucks faces a similar problem of motivating the transport
department, where the internal transport department is the agent and the marketing
department is the principal. In a hierarchical firm, there is greater control over
coordination, but there may not be enough motivation for the internal supplier to work
on innovations to reduce costs and improve service over a period of time.
 The cost involved in control and coordination of internal supply is termed agency cost
in economics.
 There is significant time and effort involved in the control and coordination of internal
activities.
 If one decides to manufacture the necessary inputs within the firm, then the firm has to
worry about agency issues. It is quite common that managers and workers of internal
 supply units sometimes knowingly do not act in the best interests of the firms. Thus,
the top management incurs agency costs associated with in-house supply.
 In-house divisions within a firm are usually treated as cost centres and are usually
insulated from competitive pressures as they have captive internal markets.
 Further, most large firms have common overheads and joint costs, which are allocated
to different units, so it is usually difficult to measure individual divisions’ contributions
to overall profitability.
 The absence of market competition along with problems involved in measuring
divisional performance make it difficult for the top management to evaluate the current
performance of input supply operations with respect to its best achievable performance.
Transaction Cost
There are costs involved in using market mechanisms, which can be avoided if those
relevant activities are brought inside the firm. These costs are known as transaction
costs. The transaction costs comprise the following:
• Search and information costs. Costs involved in locating and evaluating the right
supplier.
• Bargaining and contracting costs. A firm has to first negotiate the terms of exchange
and finally prepare the contract so that it is assured that the supplier will provide the
required goods and services as per the agreed terms and conditions.
• Policing and enforcement costs. A firm has to constantly monitor the supplier so as
to ensure that the supplier sticks to the terms and conditions of the contract. Firms might
also have to legally enforce the contract if the supplier does not follow the contract.
Bharti has put in elaborate mechanisms for monitoring the SLAs with IBM and
Ericsson.
• Cost incurred because of loss of control. The use of market mechanisms may result
in underinvestment in relationship-specific assets, which, in turn, increase the cost for
buyers. Further, there may be additional costs that firms may have to incur because of
poor coordination. There is also the risk of leakage of strategic information that will
hurt the buyer firm in long run.
The cost incurred because of loss of control is a major component of transaction costs
in several situations of market exchange. If it were possible to write a perfect contract
and enforce it, one may not have to worry about costs incurred because of loss of
control.

Integrative Framework of Market Versus Hierarchy

 To resolve the make versus buy issue, a firm has to look at the benefits as well
as the costs involved. Costs should not be viewed from a narrow perspective;
instead, the costs and risks associated with loss of control should also be
captured in the transaction costs involved in market exchange.
 Costs related to economies of scale, agency costs and transactions costs have
been integrated in the framework provided in Figure. If additional costs due to
poor economies of scale plus agency costs of internal control and coordination
are less than transaction costs of market exchange, the firm should settle for
the make option, else the firm should opt for market exchange.
 Capturing the true value of agency and transaction costs requires a deep
understanding of business. Though most garment firms outsource
manufacturing operations, Zara Corporation, a leading European garment
company, has decided to keep the bulk of its manufacturing facilities within
the firm.
 In the past few years, Benetton has also decided to increase internal
manufacturing capacities. Both these firms value responsiveness and want
tighter control over their operations, so they prefer internal manufacturing
capacities for a quick response to market trends.
 The integrative framework of make versus buy (reference: Janath Shah)

The Make-Versus-Buy Continuum

By exploring two extreme positions: (a) make an input or buy an input using the market and (b) vertical
integration versus market, where the buyer has an arm’s-length relationship with the suppliers. There
are several alternative ways in which the exchange can be organized. In this section, we discuss two
important alternatives:

(a) Tapered integration, where a firm both makes and buys a given input.

(b) Collaborative relationship, which could be a formal contractual relation or a long-term informal
relationship, based on trust. In some cases, it can lead to alliances or joint ventures.

Tapered Integration
 Tapered integration represents a mixture of market and vertical integration. A
firm makes part of the requirement in-house and procures the rest from the
market. Firms like Pizza Corner and Madura Garments fall in this category,
wherein they own some retail outlets and depend on franchisee or other models
for the rest of their sales.
 Keeping part of the manufacturing in-house allows firms to have a better
understanding of the industry cost structures, and this helps them in negotiating
better deals with suppliers.
 Firms are able to keep up the pressure on their internal supply group to innovate
and work on cost reductions by showing them benchmark numbers from
markets.
 Firms can also keep the pressure on the supplier by saying that if they do not
improve the complete manufacturing will be shifted in-house, as they have the
capability for it.
 As this helps avoid a potential hold-up situation, the firm is less vulnerable on
this front.
 By distributing production between internal and external supply groups, a firm
may not have economies of scale at both places. Further, the coordination and
monitoring activities might increase costs significantly.
 Collaborative Relationship
 In a collaborative relationship, the supplier is an extension of the firm. The firm treats its
suppliers as strategic partners and usually a supplier is assured of business for a reasonably long
period of time.
 The firm does not indulge in competitive bidding every year and does not change its supplier
to get the small price reduction offered by a competing supplier. Information is shared freely
across firms, and the supplier is willing to invest in relationship-specific assets.
 Usually, the supplier gets involved early at the product design stage and the price paid to the
supplier is based on the actual costs incurred. One major concern in collaborative relationships
is ensuring that the supplier keeps working on innovations. Just like the internal supplier, the
partner in a collaborative relationship is assured of business, and this may result in complacency
on the part of the supplier.
 Firms should periodically benchmark the partner’s costs with the market so as to ensure that
the supplier remains competitive.
 Japanese manufacturers work with a network of suppliers with whom they maintain close long-
term relationships. Japanese companies have subcontractor networks called keiretsu. This
network involves vendors, bankers and distributors. Firms within a keiretsu are linked by
informal personal relationships. As they share long-term relationships, they avoid most of the
problems associated with market exchange relationships and are willing to invest in higher
relationship-specific assets and do not worry about information asymmetry and hold-up
problems.
 This allows each firm within the keiretsu to focus on its core competence and all get the
necessary economies of scale. However, since they are assured of a market they may also suffer
from agency problems discussed in vertical integration.
SCM Module 3 notes

SUPPLY CHAIN MODULE 3:

Warehouse Management
Warehouses or stores play a vital role in the operations of a company. It is in direct touch with the user
department in its day-to-day activities. The most important purpose served by the stores is to provide
uninterrupted service to a construction site. Further, stores are often equated directly with money as
money is locked up in the stores.
Objectives and Functions of Stores
The simplest (and very outdated) definition of the warehouses or stores is that it is the place where one
keeps (or offloads) material for some time before its use.
According to a more functional definition of stores, it is a place where following activities are carefully
undertaken:
Receipt of goods, timely procurement of materials, accounting the transactions, minimising
obsolescence, surplus & scrap by proper identification and using correct preservation methods, ensuring
good housekeeping by accurately and timely updation, issue of receipts, ensuring issues and other
documentation and handling other issues pertaining to storage and cleanliness.
In some cases, the procurement and optimisation of inventory is also added to the functions of stores.
For example, the store’s manager may be given the additional powers to procure urgently required
items.
In other words, the functions of stores can be classified as follows:
(a) To receive raw materials, components, tools, equipment and other items and account for them,
(b) To provide adequate and proper storage and preservation to the various items,
(c) To meet the demands of the user departments by proper issues and account for the consumption,
[d) To minimise obsolescence, surplus and scrap through proper codification, preservation and
handling,
(e) To highlight stock accumulation, discrepancies and abnormal consumption and evolve effective
control measures,
(f) To ensure good housekeeping so that material handling, material preservation, stocking, receipt and
issue can be done adequately, and
(g) To assist in verification and provide supporting information for effective purchase action.

1. STORES SYSTEMS AND PROCEDURES

Broadly, the systems in stores can be studied under three areas namely, receipt, issue and
documentation. It may be seen that at every stage a great deal of information is required for checking,
controlling and feedback purposes. Well-designed stores systems and procedures ensure timely
information for decision making, particularly because stores is the starting point of all activities for
control. Let us briefly consider the systems and procedures in each area.
1.1 Management of Receipts
The inputs into stores or receipts can emanate from internal as well as external sources. The procedures
start even before the material reaches the stores when a Purchase Order (PO) is placed on the vendor.
In certain organisations, the stores and purchase activities are bifurcated, but care should be taken to
ensure close coordination.
The details should be maintained in a chronological order to enable the ease of understanding. The
scope of work involves following functions:

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(a) Requirement determination,

(b) Raising purchase requisition,
(c) Chasing purchase orders to expedite supplies,
(d) Scheduling arrival of materials,
(e) Receiving the materials physically and planning for storage,
(f) Quantity & quality inspection,
(g) Checking input documents like invoice, lorry receipt, delivery challans and other challans, invoices
etc.,
(h) Taking stock of material received and also of rejected material,
(i) Endorsing the suppliers bills and quantities and forwarding for payment to accounts, Provisional
goods inwards in case of later inspection,
(k) Final goods inwards in case of final acceptance of goods,
(1) Informing indenting departments of arrival of goods,
(m) Sending paperwork to purchase accounts for payment,
(n) Updating insurance paperwork for latest goods arrival, and
(0) In case of demurrages, arrange for insurance company visit.
All this demands a clearly laid out procedure which all concerned are informed about. In addition to
these functions, other functions are as follows:
(a) Regularise miscellaneous items like samples & cash purchases by raising receipt notes,
(b) Complete record keeping formalities for returnable items and items received from feeder shops for
later internal or external consumption,
(c) Keeping record of scrap received, and
(d) Keeping record of other bulk material supply items which may not be physically received or stored
in the warehouse, like fuel oil etc.
1.2 Issue Control
We now come to the stage namely, issues. Issues can be further divided into issues to consuming
departments, and issues to outside suppliers for processing or conversion.
In both cases, there are certain common system requirements. The first aspect is the control of issues.
Issues are based on scheduling of project. The second aspect is delegation of authority.
Here, in this unit, we are concerned only with the first aspect. The scope of this issue control involves
the issue of the right material, in the right quantity, to the right personnel, at the right time and place on
receiving the right authorisation, maintaining the records for the same.
Based on consumption schedules/production programs, listing for each material, quantity to be issued
for each project for that material is made and circulated to all concerned.
This automatically controls consumption as the work order issued details on the quantity of material to
be issued by the stores and the stores personnel are not authorised to issue beyond these quantities.
Thus, for routine work, operations get streamlined and free of bureaucracy.

