indroduction to supply chain 1

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1 Operations Management Notes ( Pvt Circulation Only) Compiled by Santhosh.S, Associate Professor, SCMS Cochin Unit I Part 1 Introduction to Supply Chain Management (SCM): Concept of SCM Components Features Strategic issues in SCM, The Supply Chain Revolution-Customer focus in SCM , Demand planning, Purchase Planning Make or Buy decision indigenous and global sourcing, Development and Management of suppliers Legal aspect of Buying Cost management- Negotiating for purchasing and sub contracting Purchase insurance Evaluation of Purchase performance. INTRODUCTION Supply Chain management is the process of strategically managing the procurement, movement, and storage of materials, parts and finished inventory (and related information flow) through the organization and its marketing channels in such a way that current and future profitability are maximized through system wide cost effective fulfilment of orders. Supply chain encompasses all activities involved in the transformation of goods from the raw material stage to the final stage, where goods and services reach the end customer. SCM 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 with various stages and the related flows are represented in figure 1.1 below Vendors Plants Depots Retail outlets Customers MATERIAL FLOW INFORMATION FLOW FINANCE FLOW Fig 1.1 Stages of Supply Chain Management and the related flows

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Page 1: Indroduction to Supply Chain 1

1 Operations Management Notes ( Pvt Circulation Only)

Compiled by Santhosh.S, Associate Professor, SCMS Cochin

Unit I – Part 1 Introduction to Supply Chain Management (SCM): Concept of SCM – Components – Features – Strategic issues in SCM, The Supply Chain Revolution-Customer focus in SCM , Demand planning, Purchase Planning – Make or Buy decision – indigenous and global sourcing, Development and Management of suppliers – Legal aspect of Buying – Cost management- Negotiating for purchasing and sub contracting – Purchase insurance – Evaluation of Purchase performance.

INTRODUCTION

Supply Chain management is the process of strategically managing the procurement, movement,

and storage of materials, parts and finished inventory (and related information flow) through the

organization and its marketing channels in such a way that current and future profitability are

maximized through system wide cost effective fulfilment of orders.

Supply chain encompasses all activities involved in the transformation of goods from the raw

material stage to the final stage, where goods and services reach the end customer. SCM 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 with various stages and the related flows are represented in figure 1.1

below

Vendors Plants Depots Retail outlets Customers

MATERIAL FLOW

INFORMATION FLOW

FINANCE FLOW

Fig 1.1 Stages of Supply Chain Management and the related flows

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Supply chain exists in both service and manufacturing organizations, although the complexity of

chain may vary greatly from industry to industry and firm to firm. SCM is a major source of

competitive and financial advantage, ie position of enduring superiority in terms of customer

preference.

The conceptual model of SCM is shown in Fig 1.2

Fig 1.2 The Conceptual model of Supply chain management.

IMPORTANCE OF SCM

In the past, customers were not very demanding and competition was not really intense. 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 product 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 of product lines

Companies have realized that more and more product variety is needed to satisfy the

growing range of customer tastes and requirements. Even a simple toilet soap has 50 –

odd varieties. Stock- Keeping unit (SKU) can be defined as a unit of variety. Each variety

is treated as a separate SKU. Companies like HUL, in their personal care products,

manage on an average 1200 SKU’s. Chains like Foodworld manage about 6000 SKU’s.

SUPPLY CHAIN

MANAGEMENT

Multi-Tier Supplier

Partner ship

Multiparty Net-Logistics

Highly Sophisticated IT

Systems

Multi-Tier Supplier

Partner ship

Non Core outsourcing Make / Engineer to order

Philosophy

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Shorter product life cycles

With increased competition, product life cycle across all industries is becoming shorter.

With shorter product life cycle, inventory of the product and the components needed to

manufacture it becomes obsolete within a short span of time. Hence companies that

efficiently operate their supply chain with low inventories are in a better position to avoid

loss than others with higher inventory burden. For example, the PC industry works with a

life cycle as short as 6 months. Hence companies like Dell with just 7 days average

inventory as compared to the industry standard of 35 days need not worry much about

product and component obsolescence.

High level of outsourcing

Firms increasingly focus on their core activities and outsource non-core activities to other

competent players. Apart from the primary activities in the value chain even the support

activities that were usually done in-house are outsourced in a big way now. Bharathi

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 chain more

vulnerable, thereby forcing firms to develop different types of supply chain capabilities

within the organization.

Shift in power structure in the value chain

In every industry, the entities closer to customers are becoming more powerful. With

increasing, competition, a steadily rising number of products is 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. Discount retailers like Wall-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 customer’s demands,

because of changes in the power structure within the chain.

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Globalization of manufacturing

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. In telecommunication 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

them in the international market. This has made managing supply chain extremely

complicated. Unlike information and finance flow, which can be managed electronically,

materials and product have to move physically, an as this movement can be across

continent, managing supply chain is now a extremely complex issue.