The stores also keeps check on inventory and raises alarms or raises purchase orders (as the case may
be) from time to time. Care should be exercised that work is not held up for the want of materials.
One time issues like bathtubs, furniture, almirahs etc. are to be accounted for separately.
Proper weighing and counting equipment should be used for issuing bulk materials. Thus, these
instruments need to be calibrated frequently.
Provision should be made for emergency issue and procedures should be clearly defined for all
concerned to regularise this.
1.3 Stores Documentation

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All the documents received or generated inhouse should be properly categorised and a numbering
system should be developed for proper storage and quick retrieval. Besides the receipt and issue
documents, some other methods of documentation necessary are given below:
(a) Bincard or kardex,
(b) Stores transfer voucher (from one stores to another),
(c) List of slow moving/fast moving/obsolete items,
(d) Scrap disposal,
(e) Rejection notes,
(f) Acceptance notes,
(g) Delivery notes,
(h) Travel requisitions,
(i) Tour and expense reports,
(j) Impress details,
(k) Indents,
(1) Codification methodology, and
(m) Material requirement planning.

2. STOCK VALUATION AND VERIFICATION

There is a distinct difference between the two terms "valuation" and "verification".
Valuation is the monetary equivalent of the stock or material in hand whereas verification is the
determination or quantification of the material in stock and checking its deviation from the figures
shown in the books.
Valuation becomes necessary to assess the assets of the company for sale, determining insurance cover
to be taken, during acquisition and mergers, get an idea about the difference between book and actual
depreciation etc. Since the procurement price or sale price of a material does not remain constant, it is
necessary to evaluate the stocks regularly or during specific occasions. For example, if the price of an
item in inventory which is required for producing something has gone up during its storage period,
selling it by basing its selling price on the past purchase price can mean lesser margins. Similarly, if the
price has gone down during the stocking period, selling it at a higher price can mean being out priced
by competition.
Since valuation methods can increase or decrease assets, companies occasionally resort to manipulating
the valuation methods to present rosy or drastic pictures as the case may be.
For instance, the gross profit is the difference between net sales and costs of production.
Since materials cost is a part of production, the valuation basis can determine whether the company is
going to have profits or losses. Frequent unauthorised changes are illegal.
Under the companies act, a change in the method of valuation has to be approved by the Board of
Directors of the company and must be reported along with the effect of changes in the profitability due
to the changes in method of valuation duly certified by the auditors.
2.1 Methods of Valuation
The methods of valuation are many. In actual practice, there may be more than one method being
followed; one for taxation purpose and the other for control purpose. The details of some of the
important methods are given in subsequent paragraphs.

FIFO (First in First out) Method

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FIFO method assumes that material purchased are issued in strict chronological sequence, i.e. the
material which comes in first is issued first. This method ensures that the materials are issued at the
actual cost and the valuation is done at the latest price paid. So long as the cost of the material does not
fluctuate much, the assessment works fine.
The disadvantages are that in very highly fluctuating costs periods, every batch will have different costs
and the comparison between batches becomes meaningless. Moreover, in an inflationary scenario, the
time lag from the period the material is inward to that when it is issued results in the material being
issued at a lesser price than its current price which wrongly indicate the higher profits.
An illustrative example of a FIFO method is shown in Table

LIFO (Last in First out) Method

This method assumes that the material coming in last are the first to be issued. The advantage of this
method is that the costs are reckoned closest to the latest price and thus, reflecting the latest market
positions (if receipts are recent). But the stocks are still evaluated at the old prices for valuation purpose.
In times of falling prices, the LIFO system (due to lag) charges a cost to production or cost at the time
of issue, a value which is lower than the actual market price, unlike FIFO system which could have
charged a price which might be lesser/more/same depending on the price at the time of the first
purchases. Thus, while FIFO is a conservative approach and suffers from time lag, LIFO is directed at
the latest market conditions so that the pricing conditions are up-to-date as much as possible. An
illustrative example of a LIFO method is shown in Table

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Other Variations of FIFO and LIFO Methods

The variations of these methods such as HIFO (highest in first out), NIFO (next in first out) are
modifications of the FIFO and LIFO methods but are not commonly used due to the extra monitoring
work involved. Simple Average Price Method In this method, the issues are valued on the basis of a
simple average price of the inward items. The prices of purchases prior to any issues are summed and
the average is obtained by dividing by the number of purchase prices used. An example is shown below
:
Let the prices in the last three issues be 1.0, 1.1 and 1.2. Therefore, the average
(1.0+ 1.1 + 1.2) /3 price would be = 1.1
This method is simple and easy to use and gives reasonable values for not so fast varying items.
However, approximations in calculations can give rise to errors. Moreover, the variations in the past
prices may be due to the different quantities procured and thus, the discounts availed. So if the
procurement quantities are not the same. Moreover, a temporary price fluctuation, say rise in price of
cement in an area due to floods, can give erroneous results in the valuation.
Periodic Average Price Method
The lacunae of the simple average method is attempted to be overcome in this method by considering
prices for a defined large enough period to make the variations in price more uniform. The prices
considered for valuation can be the past six months, quarter or year. The problem with this method is
the extreme amount of calculations involved by referring to past records. It also suffers from the same
drawbacks as that of the simple average price, but can be easily used for batch type productions by
suitably adjusting the periods and remove the high fluctuations in prices.

Weighted Average Price Method

The variation in prices due to different quantities in the simple and periodic price methods is overcome
largely in this method. The issues to the user department are split into equal batches from each shipment
at stock. Here, the rate is arrived by dividing the total cost by the total items. This new rate is applied
for consumers. As new items are procured, the new average is computed for further issues. In actual
usage, the weighted average is derived for a given period instead of doing everytime for every issue or
procurement as this tends to be too time consuming. The weighted average method is quite popular as
it is not tiresome and gives a fairly accurate tracking of the market conditions. The values reflected in
this method do not "jerk" the balance sheets as the weighted averages prevent it.
An illustrative example of weighted average price method is shown in Table

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Standard Cost Method

In this method, a forecasted unit price for a specific period of one year or more is used to evaluate the
issues. Some of the factors taken into consideration for calculating the standard cost are as follows :
(a) Market conditions,
(b) Depreciating nature of the item,
(c) Usage rate,
(d) Storage conditions,
(e) Handling facilities,
(f) Obsolescence, and
(g) Losses in storage.
The actual cost of procurement is thus different from the standard cost, but this figure helps in providing
guidelines to purchase unit for correct buying prices and negotiating goals. In addition, this top-down
approach tries to mould the procurement and inventory department to bring in line their thinking to the
management goals. The success of computing the standard cost is thus, very important in terms of
predicting actual values. The procurement department thus, has a guideline. The smaller the gap
between the standard value and actual costs, the better the management has control over finances. If
variation exists between the standard and actual costs, the variance can be taken care of in the actual
market selling or project pricing costs. Efficient use of the materials is truly reflected as accounting is
now separated from fluctuations in rates, thus saving the manpower accounting hours.
An illustrative example of standard cost method is shown in Table

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As can be seen this method is applicable if a very strong analytical team is available to compute the
standard costs.
Replacement Price
This method is very suitable for a relatively high inflationary economy. In this method while purchases
are valued at the price paid for, the issues are valued at the price required to replace them at the current
prevalent prices. This ensures that the final product is priced at market prevalent rates.
The problem with this method is that the replacement value is not available at all times. Thus, a very
strong system to keep updated prices has to be evolved which in turn costs money. The issue material
follows market price but since the in stock material is evaluated at the actual prices, in an inflationary
economy, the stock in hand is always under evaluated. Conversely, when the prices are falling the stocks
in hand are always over evaluated leading to frequent write-offs.
The rate of depreciation or appreciation of all materials in stock is also not the same. Thus, balancing
stocks can be problematic.

2.2 Stock Verification

As mentioned earlier, the stock verification is the determination or quantification of the material in
stock and checking its deviation from the figures shown in the books. The store’s manager holds the
responsibility for all happenings in the store. He must periodically verify all stocks to reconcile the
books with the physical presence of the material. The problems mount as the number of items or the
number of transactions increase. Stock verification also checks for pilferage and shows the qualitative
upkeep of the stores. The causes for discrepancy in stock can be due to the following reasons:
(a) The scales or weighing machines etc. have not been properly calibrated or are not of good quality
or being maintained improperly,
(b) Issues without indents or proper paperwork,
(c) Delays in updating paperwork,
(d) Untrained individuals handling paperwork,
(e) Pilferage,
(f) Obsolescence,
(g) Deterioration and damage due to natural causes like corrosion, insect damage, rodent damage or
seepage of rainwater etc., and
(h) Deterioration and damage due to unnatural causes like theft, sabotage etc.

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The process of verification is the physical counting, weighing or measuring the stock of materials that
is in stock and making a record of these figures.
The persons who normally supervise these operations are responsible people from:
(a) Accounts department,
(b) Internal audit department of large companies,
(c) Sometimes, auditors from the bankers or loan givers, and
(d) .in case of mergers, the representatives of the other company.
The verification process is normally started only after a clear cut guidelines for the process is written
down and approved by the concerned authorities. To prevent overwork or stoppage of normal work for
inconvenient time periods, the verification process must be carried out over a long period switching
from one area to another. Sometimes, this is not possible and all verification has to be done at one go.
The stores personnel should be actively involved in the verification process to make it stop seem like a
witch hunt. If the discrepancy between actual figures and the book values are substantial enough ahd
not properly explicable, it is necessary to start an immediate investigation as the organisations will gain
if the stores personnel are motivated by proper development of an atmosphere of good values and quick
justice.

3. WASTE MANAGEMENT - DISPOSAL OF SURPLUS,

OBSOLETE AND SCRAP
Before going into the details of waste management, some of the important terms, i.e. surplus, obsolete
and scrap etc. need to be defined.
Surplus: These are materials which have no immediate use or at least in the foreseable future. They
have accumulated due to faulty planning, forecasting and purchasing.
Sometimes, they may have accumulated since they are standardly bought in quantities only and not in
loose form where they would be more expensive. In short, surplus stocks are the items which are in
excess of their requirement.
Obsolete Stocks: They are those items which are not damaged and have economic worth but are not
suitable for the company's specific operations. For example, the spare parts of machines that have been
phased out. Changes in product design, technological advancements, rationalisation, food and drugs
whose effectiveness has lapsed over time, wrong codification etc. are some of the reasons why
obsolescence occurs. As the name implies, they are non-moving items of the inventory.
The difference in obsolete and surplus lies in the potential for usage. Surplus items are only in excess
of what is required, obsolete items cannot be used at all.
Salvageable Items: These are items which cannot be used for the original purpose but out of which
certain parts may be removed and used either with or without rework. For example, the motor of a spoilt
air-conditioner may be used for other air-conditioners. While removing, these motors should again be
regularised as spares for inventory purpose.
Reclaimable Items: These are items which have worn out by use but their life can be extended by
some specialised processes. An example is worn out tyres which can be retreated. Before reclaiming
items, their extended life should be properly determined as sometimes reclaiming is expensive and the
extended life is not commensurate to the cost incurred.
Scrap: This is another term which is used to describe material not useful to the organisation (sometimes,
used also for obsolete and surplus items when these are not useful to the organisation). Scrap can be
defined as the residue from a construction or manufacturing process which cannot be used economically
within the organisation. Typical scrap material in the construction industry are empty tins, drums, and
packing material etc.

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3.1 Reasons for Obsolescence

Following are some of the reasons of obsolescence:

(a) Development of better and more efficient or cost economic technology,

(b) Advent of new Automation technologies and design changes,
(c) Standardisation of items within the organisation,
(d) Cannibalisation of equipment to obtain spares for the other,
(e) Incorrect purchase practices like buying in bulk, and
(f) Faulty store keeping or inefficient material handling.

3.2 Control of Obsolescence

Computerised maintenance of records can help largely in identifying potential obsolete items. Market
intelligence should be practiced as a norm. Using the FSN analysis, the non-moving (N) items can be
tracked. Care should be taken that the critical or insurance items are not be included in this list.
This method can also be combined with the XYZ analysis to identify obsolete items.
X -items account for 70% of value but about 10% of stock items,
Y -items account for 20% of value but about 20% of stock items, and
Z - items account for 10% of value but about 70% of stock items.
Here, items coming in Y and Z category need attention whereas X category items are very critical as
they constitute a large value. Other than very necessary or insurance items, the excess items should be
used or disposed quickly.
One way of controlling can be to introduce buyback clause or having centralised purchase which can
better plan to keep a low spares level as it can divert these to other sites.

3.3 Control of Scrap

It may seem odd that scrap requires control. But the following aspects need to be addressed effectively:
(a) Proper storage and dumping places of scrap need to be identified. It is usual in India to see that all
construction sites or warehouses are littered nearby with scrap.
(b) Assess the performance of staff by assessing the cleanliness of the place.
(c) Fix tolerance limits itself on the production of scrap. Explaining the efficient use can control the use
of cloth.
(d) Scrap should be segregated and sold as this fetches better value. They can be separated as drums of
cement, gunny bags, tin of paints etc.
(e) Reclamation should be used wherever possible by seeing the economics.

Responsibility for Disposal

If the procurement department is located nearby or in the same premises, they should be given the
responsibility of disposal. Otherwise, the stores manager is the best person for the job. Since the
procurement or purchase manager has brought the material, it is likely that he keeps track of the
market value of the scrap. The salesmen who interact with him can provide him the feedback for
this purpose. It is needless to add here that the purchase, stores and accounting department have to
function as a team. A typical format of "Form of Request for Write-off &
Disposal" is given in Appendix A.

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Disposal Methods
Depending on the nature of scrap, various methods can bc prescribed. Before disposal action can
be initiated, the "paperwork" for the same has to be initiated as the stock levels as well as its value
change after this. Scrap disposal can be done in the form given below:
(a) By inviting offers from time to time,
(b) By auction, and
(c) By annual contract.
Scrap should be segregated and kept compactly and separately. Some scrap like glass wool is
dangerous and should be collected and covered. To save even the scrap collection costs, the rate
contracts or annual contracts can include even the collection of scrap from the sites. However, care
should be exercised when the collection is going on that no good material leaves the site. In this
way, the scarce manpower and its associated costs can be utilised for other constructive work.
Sometimes, the scrap (like bad earth) is not collected by anyone. In such cases, the disposal is the
responsibility of the organisation and the legal and valid dumping place should be determined
before the material is dumped there.

Distribution Network Design

The Role of Distribution in the Supply Chain:
Distribution refers to the steps taken to move and store a product from the supplier stage to a
customer stage in the supply chain. Distribution occurs between every pair of stages in the
supply chain. Raw materials and components are moved from suppliers to manufacturers,
whereas finished products are moved from the manufacturer to the end consumer. Distribution
is a key driver of the overall profitability of a firm because it affects both the supply chain cost
and the customer value directly.

The process of designing a distribution network has two broad phases. In the first phase,
the broad structure of the supply chain network is visualized. This phase decides the number
of
stages in the supply chain and the role of each stage. The second phase then takes the broad
structure and converts it into specific locations and their capability, capacity, and demand
allocation.

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Figure 3.1 Distribution network in the supply chain

Factors influencing distribution network design:

At the highest level, performance of a distribution network should be evaluated along two
dimensions:

1. Value provided to the customer

2. Cost of meeting customer needs

Although customer value is affected by many factors, we focus on measures that are
influenced by the structure of the distribution network: Based on the value provided to the
customers the following factors influences the distribution network design.

• Response time
• Product variety
• Product availability
• Customer experience
• Time to market
• Order visibility
• Returnability

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SCM Module 3 notes

Response time is the amount of time it takes for a customer to receive an order.

Product variety is the number of different products or configurations that are offered by the
distribution network.

Product availability is the probability of having a product in stock when a customer order
arrives.

Customer experience includes the ease with which customers can place and receive orders and
the extent to which this experience is customized. It also includes purely experiential aspects,
such as the possibility of getting a cup of coffee and the value that the sales staff provides.

Time to market is the time it takes to bring a new product to the market.

Order visibility is the ability of customers to track their orders from placement to delivery.
Returnability is the ease with which a customer can return unsatisfactory merchandise and the
ability of the network to handle such returns.

Based on the cost of meeting customer needs the following factors influences the distribution
network design.

• Inventories
• Transportation
• Facilities and handling
• Information

Inventories

As the number of facilities in a supply chain increases, the required inventory increases as
shown in Figure 3.2. To decrease inventory costs, firms try to consolidate and limit the number
of facilities in their supply chain network.

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Figure 3.2 . Relationship Between Number of Facilities and Inventory cost

Transportation

Inbound transportation costs are the costs incurred in bringing material into a facility.
Outbound transportation costs are the costs of sending material out of a facility. Outbound
transportation costs per unit tend to be higher than inbound costs because inbound lot sizes are
typically larger. For example, an Amazon warehouse receives full truckload shipments of
books on the inbound side, but ships out small packages with only a few books per customer
on the outbound side. Increasing the number of warehouse locations decreases the average
outbound distance to
the customer and makes outbound transportation distance a smaller fraction of the total distance
traveled by the product. Thus, as long as inbound transportation economies of scale are
maintained, increasing the number of facilities decreases total transportation cost, as shown in
Figure
3.3. If the number of facilities is increased to a point at which inbound lot sizes are also very
small and result in a significant loss of economies of scale in inbound transportation, increasing
the number of facilities increases total transportation cost, as shown in Figure 3.3.

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Figure 3.3 . Relationship Between Number of Facilities and Transportation cost

Facilities and handling

Facility costs decrease as the number of facilities is reduced, as shown in Figure 3.4, because
a consolidation of facilities allows a firm to exploit economies of scale. Total logistics costs
are the sum of inventory, transportation, and facility costs for a supply chain network. As the
number of facilities increases, total logistics costs first decrease and then \ increase, as shown
in Figure 3.5. Each firm should have at least the number of facilities that minimizes total
logistics costs. Amazon has more than one warehouse primarily to reduce its logistics costs
(and improve response time). If a firm wants to reduce the response time to its customers
further, it may have to increase the number of facilities beyond the point that minimizes
logistics costs. A firm should add facilities beyond the cost-minimizing point only if managers
are confident that the increase in revenues because of better responsiveness will be greater than
the increase in costs because of the additional facilities.