DECISION PHASES IN A SUPPLY CHAIN

Successful supply chain management requires many decisions relating to the flow of

information, product and funds. Each decision should be made to raise the supply chain

surplus (Income from product or service given minus cost of providing the product or

service to the customer). These decisions fall into three categories or phases, depending

on the frequency of each decision and the time frame during which a decision phase has

an impact.

1. Supply chain Strategy or Design:

During this phase, a company decides on the structure of its supply chain for the

next several years. It decides what the chain’s configuration will be, how

resources will be allocated, and what processes each stage will perform. Strategic

decision made by the company include

a. Whether to outsource or perform a supply chain function in-house.

b. The location and capacities of production and warehousing facilities

c. The products to be manufactured or stored at various locations.

d. The modes of transportation to be made available along different shipping

legs.

e. Type of information to be used

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These decisions are typically made for the long term (a matter of years) and are

very expensive to alter on short notice. Consequently when companies make these

decisions, they must take into account uncertainty in anticipated market

conditions over the next few years.

2. Supply chain planning

This objective of the planning phase is to maximize the supply chain surplus,

given the constraints established in the Design phase. The planning phase starts

with a forecast for the coming year, or comparable time frame, of demand in

different markets. Planning includes making decisions regarding which market

will be supplied from which locations, the subcontracting of manufacturing, the

inventory policies to be followed and the timing and size of marketing and price

promotions. As a result of planning phase, companies define a set of operating

policies that govern short term operations.

3. Supply chain Operations:

The time horizon here is weekly or daily and during this phase companies make

decisions regarding individual customer orders. At the operational level supply

chain configuration is considered fixed, and planning policies are already defined.

The goal of supply chain operations is to handle incoming customer orders in the

best possible manner. During this phase, firms allocate inventory or production to

individual orders, set a date that an order is to be filled , generate pick lists at

warehouse, allocate an order to a particular shipment mode and shipment, set

delivery schedules of trucks, and place replenishment orders. Given the

constraints established by the configuration and planning policies, the goal during

the operation phase is to exploit the reduction of uncertainty and optimize

performance.

SCM PROCESSES

A close examination of the supply chain reveals that it is a sequence of various processes and

flows within and between the various stages in the supply chain. For better understanding and

analysing the processes it is advantageous to divided the processes into different categories or

view it from different points of view. There are two different ways to view the processes

performed in a supply chain

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1. Cycle View: The processes in a supply chain are divided into a series of cycles, each

performed at the interface between two successive stages of a supply chain.

2. Push/Pull view: The processes in a supply chain are divided into two categories

depending on whether they are executed

a. in response to a customer order or

b. in anticipation of customer order

Pull processes are initiated by a customer order, whereas push processes are initiated and

performed in anticipation of customer order.

Cycle View of supply chain

All supply chain processes can be broken into the following four process cycles,

Customer order cycle

Replenishment cycle

Manufacturing cycle

Procurement cycle

The four process cycles are shown in the figure 1.2 below

CUSTOMER

RETAILER

DISTRIBUTOR

MANUFACTURER

Fig.1.3 Supply chain Process Cycles. SUPPLIER

CUSTOMER

ORDER CYCLE

MANUFACTURING

CYCLE

REPLENISHMENT

CYCLE

PROCUREMENT

CYCLE

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The cycles occur at the interface between successive stages of the supply chain. Thus the five

stage supply chain has four cycles at its interface. Not all supply chain will have all four cycles

clearly separated. For example, a grocery supply chain in which a retailer stocks finished-goods

inventory and places replenishment order with distributor is likely to have all the four cycles

separated. Dell, in contrast, sells directly to customers, thus bypassing the retailer and distributor.

Fig 1.4 Cycle view of Dell

Each of the cycle consist of six sub processes as shown in Fig. 1.5

Within each cycle, the goal of the buyer is to ensure product availability and to achieve

economies of scale of ordering. The supplier then attempts to forecast customer orders and

reduce cost of receiving orders. The supplier then works to fill the order on time and improve the

efficiency and accuracy of order fulfilment process. The buyer then works to reduce the cost of

Procurement cycle

Customer order and

manufacturing Cycle

Supplier stage

Markets product

Buyer stage Places

order

Supplier stage

Receives order

Supplier stage

Supplies order

Buyer stage

Receives Supply

Buyer stage returns

flow to supplier

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the receiving process. Reverse flows are managed to reduce cost and meet environmental

objectives.

Even though each cycle has the same basic sub processes, there are a few important differences

between cycles. The differences are

Nature of Demand: In the customer order cycle, demand is external to the supply chain

and thus uncertain, whereas in all other cycles order placement is uncertain but can be

projected based on policies followed by the particular supply chain stage. For example

in the procurement cycle a supplier of tyre to an automotive manufacturer can predict

tyre demand precisely once the production schedule of manufacturer is known.