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SCM Module 3 notes

Figure 3.4 . Relationship Between Number of Facilities and Facility cost

Figure 3.5 . Variation in Logistics Cost and Response Time with Number of Facilities

Design options for a distribution network

In this section, we discuss distribution network choices from the manufacturer to the end
consumer. When considering distribution between any other pair of stages, such as supplier to
manufacturer or even a service company serving its customers through a distribution network,
many of the same options still apply. Managers must make two key decisions when designing
a distribution network:

1. Will product be delivered to the customer location or picked up from a prearranged site?
2. Will product flow through an intermediary (or intermediate location)?

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SCM Module 3 notes

Based on the firm’s industry and the answers to these two questions, one of six distinct
distribution network designs may be used to move products from factory to customer. These
designs are classified as follows.

1. Manufacturer storage with direct shipping

2. Manufacturer storage with direct shipping and in-transit merge
3. Distributor storage with carrier delivery
4. Distributor storage with last-mile delivery
5. Manufacturer/distributor storage with customer pickup
6. Retail storage with customer pickup

Manufacturer storage with direct shipping

In this option, product is shipped directly from the manufacturer to the end customer, bypassing
the retailer (who takes the order and initiates the delivery request). This option is also referred
to as drop-shipping. The retailer carries no inventory. Information flows from the customer,
via the retailer, to the manufacturer, and product is shipped directly from the manufacturer to
customers, as shown in Figure 3.6.

3.6 Manufacturer Storage with Direct Shipping

The biggest advantage of drop-shipping is the ability to centralize inventories at the

manufacturer, which can aggregate demand across all retailers that it supplies. As a result, the
supply
chain is able to provide a high level of product availability with lower levels of inventory. A
key
issue with regard to drop-shipping is the ownership structure of the inventory at the
manufacturer. If specified portions of inventory at the manufacturer are allocated to individual
retailers,

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SCM Module 3 notes

there is little benefit of aggregation even though the inventory is physically aggregated. Benefit
of aggregation is achieved only if the manufacturer can allocate at least a portion of the
available
inventory across retailers on an as-needed basis. The benefits from centralization are highest
for
high-value, low-demand items with unpredictable demand.

Although inventory costs are typically low with drop-shipping, transportation costs are
high because manufacturers are farther from the end consumer. With drop-shipping, a customer
order including items from several manufacturers will involve multiple shipments to the
customer. This loss in aggregation of outbound transportation also increases cost.

Table 3.1 Performance Characteristics of Manufacturer Storage with Direct Shipping Network

Supply chains save on the fixed cost of facilities when using drop-shipping because all
inventories are centralized at the manufacturer. This eliminates the need for other warehousing
space in the supply chain. There can be some savings of handling costs as well, because the
transfer from manufacturer to retailer no longer occurs. Handling cost savings must be
evaluated
carefully, however, because the manufacturer is now required to transfer items to the factory
warehouse in full cases and then ship out from the warehouse in single units. The inability of
a
manufacturer to develop single-unit delivery capabilities can have a significant negative effect

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on
handling cost and response time. Handling costs can be reduced significantly if the
manufacturer
has the capability to ship orders directly from the production line.

Manufacturer storage with Direct shipping and in-Transit Merge

Unlike pure drop-shipping, under which each product in the order is sent directly from its
manufacturer to the end customer, in-transit merge combines pieces of the order coming from
different locations so the customer gets a single delivery. Information and product flows for
the in-transit merge network are shown in Figure 3.7 . In-transit merge has been used by Dell
and can be used by companies implementing drop-shipping. When a customer ordered a PC
from Dell along with a Sony monitor (during Dell’s direct selling period), the package carrier
picked up the PC from the Dell factory and the monitor from the Sony factory; it then merged
the two at a hub before making a single delivery to the customer.

Figure 3.7 In-Transit Merge Network

As with drop-shipping, the ability to aggregate inventories and postpone product customization
is a significant advantage of in-transit merge. In-transit merge allowed Dell and Sony to hold
all their inventories at the factory. This approach has the greatest benefits for products with
high value whose demand is difficult to forecast, particularly if product customization can be
postponed. ned.

Although an increase in coordination is required, in-transit merge decreases transportation

costs relative to drop-shipping by aggregating the final delivery.

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SCM Module 3 notes

Table 3.2 Performance Characteristics of In-Transit Merge

Distributor storage with Carrier Delivery

Under this option, inventory is held not by manufacturers at the factories, but by distributors/
retailers in intermediate warehouses, and package carriers are used to transport products from
the intermediate location to the final customer. Information and product flows when using
distributor storage with delivery by a package carrier are shown in Figure 3.8.

3.8 Distributor Storage with Carrier Delivery

Relative to manufacturer storage, distributor storage requires a higher level of inventory

because of a loss of aggregation. From an inventory perspective, distributor storage makes
sense for products with somewhat higher demand.
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SCM Module 3 notes

Transportation costs are somewhat lower for distributor storage compared with those for
manufacturer storage because an economic mode of transportation (e.g., truckloads) can be
employed for inbound shipments to the warehouse, which is closer to the customer. Unlike
manufacturer storage, under which multiple shipments may need to go out for a single customer
order with multiple items, distributor storage allows outbound orders to the customer to be
bundled into a single shipment, further reducing transportation cost. Distributor storage
provides
savings on the transportation of faster-moving items relative to manufacturer storage.

Table 3.3 Performance Characteristics of Distributor Storage with Carrier Delivery

Response time under distributor storage is better than under manufacturer storage because
distributor warehouses are, on average, closer to customers, and the entire order is aggregated
at
the warehouse before being shipped.

Distributor storage with last-Mile Delivery

Last-mile delivery refers to the distributor/retailer delivering the product to the customer’s
home

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SCM Module 3 notes

instead of using a package carrier. The automotive spare parts industry

is one in which distributor storage with last-mile delivery is the dominant model. It is too
expensive for dealers to carry all spare parts in inventory. Thus, original equipment
manufacturers
(OEMs) tend to carry most spare parts at a local distribution center typically located no more
than a couple of hours’ drive from their dealers and often managed by a third party.

Figure 3.9 Distributor Storage with Last-Mile Delivery

Unlike package carrier delivery, last-mile delivery requires the distributor warehouse to be
much closer to the customer. Given the limited radius that can be served with last-mile delivery,
more warehouses are required compared to when package delivery is used. The warehouse
storage with last-mile delivery network is as shown in Figure 3.9.

Distributor storage with last-mile delivery requires higher levels of inventory than the other
options (except for retail stores) because it has a lower level of aggregation. From an inventory
perspective, warehouse storage with last-mile delivery is suitable for relatively fast-moving
items
that are needed quickly and for which some level of aggregation is beneficial. Auto parts
required
by car dealers fit this description.

Among all the distribution networks, transportation costs are highest for last-mile delivery,
especially when delivering to individuals. This is because package carriers aggregate delivery
across many retailers and are able to obtain better economies of scale than are available to a
distributor/retailer attempting last-mile delivery.

Table 3.4 Performance Characteristics of Distributor Storage with Last-Mile Delivery

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SCM Module 3 notes

Response times for last-mile delivery are faster than those for package carriers. Product variety
is generally lower than for distributor storage with carrier delivery.
The cost of providing product availability is higher than for every option other than retail stores.
The customer experience can be good using this option, particularly for bulky, hard-to-carry
items. Time to market is even higher than for distributor storage with package carrier delivery
because the new product has to penetrate deeper before it is available to the customer. Order
visibility is less of an issue, given that deliveries are made within 24 hours.

Manufacturer or Distributor storage with Customer pickup

In this approach, inventory is stored at the manufacturer or distributor warehouse, but

customers
place their orders online or on the phone and then travel to designated pickup points to collect
their merchandise. Orders are shipped from the storage site to the pickup points as needed. The
information and product flows shown in Figure 3.10.

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SCM Module 3 notes

Figure 3.10 Manufacturer or Distributor storage with Customer pickup

Inventory costs using this approach can be kept low, with either manufacturer or distributor
storage to exploit aggregation. Transportation cost is lower than for any solution using package
carriers because significant aggregation is possible when delivering orders to a pickup site.
This allows the use of truckload or less-than-truckload carriers to transport orders to the pickup
site.

Table: 3.5 Manufacturer or Distributor storage with Customer pickup

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Retail storage with Customer pickup

In this option, often viewed as the most traditional type of supply chain, inventory is stored
locally at retail stores. Customers walk into the retail store or place an order online or by phone
and pick it up at the retail store. Local storage increases inventory costs because of the lack of
aggregation. For fast- to very fast-moving items, however, there is marginal increase in
inventory, even with local storage.
Transportation cost is much lower than with other solutions because inexpensive modes of
transport can be used to replenish product at the retail store. Facility costs are high because
many
local facilities are required. A minimal information infrastructure is needed if customers walk
into the store and place orders. For online orders, however, a significant information
infrastructure is needed to provide visibility of the order until the customer picks it up. Good
response times can be achieved with this system because of local storage. Product variety
stored locally is lower than that under other options. It is more expensive than with all other
options to provide a high level of product availability. Customer experience depends on
whether or not the customer likes to shop. Time to market is the highest with this option because
the new product must penetrate through the entire supply chain before it is available to
customers. Order visibility is extremely important for customer pickups when orders are placed
online or by phone. Returns can be handled at the pickup site. Overall, returnability is fairly
good using this option.
Table: 3.6 Performance Characteristics of Retail Storage at Consumer Pickup Sites

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Models for facility location and Capacity allocation

A manager’s goal when locating facilities and allocating capacity should be to maximize the
overall profitability of the resulting supply chain network while providing customers with the
appropriate responsiveness. Revenues come from the sale of product, whereas costs arise from
facilities, labor, transportation, material, and inventories. The profits of the firm are also
affected by taxes and tariffs. Ideally, profits after tariffs and taxes should be maximized when
designing a supply chain network.