Scale of Order: The second difference is as we move from customer to the supplier the

number of individual orders decreases but the size of each order increases. For example

customers order a single car where as dealers order multiple cars at a time from the

manufacturer and the manufacturers in turn orders an even larger quantity of tyres from

the supplier. So from customer to supplier number of orders decreases but size of order

increases. Thus sharing of information and operating policies across the supply chain

stages become more important as we move from customer to supplier end.

The cycle view of the supply chain is very useful when considering operational decisions

because it clearly specifies the roles of each member of the supply chain. A detailed process

description of a supply chain in the cycle view forces a supply chain designer to consider the

infrastructure required to support these processes. Cycle view is useful while setting up the

information system to support the supply chain operations.

Push / Pull view of Supply chain processes

In this view all processes in a supply chain fall into one of the two categories depending on the

timing of their execution relative the end-customer demand. With pull processes, execution is

initiated in response to a customer order. With push processes, execution is initiated in

anticipation of customer order. There fore, at the time of execution of a pull process, customer

demand is known with certainty, whereas at the time of execution of push process, demand is not

known and must be forecast. Pull processes may also be referred to as reactive processes because

the react to customer demand. Push process may also be referred to as speculative processes they

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respond to speculated (or forecasted) rather than actual demand. The push/pull boundary

separates the push processes from the pull processes. Push processes operate in an environment

of uncertainty whereas the pull processes are often constrained by the inventory and capacity

decisions that were made in the push phase. ( for example the customer order cycle cannot order

more than what is available in stock with the retailer which is decided by the replenishment

cycle which is a push cycle)

PUSH / PULL BOUNDARY

Push processes Pull Processes

Customer Order Arrives

We shall analyse an apparel company (Zodiac) which stocks the fashion apparels in its retail

showrooms and a retailer selling Asian paints which stocks paint bases and colour chemicals at

the retailer which is mixed as per the customer order.

Analysis of Zodiac

Zodiac executes all processes in the customer order cycle after the customer arrives. So all the

processes that are part of the customer order fulfilment cycle are pull processes. Order

Process n Process n-1 Process n-2 Process Process 3 Process 2 Process 1

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fulfillment takes place from product in inventory that is built up in anticipation of customer

orders. The goal of the replenishment cycle is to ensure availability when a customer order

arrives. All processes in the replenishment cycle are performed in anticipation of demand and are

thus push processes. The same holds true for processes in the manufacturing and procurement

cycle.

Analysis of Asian Paints

The customer order cycle and part of manufacturing process is pull process as the mixing of

paint is done on the demand placed by the customer. Procurement cycle is push process.

Supply Chain Macro Processes

All the supply chain processes can be classified into 3 macro processes. They are

1. Customer Relationship Management ( CRM): All processes that focus on the interface

between the firm and its customers

2. Internal Supply Chain Management (ISCM): All processes those are internal to the firm.

3. Supplier Relationship Management (SRM): All processes that focus on the interface

between the firm and its suppliers.

Strategic Issues in Supply chain Management

The strategic issue of a supply chain can be summarized as “How to provide superior value to

the end customer in an efficient manner”. In other words how to match the supply chain

capabilities to the uncertainties of demand. The issue is of achieving appropriate ‘fit’ with the

Business Strategy. This issue is the key consideration during the design phase of the Supply

chain management process.

The strategic fit between the Business Strategy and the Supply chain Strategy can be achieved

through three basic steps

1. Understanding the Customer (demand) and Supply chain uncertainty

2. Understand the supply chain capabilities

3. Achieving the strategic fit.

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1. Understanding the customer and supply chain uncertainty

Customer demand uncertainty

The demand of a product by various customer segment depends on various attributes like

Quantity of product needed in each lot – eg. A component needed to repair a production

line will be very small, where as a component needed build a new product line will be

very large.

The response time of the company in meeting the demand- Example – a tolerable

response time for an emergency order would be very short where as it would be long for

a construction order.

The product variety offered – emergency repair order all products expected from a single

supplier where as for construction order that is not so important.

The Service level required- Emergency repair order expects immediate delivery,

construction order this is not insisted.

The price of the product- Emergency order not sensitive to price, construction order is

price sensitive.

The innovativeness expected in the product.- Customers of high end department store

may expect a lot of product innovativeness where as a customer at the govt. Dept. Store

may not expect products to be innovative.

One key measure that combines all the attributes along which the demand of a product varies and

which is particularly useful in the design of supply chain is the implied demand uncertainty.