A manager must consider many trade-offs during network design. For example, building
many facilities to serve local markets reduces transportation cost and provides a fast response
time, but it increases the facility and inventory costs incurred by the firm.

Managers use network design models in two situations. First, these models are used to
decide on locations where facilities will be established and determine the capacity to be
assigned to each facility. Managers must make this decision considering a time horizon over
which locations and capacities will not be altered (typically in years). Second, these models are
used to assign current demand to the available facilities and identify lanes along which product
will be transported. Managers must consider this decision at least on an annual basis as demand,
prices, exchange rates, and tariffs change. In both cases, the goal is to maximize the profit while
satisfying customer needs. The following information ideally is available in making the design
decision:

• Location of supply sources and markets

• Location of potential facility sites
• Demand forecast by market
• Facility, labor, and material costs by site
• Transportation costs between each pair of sites
• Inventory costs by site and as a function of quantity
• Sale price of product in different regions
• Taxes and tariffs
• Desired response time and other service factors

Dept. of Mechanical Engineering, MITE

 Supply Chain Management
Module-4
The role of network design in the supply chain:
Supply chain network design decisions include the assignment of facility role; location of
manufacturing-, storage-, or transportation-related facilities; and the allocation of capacity and
markets to each facility. Supply chain network design decisions are classified as follows:
1. Facility role: What role should each facility play? What processes are performed at each
facility?
2. Facility location: Where should facilities be located?
3. Capacity allocation: How much capacity should be allocated to each facility?
4. Market and supply allocation: What markets should each facility serve? Which supply
sources should feed each facility?
Network design decisions have a significant impact on performance because they determine the
supply chain configuration and set constraints within which the other supply chain drivers can be
used either to decrease supply chain cost or to increase responsiveness.

Factors influencing network design

Strategic factors
A firm’s competitive strategy has a significant impact on network design decisions within the
supply chain. Firms that focus on cost leadership tend to find the lowest cost location for their
manufacturing facilities, even if that means locating far from the markets they serve. Electronic
manufacturing service providers such as Foxconn and Flextronics have been successful in
providing low-cost electronics assembly by locating their factories in low-cost countries such as
China. In contrast, firms that focus on responsiveness tend to locate facilities closer to the market
and may select a high-cost location if this choice allows the firm to react quickly to changing
market needs. Zara, the Spanish apparel manufacturer, has a large fraction of its production
capacity in Portugal and Spain despite the higher cost there. The local capacity allows the company
to respond quickly to changing fashion trends. This responsiveness has allowed Zara to
become one of the largest apparel retailers in the world.

Technological factors
Characteristics of available production technologies have a significant impact on network design
decisions. If production technology displays significant economies of scale, a few high-capacity
locations are most effective. This is the case in the manufacture of computer chips, for which
factories require a large investment and the output is relatively inexpensive to transport. As a
result, most semiconductor companies build a few high-capacity facilities.
In contrast, if facilities have lower fixed costs, many local facilities are preferred because
this helps lower transportation costs. For example, bottling plants for Coca-Cola do not have a
high fixed cost. To reduce transportation costs, Coca-Cola sets up many bottling plants all over
the world, each serving its local market.

Macroeconomic factors
Macroeconomic factors include taxes, tariffs, exchange rates, and shipping costs that are not
internal to an individual firm. As global trade has increased, macroeconomic factors have had a
significant influence on the success or failure of supply chain networks. Thus, it is imperative
that firms take these factors into account when making network design decisions.
Tariffs and tax incentives Tariffs refer to any duties that must be paid when products
and/or equipment are moved across international, state, or city boundaries. Tariffs have a strong
influence on location decisions within a supply chain. If a country has high tariffs, companies
either do not serve the local market or set up manufacturing plants within the country to save on
duties. High tariffs lead to more production locations within a supply chain network, with each
location having a lower allocated capacity.

Developing countries often create free trade zones in which duties and tariffs are relaxed as
long as production is used primarily for export. This creates a strong incentive for global firms to
set up plants in these countries to be able to exploit their low labor costs.
Exchange-rate and demand risk Fluctuations in exchange rates are common and have
a significant impact on the profits of any supply chain serving global markets. For example, the
dollar fluctuated between a high of 124 yen in 2007 and a low of 81 yen in 2010, then back to
over 100 yen in 2014. A firm that sells its product in the United States with production in Japan
is exposed to the risk of appreciation of the yen. The cost of production is incurred in yen,
whereas revenues are obtained in dollars. Thus, an increase in the value of the yen increases the
production cost in dollars, decreasing the firm’s profits. In the 1980s, many Japanese
manufacturers faced this problem when the yen appreciated, because most of their production
capacity was located in Japan. The appreciation of the yen decreased their revenues (in terms
ofyen) from large overseas markets, and they saw their profits decline. Most Japanese
manufacturers responded by building production facilities all over the world. The dollar fluctuated
between0.63 and 1.15 euros between 2002 and 2008, dropping to 0.63 euro in July 2008. The drop
in the dollar was particularly negative for European automakers such as Daimler, BMW, and
Porsche, which export many vehicles to the United States. It was reported that every one-cent rise
in theeuro cost BMW and Mercedes roughly $75 million each per year.

Freight and fuel costs Fluctuations in freight and fuel costs have a significant impact on
the profits of any global supply chain. For example, in 2010 alone, the Baltic Dry Index, which
measures the cost to transport raw materials such as metals, grains, and fossil fuels, peaked at
4,187 in May and hit a low of 1,709 in July. Crude oil prices were as low as about $31 per barrel
in February 2009 and increased to about $90 per barrel by December 2010. It can be difficult to
deal with this extent of price fluctuation even with supply chain flexibility. Such fluctuations are
best dealt with by hedging prices on commodity markets or signing suitable long-term contracts.

Political factors
The political stability of the country under consideration plays a significant role in location
choice. Companies prefer to locate facilities in politically stable countries where the rules of
commerce and ownership are well defined. While political risk is hard to quantify, there are some
indices, such as the Global Political Risk Index (GPRI), that companies can use when investing
in emerging markets. The GPRI is evaluated by a consulting firm (Eurasia Group) and aims to
measure the capacity of a country to withstand shocks or crises along four categories: government,
society, security, and economy.

Infrastructure factors
The availability of good infrastructure is an important prerequisite to locating a facility in a given
area. Poor infrastructure adds to the cost of doing business from a given location. In the 1990s,
global companies located their factories in China near Shanghai, Tianjin, or Guangzhou—even
though these locations did not have the lowest labor or land costs—because these locations had
good infrastructure. Key infrastructure elements to be considered during network design include
availability of sites and labor, proximity to transportation terminals, rail service, proximity to
airports and seaports, highway access, congestion, and local utilities.

Socioeconomic factors
The Government of India has, as a matter of state policy, promoted industrial development of
industrially backward areas in the country concentrating in particular on the northeastern region,
Jammu & Kashmir, Himachal Pradesh, and Uttarakhand. Balanced regional development through
locational dispersal of industries has been one of the principal objectives of the successive
FiveYear Plans and government’s industrial policy.

Customer Response Time and local presence

Firms that target customers who value a short response time must locate close to them. Customers
are unlikely to come to a convenience store if they have to travel a long distance to get there.
It is thus best for a convenience store chain to have many stores distributed in an area so most
people have a convenience store close to them. In contrast, customers shop for larger quantity of
goods at supermarkets and are willing to travel longer distances to get to one. Thus, supermarket
chains tend to have stores that are larger than convenience stores and not as densely distributed.
Most towns have fewer supermarkets than convenience stores.

Logistics and facility Costs

Logistics and facility costs incurred within a supply chain change as the number of facilities,
their location, and capacity allocation change. Companies must consider inventory, transportation,
and facility costs when designing their supply chain networks.
Inventory and facility costs increase as the number of facilities in a supply chain increases.
Transportation costs decrease as the number of facilities increases. If the number of facilities
increases to the point at which inbound economies of scale are lost, then transportation costs
increase.

Uncertainty in Network Design:

Facility design decisions are strategic in nature and a firm will have to live with facility location
and capacity decisions for several years. Most of the data used in the network design
model are likely to change over a period of time. Projections of cost, price and demand over
a longer horizon usually have a lot of uncertainties associated with those numbers. For example,
in international network design, foreign exchange rates affect relative cost structures significantly
and predicting the same is extremely difficult, if not impossible. Firms like Birla
Cement or Asian Paints do not face this problem because they design multi-plant networks
within a country. Though cost of living, inflation and other factors are likely to vary in different
regions even within a country, the extent of variations is likely to be of much lower in
magnitude because migration within a country is much easier compared to migration across
countries. So, in general, design decisions about multi-plant networks within a country are
easier compared to global networks. There are several ways in which firms handle these issues.
Firms try and use scenario building through which they try and generate large numbers of
likely future scenarios and select an option that performs reasonably well across the projected
scenarios. So the focus shifts to selecting a robust solution rather than on picking a solution
that is optimal for one scenario.
Over a period of time, Toyota has introduced greater flexibility in its plants worldwide.
That is, a plant should be able to produce models that are required in the domestic market but must
also be able to produce models for a few export markets. On the whole, the
network will have excess capacity, so based on the exchange rates movement, volume will
be allocated to the respective plants in the network. For example, Toyota might look at its
Indian and Thai plants as the supply source for the South Asian market and keep excess
capacity at both places. If baht is cheaper, it can allocate more volume to the Thailand
facility, and if rupee is cheaper, it can allocate a higher share of the export market to India.
This excess capacity in network provides the luxury of options to the Toyota network. This
is known as real option because it provides a firm flexibility similar to financial options in
financial markets. But unlike financial options, real options are difficult to trade. Firms that
have excessively focused on their global manufacturing facilities have realized that any significant
change in Yuan rate can change the cost structures in a significant way. There is a
lot of pressure on China to devalue Yuan. Currently, LG uses its China facility as an export
base and exports 70 per cent of its production from China. Given the uncertainty on the
Yuan front, LG has decided to build excess capacity in India so that there is another hub
available as an option for export.
The idea of excess capacity in global networks may go against the current logic of a lean
supply chain design. In the lean philosophy, firms are not encouraged to keep this excess capacity,
which has associated costs. Because of the pressures faced by global firms, it is quite tempting to
avoid any excess capacity that may not have short-term payoffs. However, by doing so,
the process firms will lose their flexibility.