Implied demand uncertainty can be explained with an example, the electronic components used

in TV. Demand uncertainty of electronic component depends on the demand for TVs and also for

the repair of the TVs. The needs of the TV manufacturer and the needs of the emergency repair

of TV are different. The response time that each of these customers are willing to tolerate are

different. The TV manufacturer may be willing to wait for a day for delivery where as the

emergency repair customer would prefer immediate delivery of the components. So depending

upon which need is attempted to be satisfied by the supply chain, the demand varies. This is the

implied demand uncertainty. So implied demand uncertainty is the uncertainty imposed on the

supply chain because of the customer needs it seeks to satisfy. From the supply chain design

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point of view, products with low implied demands uncertainty are generally known as functional

products and products with high implied demand uncertainty are Innovative products.

The difference on various aspects of demand of functional and innovative products is tabulated

below

Aspect of Demand Functional ( Low implied

demand uncertainty)

Innovative ( High implied

demand uncertainty)

Product Life cycle

More than 2 years

3 months to 1 year

Contribution margin 5-20% 20-60%

Product Variety Low ( 10-20 variants per

category)

High ( Often thousands of

variants per category)

Likely forecast error 5-20% 40-100%

Average stock out rate 1-2% 10-40%

End of season markdown 0% 10-30%

Source: Adapted from M.LFisher ‘What is the right supply chain of your product?’ Harvard

business Review( March-April 1997)

Supply uncertainty

Supply side uncertainty is typically high with products in the early stages of its life cycle, eg a

newly introduced component which has not yet stabilized its manufacturing, or agricultural

products dependant on weather ( coffee, spices). The supply side uncertainty is low with mature

products because design and manufacturing processes have evolved and stabilized.

2. Understanding the supply chain capabilities

In order to create a best strategic fit it is important to understand supply chain capabilities.

Supply chain capability is ability of the supply chain to provide superior value to the end

customer in an efficient manner. Customer service and supply chain costs are closely related. As

service level increases the cost of service also increases. The first step of understanding the

supply chain capabilities is to understand the position of the supply chain in the cost and service

level graph given below

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Cost Efficiency Frontier

Existing Position

Service level

If the firm is not on the efficiency frontier due to the inefficiencies in the supply chain then the

first effort would be to address these inefficiencies. The business strategy of a firm helps in

choosing an appropriate position on the efficiency frontier.

The demand and profit are directly dependant on the service level and the service level is closely

related to the cost. Hence it would be optimal for a company to operate at a specific level of

customer service where the customer taste and competitor offering affects the revenue curve and

the supply chain innovations affect the cost curve.

Revenue

Profit contribution

Service Level

cost

Revenue

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The customer service has various dimensions like

Order Delivery lead time

Responsiveness

Delivery reliability

Product variety

Order delivery lead time

Order delivery time is the time taken by the supply chain to complete all the activities from order

to delivery. This dimension of customer service has a significant impact on the way a supply

chain is designed and operated. The figure 1.5 shows the supply chain lead time and the order

delivery lead time of a typical firm that sources material, manufactures components, assembles

the product and delivers the finished product to the end customer. The aggregate of all the

individual stages is the supply chain lead time, which is total time required for the supply chain

to carry out all activities from beginning to the end. In the competitive market the order delivery

Customer order

Order penetration point

Order delivery lead time

Supply Chain lead time

Fig 1.5 Interaction between Supply chain lead time and delivery lead time.

lead time is dictated by competitive offerings and customer needs and the supply chain lead time

is usually much longer than the order delivery lead time.

A critical characteristic of the supply chain is the customer order penetration or decoupling point.

There are essentially three types of supply chain characterized by the customer order penetration

point: Make to stock ( MTS), Make to order (MTO), and configure to order ( CTO) also known

as Assemble to order or build to order. See figure 1.6 below

Source Make components Assembly Deliver

y

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Fig 1.6 Order penetration point based supply chain typology

Supply Chain Responsiveness

Responsiveness captures the firm’s ability to handle the uncertainty of market demand. Based on

the kind of demand uncertainty faced by the product the supply chain strategy should design the

supply chain. The figure below provides an idea of matching the supply chain design with the

nature of product

Functional Innovative

Products Products

MATCH

MISMATCH

MISMATCH

MATCH

Fig 1.7 Matching supply chain design with nature of product.

Delivery Reliability

Delivery lead time is an important dimension of customer service, and delivery reliability

essentially captures the degree to which a firm is able to service its customers with the promised

delivery time. Delivery reliability measures the fraction of customer demand that is satisfied

Source Make components Assembly Deliver

y

Customer order

MTS

Source Make components Assembly Deliver

y

Customer order

MTO

Source Make components Assembly Deliver

y

Customer order

CTO

Efficient supply

chain

Responsive

supply chain

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within the promised delivery lead time. For firms operating on MTS model, the percentage of

orders getting served from the stock is known as product availability also commonly referred to

as the service level in supply chain literature.

Product Variety

The quantum of variety offered by the firm is an important dimension of customer service. In the

past couple of years a ‘variety explosion’ has taken place in most product categories. Higher the

product variety offers greater choices to the customer who is likely to get a product that fits

closer to his or actual requirement. Higher variety would lead to greater complexity, resulting in

higher supply chain costs.