Pricing and Revenue Management:

Pricing
The decision to price a product at a particular value is a marketing decision. Prices are fixed
with the ultimate goal of maximizing profits. The law of demand states that as the price of
a good or service increases, the demand for the good or service will decrease and vice versa.
Therefore, for maximizing profits, an optimal pricing decision is needed.

Law of Demand and Optimal Pricing Decision

The law of demand is normally depicted as an inverse relation of demand quantity and price.
To illustrate this concept, let us take the hypothetical case of Super Airlines, which wants to
make a pricing decision for its daily morning flight from Bangalore to Mumbai. Super Airlines
caters to business customers, and based on market surveys, it has estimated the following
relationship between demand for seats on the said flight and price charged by the airline:

Demand = 160 - 20 × Price (where price is in thousand rupees)

The above equation is valid only in the price range of Rs 0–8,000. At Rs 8,000, no customer
will be willing to book a seat and demand will increase by 20 units with decline in unit price (unit
in this case is thousand rupees). At a price close to zero, demand will shoot up to 160. The
profit generated from the flight is as follows:

Profit = Revenue - Fixed cost - Variable cost

= Price × Seats booked - Fixed cost - Variable unit cost × Seats booked

The bulk of the cost of operating a flight between Bangalore to Mumbai is fixed. Once
the Airline has announced the flight and allocated aircrafts (these decisions are made well in
advance), the firm has no choice but to operate the announced flight and hence the fixed cost is
like a sunk cost. Let the fixed cost involved in operating a flight from Bangalore to Mumbai be
Rs 300,000 and we start with the assumption that the marginal cost of filling one more seat is
close to zero. In such a case, optimizing profit is equivalent to optimizing revenue. The revenue
function for this airline will be as follows:
Revenue = 160 Price 20 Price2
As one can see from Figure shown below, the revenue against price curve will be an inverted
U-shaped curve. The revenue will increase initially when the firm increases its price from zero
and will peak at a price of Rs 4,000 and will subsequently decline with further increase in price.
So it will be optimal for the airlines to price the Bangalore–Mumbai flight at Rs 4,000, which
will result in a demand of 80 seats. This will generate a revenue of Rs 320,000 and amount to
a profit of Rs 20,000 per flight.
For a general case of the linear demand curve, the formula is as follows:
D = a – bp
where D is the demand, p is the price and a and b are parameters of the demand curve.
One can easily show that the optimal price denoted as p* is as follows:

In the case of Super Airlines

At a price of Rs 4,000, 80 seats will get booked. So while choosing the aircraft for this
flight, the firm should ideally choose an aircraft whose capacity is just higher than the demand

Multiple-item, Multiple-location Inventory Management:

Selective Inventory Control Techniques
When dealing with a large number of items, the management may not be in a position to
focus attention on all items. For example, a large company like IndianOil will have lakhs of
SKUs to handle; similarly, a grocery chain like Foodworld has to manage thousands of SKUs.
Obviously, not all items are likely to be of equal importance. So it makes sense for a company
to classify items so that managers can pay suitable attention to different categories of items.
There are several classification schemes for categorizing SKUs:
• ABC classification. Items are classified into three categories based on the value of the
consumption. A-category items contribute significantly to the value of inventory and consumption
and are controlled tightly and get more managerial attention. ABC classification is discussed
in greater detail at a later stage.

• FSN classification. Items are classified based on volume of usage: fast moving (F), slow
moving (S) and non-moving (N). Fast-moving items are usually stocked in a decentralized
fashion while slow-moving items are stocked centrally. Non-moving items are candidates for
disposal and the firm will like to make sure that non-moving items do not take up a significant
share of inventory investment. This classification is quite popular in the retail industry.

• VED classification. Items are based on criticality: vital (V), essential (E) and desirable (D).
This classification is quite popular in maintenance management. Based on the VED classification,
one can fix different service levels for different items. Of course, a firm prefers to work
with a very high service level for V category of spare items. For example, Reliance industry
maintains a 99.995 per cent service level for V category of spares. While deciding the inventory
level for a D category product, one will fix relatively lower levels of service requirements.
Cummins India is a classic example of a firm that has applied ideas of selective inventory
control techniques in managing its spares inventory.
ABC Classification

One of the most popular methods of classification of items is the ABC classification. It is a
common practice to use three ratings: A (very important), B (moderate importance) and C
(little importance). SKUs in A categories can be given higher priority in terms of allocation of
management time. To carry out the ABC analysis, all the items are rank-ordered based on the
sales in value terms. Cumulative percentages of the total sales (in rupee) and the total number
of items are computed and these percentages are plotted. We illustrate the concept with an
example of ABC analysis carried out by a mattress manufacturing firm for its sales office at
Delhi. In this particular case, since all the items had more or less the same price, ABC analysis
was done on quantity, but typically it should be done on rupee value.
The company has 126 SKUs, but the top three SKUs accounted for
about 60 per cent of the sales volume. The format of the ABC analysis is illustrated in Table 4
The same data have been plotted in Figure As can be seen, 75 per cent of the items
constitute less than 5 per cent of value, so the firm has to find a method for the Delhi sales
manager to prioritize his time. That is, he should have very simple systems for these 75 per cent
of items and spend most of his time and attention on A-category items.
ABC categorization has been used with success in following areas:
• Allocation of managerial time. An A-category item should receive the bulk of managerial
attention and C category items should receive very little.
• Improvement efforts. The improvement effort should be directed at A-category items
only. For example, supplier relationships, lead time reduction, reduction in uncertainty
in lead time, etc.
Setting up of service levels. According to one philosophy, the A category should receive
99 per cent service level, the B category should receive 95 per cent and the C category
should receive 90 per cent service level so that the overall weighted service level for the
company will be around 97 per cent. Some firms do exactly the opposite. They provide
99 per cent of service level to C-category items, 95 per cent to B-category items and 90
per cent to A-category items. It is not that the firm actually allows 10 per cent of stockouts in A-
category items, but during the replenishment cycle, the firm monitors closely
all the A-category items in terms of actual demand as well as the status of supply. If
the manager anticipates the possibility of a stockout situation, even before the actual
stockout takes place he or she start working on contingency plans so that he or she can
avoid the stockout situation. So although actual safety stock is kept at a low level, the
effective service level is very high. Obviously, this kind of close monitoring cannot be
handled for all items but can be carried out for a few A-category items. We suggest that
the firm work with this approach of low safety stock but have contingency plans in
place for A-category items.
Stocking decision in the distribution system. A-category items are kept at all regional distribution
points, but C-category items are kept at a central warehouse only. B-category
items are kept only at a few regional hubs but not at all regional stock points.
ABC analysis can be done on sales data as well as on inventory data, on supplier data and
on purchase orders data. One will find a similar relationship. Although the exact distributions
among the three categories vary according to industry, based on our field experience, we find
that the range within which distribution is likely to vary could be as follows:
Some firms use a similar concept, called the 80–20 rule, that is, 80 per cent of the sales is
taken care of by 20 per cent of the items. In this system, items are classified in just two categories.
So far we have focused on constraints related to managerial time. The company may have
certain other constraints such as financial constraints. It is not uncommon for financial controllers
to provide an upper limit on the amount of inventory that the company should keep.
Sometimes organizations may have space constraint too, which may force the firm to look at
all the items together and vary service levels for different category of items to meet the constraints
on finance or space.
SCM Module 3 notes

SCM Module 5
Current Trends: Supply Chain Integration
Supply Chain Integration:
A typical firm is functionally organized, and material and information have to go through
multiple departments across the internal supply chain. As each function is myopic in nature
and is focusing on a narrowly defined local performance, there are many inefficiencies and
buffers at departmental boundaries. This is illustrated using two examples.
1. An electric machinery firm, which has a manufacturing plant in Mumbai, serves the
southern market through a stock point in Chennai. The Mumbai plant ships goods to
the Chennai stock point once a month because monthly demand amounts to
approximately a full truckload. Obviously by shipping goods using full truckloads, the
plant is able to minimize transportation costs. As it receives goods only once a month,
the Chennai stock point has to keep high safety stocks to ensure a reasonable level of
service to its customers. Thus, both the Mumbai plant and the Chennai regional stock
point have made so-called locally optimal decisions A detailed analysis shows that it
will be optimal (total transportation and inventory cost will be lowest) for the firm to
ship goods to Chennai from Mumbai once a week. There is a trade-off between
transportation and inventory costs, individual departments chose to ignore this trade-
off to make locally optimal decisions, resulting in a substantial increase in the overall
cost in the system.
2. A split pump manufacturer used to offer about 30-odd varieties of pumps in the
marketplace. As per the product design, the pump housing consisted of a top housing
and a bottom housing and the exact size of the pump housing varied with each model.
The machining of housings was one of the most critical tasks, involving expensive
equipment and a significant amount of time. One of the critical operations in the
machining of housing involved joint machining of both the housing castings (top and
bottom of same model) in one setup. However, the firm found that though it had a huge
inventory of housing castings, it rarely had matching pairs of top and bottom housing
castings, resulting in serious difficulties in scheduling machining operations, upsetting
promised customer delivery schedules. The purchase department had placed orders for
top housings with one vendor and bottom housings with another. Since one vendor had
quoted lowest for top housing castings and another had quoted lowest for bottom