3. Achieving Strategic fit

Achieving strategic fit is to ensure that the degree of supply chain responsiveness is consistent

with implied demand uncertainty. The goal is to target high responsiveness for a supply facing

high implied uncertainty( Innovative products) and to target efficiency for a supply chain facing

low implied uncertainty.

Responsive

supply Chain

Responsiveness

Spectrum

Efficient

Supply chain Certain Demand Uncertain demand

Implied demand uncertainty

Implied demand uncertainty depends on the customer segment that the supply chain wishes to

satisfy, Or the firms target customer. This target customer is usually specified by the business

Zone of strategic fit

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strategy so in other words the supply chain strategy should achieve a perfect fit with the

corporate or the overall business strategy.

Other issues in Strategic Supply Chain Management

Multiple products and customer segments

Product life cycle

Globalization and competitive changes over time

Growing supply chain uncertainty

Environment and sustainability

Multiple Products and Customer Segments

Companies produce and sell multiple products to multiple customer segments, each with

different characteristics. Depending on the nature of the product and the need of the customer

that the product attempts to meet the implied demand uncertainty is different and the design of

supply chain varies. For example Levi Strauss which sells both standard-size jeans and the

customized jeans. The demand uncertainty for standard size jean, a functional product is much

lower than the demand uncertainty of customized jeans, a innovative product. When devising the

supply chains for each different product or customer segment, the key issue for the companies

like Levi Strauss is to balance the supply chain efficiency and supply chain responsiveness given

its portfolio of products, customer segments, and supply chain sources. One of the ways in which

to achieve this is to set up independent supply chains for each different product or customer

segment. This is feasible if the segment is large enough to support a dedicated supply chain. This

strategy however fails to take advantage of any economies of scope that often exists among a

company’s different products. Therefore, preferable strategy is to tailor the supply chain to best

meet the needs of each product demand. Tailoring the supply chain requires sharing some links

in the supply chain with some products while having separate operations for other links. The

links are shared to achieve maximum possible efficiency while providing the appropriate level of

responsiveness to each segment. For instance, all product may be made on the same line in a

plant, but products requiring a high level of responsiveness may be shipped using a fast mode of

transportation while products that do not need to have high responsiveness may be shipped using

slower cost effective modes of shipment.

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Product life cycle

The demand and supply characteristics change over a product’s life cycle. Because demand and

supply characteristics change, the supply chain strategy must also change over the product life

cycle if the company is to continue achieving strategic fit. A classic example is the case with

pharmaceutical companies. When a new drug is introduced by a pharmaceutical company it

would be protected under patent it is an innovative product where the demand is uncertain and

supply unpredictable, profit margins are very high, Cost is not an important consideration but as

time goes the patent expires and the drug becomes a generic drug and exhibits characteristics of a

functional product. At this stage the demand has become more stable and supply is predictable,

the profit margins have dropped and price becomes a significant factor in customer choice. So

the supply chain of this pharmaceutical company should also evolve along with the product as it

moves through its product life cycle.

Globalization and competitive changes over time

The changing competitor behaviour resulting from changing marketplace or increased

globalization is also an important issue to be considered in the designing the supply chain of an

organization. As competitors flood the market with variety of products the customers are

becoming accustomed to having their individual needs satisfied. Thus, the competitive focus is

on producing sufficient variety at a reasonable price. Another big change is the increase in global

sourcing of products. As the competitive landscape changes, a firm is forced to alter its

competitive strategy and with change in competitive strategy, a firm must also change its supply

chain strategy to maintain strategic fit.

Growing supply chain uncertainty and issues relating to environment and sustainability too have

to accounted for while designing the supply chain.

What are the strategic issues faced by a manager of a Supply chain?

Answering tips-

The strategic issues are

1. Understanding the customer demand uncertainties.

2. Understanding the supply chain capability ( efficiency and responsiveness)

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3. Formulating a SC strategy that achieves a fit with the business strategy. Fit means the

SC strategy that

a. Matches the SC strategy to the overall corporate business strategy

b. Matches the with various individual functional strategies ( marketing, pricing,

inventory, supplier strategy, financial strategy etc.)

c. Matches the SC capability with the implied demand uncertainty.

4. Issues arising due to the changing business scenario like

a. Multi-products and customer segments

b. Shorter product life cycles

c. Globalization

CUSTOMER FOCUS IN SCM

The primary objective of any supply chain is to meet the customer’s delivery expectation and

requirements and also the availability of inventory.

To understand the Customer focus in SCM you need to understand

1. How SCM

a. Supports Customer-Focussed Marketing

b. Meets Customer Service requirements

A. How SCM supports Customer Focussed Marketing

Of the four fundamental ideas of marketing concepts, SCM’s focus is on the idea that products

and services become meaningful when available and positioned from customer’s perspective.