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housing castings, the purchase department had placed orders accordingly. While the
purchase department had substantially minimized the buying cost at the purchase stage,
this kind of ordering resulted in uncoordinated supply by each vendor leading to
constant problems for manufacturing. The manufacturing team faces serious problems
in scheduling its operations. Even with a huge inventory of individual top and bottom
housing castings, operations find it difficult to match pairs for manufacturing. Hence,
the company had a typical problem of high inventory and low customer service. A
simple solution therefore will be an order of top and bottom housing casting with the
same vendor with clear instructions to supply both castings of the same model in one
shipment. The purchase department had tried to similarly cut costs by splitting “C”
category hardware items’ orders to several suppliers and found eventually that many
times crucial shipments could not be made because of non-availability of some of these
items

Building partnership and trust in Supply chain Value of

Information:
Bullwhip Effect: Demand Volatility and Information Distortions
Across Supply Chains:

 Supply chain coordination improves if all stages of the chain take actions that
together increase total supply chain profits. Supply chain coordination requires
each stage of the supply chain to take into account the impact its actions have
on other stages.
 A lack of coordination occurs either because different stages of the supply chain
have objectives that conflict or because information moving between stages is
delayed and distorted. Different stages of a supply chain may have conflicting
objectives if each stage has a different owner. As a result, each stage tries to
maximize its own profits, resulting in actions that often diminish total supply
chain profits.
 Today, supply chains consist of stages with many different owners. For
example, Ford Motor Company has thousands of suppliers from Goodyear to
Motorola, and each of these suppliers has many suppliers in turn.
 Information is distorted as it moves across the supply chain because complete
information is not shared between stages.

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 This distortion is exaggerated by the fact that supply chains today produce a
large amount of product variety. For example, Ford produces many different
models with several options for each model. The increased variety makes it
difficult for Ford to coordinate information exchange with thousands of
suppliers and dealers.
 The fundamental challenge today is for supply chains to achieve coordination
in spite of multiple ownership and increased product variety.
 Many firms have observed the bullwhip effect, in which fluctuations in orders
increase as they move up the supply chain from retailers to wholesalers to
manufacturers to suppliers, as shown in Figure 1.
 The bullwhip effect distorts demand information within the supply chain, with
each stage having a different estimate of what demand looks like. The result in
a loss of supply chain coordination.
 Proctor & Gamble (P&G) has observed the bullwhip effect in the supply chain
for Pampers diapers. The company found that raw material orders from P&G to
its suppliers fluctuated significantly over time. Farther down the chain, when
sales at retail stores were studied, it was found that the fluctuations, while
present, were small. It is reasonable to assume that the consumers of diapers
(babies) at the last stage of the supply chain used them at a steady rate. Although
consumption of the end product was stable, orders for raw material were highly
variable, increasing costs and making it difficult for supply to match demand.

Figure 1: Demand fluctuations at different stages of a supply chain

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Effective Forecasting
The following basic, six-step approach helps an organization perform effective forecasting.
1. Understand the objective of forecasting.
2. Integrate demand planning and forecasting throughout the supply chain.
3. Understand and identify customer segments.
4. Identify the major factors that influence the demand forecast.
5. Determine the appropriate forecasting technique.
6. Establish performance and error measures for the forecast.
UNDERSTAND THE OBJECTIVE OF FORECASTING
Every forecast supports decisions that are based on the forecast, so an important first step is to
identify these decisions clearly. Examples of such decisions include how much of a particular
product to make, how much to inventory, and how much to order. All parties affected by a
supply chain decision should be aware of the link between the decision and the forecast. For
example, Wal-Mart's plans to discount detergent during the month of July must be shared with
the manufacturer, the transporter, and others involved in filling demand, as they all must make
decisions that are affected by the forecast of demand. All parties should come up with a
common forecast for the promotion and a shared plan of action based on the forecast. Failure
to make these decisions jointly may result in either too much or too little product in various
stages of the supply chain.
INTEGRATE DEMAND PLANNING AND FORECASTING THROUGHOUT THE
SUPPLY CHAIN
A company should link its forecast to all planning activities throughout the supply chain.
These include capacity planning, production planning, promotion planning, and purchasing,
among others. This link should exist at both the information system and the human resources
management level. As a variety of functions are affected by the outcomes of the planning
process, it is important that all of them are integrated into the forecasting process. In one
unfortunately common scenario, a retailer develops forecasts based on promotional activities,
whereas a manufacturer, unaware of these promotions, develops a different forecast for its
production planning based on historical orders. This leads to a mismatch between supply and
demand, resulting in poor customer service.
To accomplish this integration, it is a good idea for a firm to have a cross-functional team, with
members from each affected function responsible for forecasting demand and an even better

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idea is to have members of different companies in the supply chain working together to create
a forecast.

Coordination in supply chain

 Effectively managed supply chain relationships foster cooperation and trust, thus
increasing supply chain coordination. In contrast, poorly managed relationships lead to
each party being opportunistic, resulting in a loss of total supply chain profits. The
management of a relationship is often seen as a tedious and routine task. Top
management, in particular, is often very involved in the design of a new partnership but
rarely involved in its management. This has led to a mixed record in running successful
supply chain alliances and partnerships.
 Figure 2 shows the basic process by which any supply chain partnership or alliance
evolves. Once the partnership has been designed and established, both partners learn
about the environment in which the partnership will operate, the tasks and processes to
be performed by each partner, the skills required and available on each side, and the
emerging goals of each side. The performance of each side is evaluated based on the
improvement in profitability and on equity or fairness. At this stage, a better evaluation
of the value of the partnership becomes available, which provides both parties in the
supply chain partnership an opportunity to revise the conditions of the partnership to
improve profitability and fairness. It is important that the initial contracts be designed
with sufficient flexibility to facilitate such alterations.
 Formal contracts may be restructured to reflect the changes. As the business
environment and company goals change, the cycle repeats itself and the relationship
evolves. Any successful supply chain partnership will go through many such cycles. A
supply chain partnership falters if the perceived benefit from the relationship diminishes
or one party is seen as being opportunistic. Problems arise when communication
between the two parties is weak and the mutual benefit of the relationship is not
reiterated regularly. When managing a supply chain relationship, managers should
focus on the following factors to improve the chances of success of a supply chain
partnership:
1. The presence of flexibility, trust, and commitment in both parties helps a supply chain
relationship succeed. In particular, commitment of top management on both sides is
crucial for success.

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2. Good organizational arrangements, especially for information sharing and conflict

resolution, improve chances of success. Lack of information sharing and the inability
to resolve conflicts are the two major factors that lead to the breakdown of supply chain
partnerships.
3. Mechanisms that make the actions of each party and resulting outcomes visible help
avoid conflicts and resolve disputes. Such mechanisms make it harder for either party to be
opportunistic and help identify defective processes, increasing the value of the relationship
for both parties.
4. The more fairly the stronger partner treats the weaker, vulnerable partner, the stronger
the supply chain relationship tends to be.

Figure 2: Process of alliance and partnership Evolution

 The issue of fairness is extremely important in the supply chain context because
most relationships involve parties with unequal power. Unanticipated situations that
hurt one party more than the other often arise.
 The more powerful party often has greater control over how the resolution occurs.
The fairness of the resolution influences the strength of the relationship in the
future.
 The relationship between Marks & Spencer and a manufacturer of a kitchen product
provides an excellent example of a fair sharing of benefits. A few months after the
product's introduction, the manufacturer realized that costs had been miscalculated
and exceeded the price at which the product was being sold to Marks & Spencer.

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Meanwhile, given its low retail price, customers found the product an outstanding
value and made it a big hit.
 When the manufacturer brought the problem to the attention of Marks & Spencer,
its managers helped the manufacturer reengineer both the product and the process
to lower cost. Marks & Spencer also lowered its margin to provide a sufficient profit
for the manufacturer. The outcome was one in which the relationship was
strengthened between the two partners because Marks & Spencer's fairness allowed
a resolution that recognized the manufacturer's needs. In the long run, both partners
benefited and a higher level of trust developed.

Supply chain Restructuring:

Introduction:
 In the era of globalization, firms are under relentless pressure to continuously
improve their supply chain performance so as to minimize cost and maintain high
levels of customer service.
 In the last decade, several leading firms have reaped substantial benefits by working
on initiatives involving supply chain integration and supply chain optimization.
These initiatives have helped these firms in ensuring above-average business
performance in their respective industry sectors.
 But in the last few years, leading firms have realized that initiatives involving
supply chain integration and supply chain optimization are not enough for ensuring
above-average business performance. These initiatives are necessary for the very
survival of a firm. These do not ensure an above-average performance.
 Supply chain integration and related best practices have received adequate attention
in the industry. These practices have percolated down from the best firms to emerge
as necessary but insufficient conditions for firms to establish themselves as market
leaders.
 Industries have realized that if they want to retain their leadership, they will have to
go beyond these initiatives and look at ways in which they can restructure supply
chain architecture and processes. Supply chain restructuring focuses on these
innovative practices that separate leaders from the “also-ran” companies.
 Unlike supply chain integration and supply chain optimization, supply chain
restructuring goes beyond supply chain function and requires integrating product

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and process engineering with supply chain function. Similarly, it may also involve
closer integration between marketing and supply chain function.
Supply Chain Mapping:
 Before a firm sets out to restructure its supply chain, it has to find a method to
successfully capture and evaluate the existing supply chain processes. The method
used to capture current supply chain processes is termed supply chain mapping.
 As can be seen in Figure 3, existing supply chain processes can be characterized on
the basis of the following dimensions:
• Shape of the value-addition curve
• Point of differentiation
• Customer entry point in the supply chain

Figure 3: Supply chain mapping:

existing position.
Restructuring of the supply chain process involves altering the supply chain on at least one the
three dimensions. It may also involve altering more than one dimension of the supply chain
process. We initially take one dimension at a time and later on discuss a specific innovation,
which involves altering two dimensions in the process.
Value-addition Curve:
 The supply chain encompasses all the activities/processes associated with the
transformation of goods from the raw material stage to the final stage when the goods
and services reach the end customer.
 A typical supply chain starts with some input material and information, which are
transformed into the end product and delivered to the customer. This transformation
involves a number of activities, with each activity taking time, incurring cost and adding
value.