(Other marketing concepts are: Customer’s needs and requirements are more basic than products

and services, different customers have different needs and requirements, and volume is

secondary to profit.)

As long as individuals specialize in production of specific products and services a mechanism

must arise for the exchange of those goods and services to satisfy the consumption needs of

individuals. To do so effectively and efficiently firms must overcome three discrepancies:

Discrepancy in space, discrepancy in time and discrepancy in quantity and assortment.

Discrepancy of space refers to the fact that the location of production activities and the location

of consumption are seldom the same. Similarly the time of production and the time of

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consumption are different. Discrepancy of quantity and assortments refers to the fact that

production typically aims at producing large quantities with very little product variety whereas

consumption is characterized by small quantities with a lot of variations. To address these

discrepancies Bucklin developed a long standing theory that specifies four generic service

outputs necessary to accommodate customer requirements they are

1. Spatial convenience

2. Lot size

3. Waiting time

4. Product variety and assortment.

Spatial convenience refers to the amount of shopping time and effort that will be required on the

part of the customer. Higher levels of spatial convenience are achieved in a supply chain by

providing customers with access to its products in a larger number of places, thus reducing he

shopping effort.

Similarly SCM facilitates the purchase of small quantities in small lot sizes, reduces the waiting

time and provides for the product variety and assortment desired by the customer.

B. How SCM meets customer service requirements

(How SCM meets the three fundamental attributes of customer service)

The fundamental attributes of Customer service are

1. Availability

2. Operational performance and

3. Service reliability

Availability

Availability is the capacity to have inventory when desired by the customer. Availability is based

on the performance measures : Stock out frequency, fill rate and orders shipped complete. Stock

out frequency is the probability that a firm will not have inventory available to meet a customer

order. Fill rate measures the magnitude and impact of stock outs over time. If a customer wanted

100 units and only 97 units are available then the fill rate is 97 %. Orders shipped complete ( is

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complete orders shipped) – Even if one item ordered by the customer is missing then order is

counted as incomplete order.

Operational Performance

Operational performance deals with the time required to deliver a customer’s order. Operational

performance is specified in terms of

Speed of performance – elapsed time from when a customer establishes a need to order

until the product is delivered and is ready for customer use.

Consistency- Number of times that actual cycles meet the time planned for completion.

Flexibility- Flexibility involves a firm’s ability to accommodate special situations and

unusual or unexpected customer requests.

Malfunction reliability- The availability of contingency plans to accomplish recovery in

case of malfunction.

Service Reliability

Service reliability involves the combined attributes of logistics and concerns a firm’s ability to

perform all order-related activities as well as provide customers with critical information

regarding logistical operations and status. Beyond availability and operational performance

Reliability may mean that shipments arrive damage-free, invoices are correct and error-free;

shipments are made to the correct locations and the exact amount of product ordered is included

in the shipment.

The above discussion illustrates the Customer focus of SCM.

CUST OMER RELATIONSHIP MANAGEMENT

CRM and Customer Relationship

CRM is one of the three major processes within the Supply chain that consists of processes that

take place between an enterprise and its customers downstream in the supply chain. If we look

closely at the macro-processes of an organization we can see that they are 3 kinds

1. Processes that are downstream of their supply chain – Customer side

2. Processes internal to the organization – Internal

3. Processes that are upstream of their supply chain – Supplier side.

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Upstream processes Downstream Processes

Supplier Relationship

Management

(SRM)

Internal Supply Chain

Management

(ISCM)

Customer Relationship

Management

(CRM)

TRANSACTION MANAGEMENT FUNCTION

(TMF)

The goal of CRM macro process is to generate customer demand and facilitate transmission and

tracking of orders.

The key processes under CRM are as follows

Marketing

Marketing processes involve decisions regarding which customer to target, how to target

customers, what products to offer, how to price products, and how to manage actual campaigns

targeting customers.

Sell

The sell process focuses on making an actual sale to a customer (compared to marketing, in

which processes are more focused on planning who to sell to and what to sell). The sell process

includes providing the sales force the information it needs to make a sale and then execute the

actual sale.

Order Management

The process of managing customer orders as they flow through an enterprise is important for

customer to track his order and for the enterprise to plan and execute order fulfilment. The

process ties together the demand from the customer with the supply from the enterprise.

Call/ Service Center.

A call/ service center is often the primary point of contact between a company and its customers.

A call center, helps customer’s place orders, suggests products, solves problems and provides

information on order status.

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Importance of CRM

CRM helps the enterprise to better understand the needs and requirements of the customer, their

profile, buying behaviour. CRM captures vital data about the customers and the potential

customers, stores them and generates customer related information that can be used effectively

by the enterprise to attract and retain customers

Information provided by CRM can be used in determining the customer value to the

organization. CRM also helps in evaluating the probability of success of doing business with any

particular customer. Now the two information can be used to zero in on the effective strategies

that can be adopted for the customers using the following matrix.