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 One can debate on whether all activities add value or if there some activities that are
non-value-added activities. At this stage, we assume that the firm has removed all non-
value added activities from the supply chain processes.
 On the x-axis we have the total time in a chain or the average flow time in the chain
and on the y-axis we have the total cost (cumulative) in the chain.
Customer Entry Point in the Supply Chain:
 The point at which a customer places an order is shown as a dotted line in Figure 3. In
several industries customers expect material off the shelf in the neighbourhood retail
store.
 In such a case, the customer entry point is at the end of chain and is the same as the
delivery time. But in several industries it is not uncommon for customers to give some
amount of delivery lead time and in such a case obviously the customer entry point will
be ahead of the delivery time. This is similar to build-to-order or configure-to-order
supply chain situations.
 Essentially, the customer entry point captures the order to delivery lead time. This
dimension is important because all the operations before the customer order has to be
done based on forecast, whereas after the customer order one will be working with
actual orders.
 In other words, before the customer entry point all the activities are carried out based
on forecast while subsequent activities are done based on order. As discussed in the
chapter on demand forecasting, however good the forecasting process, as per the first
law of forecasting, a forecast is always wrong.
 So if bulk of the activities can be carried out based on order rather than forecast one
does not have to worry about the likely forecast error that is inherent in any forecasting
exercise.
Point of Differentiation:
 The concept of the point of differentiation is valid for any organization that is offering
a variety of end products to customers. Products are made in a supply chain consisting
of multiple stages. As the product moves in the chain, progressively, the product
assumes an identity that is closer to the end product.
 The point of differentiation is a stage where the product gets identified as a specific
variant of the end product. We will illustrate the concept using a toothpaste
manufacturing firm. Let us assume that the firm offers variety only in pack sizes.

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 In such a firm, the packing stage is a point of differentiation. At a packing station the
same basic material, that is, toothpaste, is packed in sizes of varying dimensions. So till
the packing station one has been working with the generic material, but at the packing
station the firm has to make an irreversible decision in terms of committing the generic
material to a specific product variant. Similarly, at a garment manufacturing firm, at the
stitching stage the firm is committing the fabric to different sizes and styles of garment.
 In automobile manufacturing firms like Tata, where usually large variety is offered in
terms of colours, the painting stage becomes the point of differentiation because at that
stage the firm makes an irreversible decision about the colour of the car.

Supply Chain Process Restructuring:

Supply chain process restructuring involves playing around with at least one of the three
dimensions of the supply chain in the direction as shown below:
• Postpone the point of differentiation. By moving the point of differentiation as much
as possible, a bulk of the activities can be carried out using the aggregate-level forecast
rather than the variant-level forecast.
• Alter the shape of the value-addition curve. Shift the bulk of the cost addition as
late as possible. This will reduce the inventory in the chain and also help the firm in
having some flexibility. If the bulk of the cost addition takes place at a later point in
time in the chain, one will be in a position to respond to unforeseen changes with the
least cost.
• Advance the customer ordering point. Move from an MTS to a CTO supply chain.
By moving the customer ordering point as early as possible, one can carry out the bulk
of the activities against an order, which reduces the importance of forecasting. If one
were also able to postpone the point of differentiation, one will be able to move from
an MTS to a CTO supply chain.
In a CTO supply chain, since the point of differentiation takes place after customer
order, one does not have to prepare a variant-level forecast.
Before we get into a detailed discussion about supply chain restructuring, it will be
important to compare it against supply chain integration and supply chain optimization.
As can be seen in Figure 4, supply chain integration and supply chain optimization
focus on lowering the value-addition curve. This results in overall reduction in cost and
time and will result in an absolute shift in the point of differentiation but the relative
position of the point of differentiation does not change. Unlike these two approaches,

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supply chain restructuring affects the shape of the value-addition curve, shifts customer
ordering, or shifts the point of differentiation.
This will essentially require supply chain process restructuring and may also involve a
change in product design or a change in the product service bundle offered to customers.
Supply chain restructuring is likely to bring in substantial business benefits in general
and in special cases it fundamentally changes the way in which the supply chain is
managed by moving from the MTS to the CTO business model.

Figure 4: Impact of supply chain

Integration /optimization.

Postpone the Point of Differentiation:

Delaying an operational process that results in variety explosion or customization to a
later point in the supply chain postpones the point of product differentiation. Delaying
the differentiating operations, apart from reducing inventories, also reduces the time
period for which one has to carry out forecasting at the variant level and thereby reduces
inventory and improves customer service and reduces product obsolescence.
Postponement for Reducing Transportation Cost
Usually, postponing of the assembly process is carried out for shifting the point of
differentiation to a later stage. But there have also been cases where firms have used
the postponement strategy for delaying an operational process to a later point in the
supply chain in order to reduce transportation costs. Transportation cost is reduced in
the case of bulky finished products by shifting the assembly operations to the customer
end as transporting parts as kits is cheaper than transporting a finished product.
Postponement in Bicycle Industry
The bicycle industry in India belongs to a category of industries that traditionally
practices the postponement strategy. The reasons for this practice are as follows:

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• To reduce transport complexities and costs. The bicycle manufacturers limit their
activities to production of frames, handle bars and transmission parts. Other suppliers
produce the tyres, tubes, seats and many extra fittings. A large number of bicycle
dealer’s stock products of all bicycle manufacturers. The bicycle purchasing process is
as follows: when the customer arrives at the bicycle shop, she/he opts for a particular
frame size offered by a particular bicycle manufacturer. Similarly, she/he will opt for a
particular tyre size, offered by a particular tyre manufacturer and so on. Given this
situation, it is imperative that the assembly of the final product is carried out at the
dealer point. Additionally, the entire assembly takes just 15–30 minutes.
• Less exposure to damage than when transported as fully assembled bicycles.
• Less need for shop space when material is stocked as components instead of as fully
assembled bicycles.
• Low-technology nature of the assembly operation, which ensures there are no
inconsistencies in product quality.
Though the bicycle industry has worked on the idea of postponement of assembly so as
to primarily reduce transportation cost, they can also take advantage of this strategy and
offer higher variety. The bicycle industry can design a modular-level variety and allow
customers to choose a combination of modules and the retailer can assemble the
bicycle, which is essentially configured to customer requirements. This facilitates the
bicycle industry’s transition to a mass-customization environment.
Problems with Implementing the Postponement Strategy
The examples cited above help in understanding the industrial and technological
characteristics that make the postponement strategy viable. In general, postponement
strategy is likely to be advantageous in the following situations:
• High level of product customization
• Existence of modularity in product design
• High uncertainty in demand
• Long transport lead time
• Short lead time of postponed operation
• Low value addition in transportation
• High value addition in postponed operation
• Difference in tariff rates for components and finished goods in different markets.

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THE ROLE OF IT IN NETWORK DESIGN:

Even though it may seem at first glance that the strategic nature of the network design
problem makes information technology systems less valuable, good IT systems can
significantly improve the capability of a network designer. In this chapter, we discuss
a variety of methodologies in Excel that can be used to solve network design problems.
Even though the core models are the same, problems in practice tend to be much larger
than the problems considered in the chapter. For much larger problems, there are four
ways that an IT system can help with network design relative to the use of a general-
purpose tool such as Excel.
1. A good network design IT system makes the modeling of the network design
problems much easier than in a general-purpose tool such as Excel. These applications
have many built-in tools that facilitate an accurate description of a large supply chain
network and incorporate realistic features that would be time consuming and difficult
to build in Excel.
2. An IT system contains high-performance optimization technologies, which deliver a
high-quality solution for large problems in a reasonable amount of time. Although
Excel's solver can be upgraded, there are many cases in which the size and complexity
of the optimization require a more sophisticated system that a network design
application can provide.
3. A good network design application also allows for an analysis of various "what if"
scenarios. Given the uncertainty associated with forecasts, the ability to evaluate
network designs in a variety of scenarios is a very powerful tool for a designer. A
network designer may find it much more appropriate to select a design that gives very
good costs in many likely scenarios rather than a design that is optimal in one scenario
but very poor in another. The ease of modeling and speed of solution allows a good
network design application to facilitate what-if analysis to a far greater extent than a
general-purpose tool such as Excel.
4. Finally, network design applications are structured to interface easily with the
planning and operational software used by firms, which contain much of the actual data
required for network design. The ease of interfacing with the data source speeds up the
creation and solution of a network design model.
Network design applications are often quite inexpensive relative to the other uses of IT
we discuss. Network design applications, sometimes called supply chain strategy
modules, are often thrown in for free on top of the much more expensive planning and

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execution modules. In fact, many companies have rights to these products without even
realizing it, as a result of past software purchases.
There are some caveats, however, to the use of IT systems in network design.
Network design decisions are strategic and involve many factors that are hard to
quantify.
When using a network design tool, it is easy to fall into the trap of allowing the
application to make the decision based only on aspects that are quantifiable. Important
factors such as culture, quality-of-life issues, and cost of coordination that are hard for
IT to handle can be significant in making a network design decision. Thus, relevant non
quantifiable factors should be included with the output of IT systems when making
network design decisions.

Dept. of Mechanical Engineering, MITE