Marketing Strategies based on customer value and probability of success.

Probability of Success with the Customer

Customer

value

Low Medium High

Low

Withdraw

Service Minimally

Retain minimally

Medium

Defend Minimally

Selectively develop

Defend against

competition

High

Build Brand Image

Target for

development

Build strategic

Relationship

Thus a good CRM helps in

1. Getting a good understanding of the customer’s needs and requirements

2. To gain insight into the behaviour of the customer, their purchasing habits, opinions,

preferences and modify their business.

3. To anticipate needs and take proactive steps.

4. To facilitate cross selling of products

5. To identify which customers are profitable.

6. To use all the above information in determining the value of various customers to the

enterprise, which in turns helps in formulating various strategies.

DEMAND PLANNING

Demand planning and forecasting is considered to be the very first step in determining the long-

term capacity needs, yearly business plan and supply chain activities of any organization.

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Forecasting is the basis on which all the demand planning rests. Forecasts drive the supply chain

information system planning and coordination. Forecast is a projection or the prediction of the

number of units that will be produced, shipped or sold. Prior to determining a forecast process, it

is important to understand the nature of demand and the major forecast components

Nature of Demand

Demand can be of two types

Independent Demand

Dependant Demand or derived Demand

Independent demand items are generally finished goods while dependant demand items

are generally components or sub assemblies. Independent demand items are forecasted,

as the future requirements are not known, whereas dependant demand item requirements

can be derived based on demand for finished goods. For example demand for a car in the

month of January would be forecasted, say 100 but the demand for the tires (5 per car)

would be calculated as 500 tires. Demand for Car is independent while the demand for

tire is dependant.

Key steps in demand planning include:

• Importing historical sales data

• Creating statistical forecasts

• Importing customer forecasts

• Collaborating with customers

• Managing forecasts

• Building consensus forecasts

• Supply and demand collaboration

• Securing constrained forecasts

• Confirmation with customers

• Re examining data and adjusting planning accordingly.

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FORECASTING

Is important because, businesses can benefit from accurate forecasts to

1. Optimise the businesses to reduce the cost of operations by prevention of unforeseen

changes in production schedules – resulting in high costs due to changes in personnel ,

equipments, raw material movements etc.

2. By accurate projections of raw material and finished goods leading to better inventory

management – resulting in low inventory carrying costs and minimum shipping costs.

3. Increase sales opportunities for maximising profits.

4. Provide accurate information for making better decisions.

5. Provides basis for many functional and strategic decisions.

Example:

Production : Scheduling, Inventory control, aggregate planning.

Marketing: Sales force allocation, promotion, and new product introduction.

Finance: Plant / equipment investment, budgetary planning.

Personnel: Workforce planning, hiring, layoffs.

Forecasting of mature products with stable demand like Milk, groceries etc is relatively easy

where as the forecast is extremely difficult when either the raw material supply or demand of

finished products is highly unpredictable.

Wrong forecasts or no forecasts would lead to misguided business plans, errant decisions and a

lack of collaboration and consensus, which limits buying across the organisations.

Characteristics of Forecasts

Forecasts are always wrong: All forecasts include both and expected value and the

measure of forecasting error (demand uncertainty).

Long term forecasts are usually less accurate than short-term forecasts: Forecasts for next

6 month would be more accurate than the forecast for next week, which would be more

accurate than the forecast for the next day.

Aggregate forecasts are usually less accurate than disaggregate forecasts: The forecast of

the demand for A-segment passenger cars ( Santro, Alto, indica, figo, Micra ) would be

more accurate than the specific forecast of Santro cars.) Forecast for bathing soap would

be more accurate than forecast for the specific bathing soap say Lux.

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The farther up the supply chain a company is the greater is the forecast error due to

greater distortion in the information it receives. ( Bull Whip Effect )

Factors affecting demand.

It is important to understand the factors that affect the demand so that adequate provisions are

made for these factors while forecasting is done. These factors also affect the choice of selection

of the methodology to be used for forecasting.

These factors are

Past demand

Lead time replenishment

Planned advertising or marketing efforts

State of economy.

Planned price decisions

Actions that competitors have taken.

FORECASTING METHODS

Forecasting methods are classified according to the four types

Qualitative: Are subjective and rely on human judgement. Are more appropriate when very

less historical data is available or the experts have the market intelligence to make the

forecast. eg Expert opinion, Delphi approach, Market research.

Time Series: Uses historical data to make a forecast. Based on the assumption that past

demand is a good indicator of future demand. These methods are very suitable when the

environmental situation is stable and the basic demand pattern does not vary significantly

from one year to another. Are simple to implement and provide a very good beginning.

Causal : Causal forecasting method assume that the demand forecast is highly correlated with

certain factors in the environment ( the state of the economy, interest rates etc.) Causal

forecasting methods find the correlation between demand and environmental factors and

use estimates of what environmental factors will be to forecast future demand.

Simulation: Simulation forecasting imitate the consumer choices that give rise to demand to

arrive at a forecast.

Companies find it difficult to decide which forecasting method is most appropriate for

forecasting. Using multiple methods of forecasting to arrive at a combine forecast is more

effective than using one method alone.

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Observed demand generally has two components ; the Systematic component and the Random

component.

Observed demand = Systematic Component + Random component

Systematic component measures the expected value of demand and consists of

Level component : the current de-seasonalized demand.

Trend: the rate of growth or decline in demand for the next period.

Seasonality: the predictable seasonal fluctuations in demand.

The random component is that part of the forecast that deviates from the systematic part. A

company cannot ( and should not) forecast the random component. All a company can predict is

the size and variability of the random component which provides a measure of the company’s

forecast error.

Selecting a particular forecast method

Step1 : Consider the nature of the industry, the type of the product for which forecast demand is

needed. By looking at the pattern of demand, a few forecasting methods can be shortlisted.

Step 2: Consider the various estimates of forecast errors and prepare a priority list based on their

relative importance to the organization.

Step 3: Estimate the forecast error of each of the short-listed forecast methods in step one.

Step 4: Choose the forecast method/ methods which give the least forecast error estimate.

COLLABORATIVE PLANNING FORECASTING AND REPLENISHMENT - CPFR

Definition : CPFR is the sharing of forecast and related business information among, business

partners in the supply chain to enable automatic product replenishment.

The voluntary Inter industry commerce Standards association ( VICS ) has defined

CPFR as “ a business practice that combines the intelligence of multiple partners in

the planning and fulfilment of customer demand.”

Sales history, sales projections, raw material availability, lead times and other important business

information are shared between the manufacturer and business partners. The information is then

integrated, synchronised and used to eliminate excess inventory and improve in-stock positions

making everyone in the supply chain more profitable.

Sellers and buyers in a supply chain may collaborate along any or all of the following four

supply chain activities

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Strategy and planning: Both partners decided the roles and responsibilities and checkpoints.

They then identify the significant events that affect the demand and supply like the new

product introduction, promotions, store opening / closing, changes in inventory policy

etc.

Demand and supply management: The consolidated forecast of customer demand estimate of

the partners ( Collaborative sales forecast) is projected at the point of sale and based on

this a collaborative order plan is created that determines the future orders and delivery

requirements based on the sales forecast, inventory positions and replenishment lead

times.

Execution: As forecasts become firm they are converted to actual orders. The fulfilment of

these orders then involves production, shipping, receiving, and stocking of products.

Analysis: The key analysis focuses on identifying exceptions and on performance evaluation

metrics that are used to asses the performance or identify trends.

Risks and Hurdles of CPFR implementation

Risk of misuse of information : Lot of information is shared between the supplier and buyer

(partners ) and sometimes the supplier may be supplying to the buyer’s competition too.

If one partner changes the scale of operation or technology the other partner is also forced to

follow suit or lose the collaborative relationship.

The partners may have huge cultural differences and hence fostering a collaborative culture

may be very difficult.

Steps to achieve Collaborative coordination

Quantify bullwhip effect: Analyse the variance between the demand from your customer and

the demand you place on the supplier. This is the internal bullwhip that you are creating.

Evidence of size of bull whip effect is very effective in getting different stages of the

supply chain to focus on efforts to achieve coordination and eliminate the variability

created within the supply chain.

Get top management commitment for coordination.

Devote resources to coordination: Without committing significant managerial resources

success in coordination may not be achieved.

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Focus on communication with other stages: Regular communication helps different stages of

the supply chain share their goals and identify common goals and mutually beneficial

actions and improve coordination.

Try to achieve coordination of the entire supply chain network: The full benefit of

coordination is achieved only when the entire supply chain network is coordinated.

Use technology to improve connectivity in the supply chain: Internet and a variety of

different types of software systems can be used to increase the visibility of information

throughout the supply chain.

Share benefits of coordination equitably: The greatest hurdle to coordination in the supply

chain is the feeling on the part of any stage that the benefits of coordination are not being

equitably shared. Managers from the stronger party in the supply chain relationship must

be sensitive to this fact and ensure that all parties perceive that the way benefits are

shared is fair.

Traditional supply chain relationship

Collaborative Planning Forecasting and replenishment ( CPFR)

Synchronization of customer trend or ordering Information

PURCHASE PLANNING

Make or Buy Decisions

The decision of a firm, to perform its activities internally or get those activities done from an

independent firm, is known as, make or buy decision. The make or buy decision is strategic in

nature and involves the following key decisions

1. What activities should be done in-house and what activities should be outsourced?

2. How to select entities/partners to carry out outsourced activities?

store Retail DC Wholesale

DC

Manufacturing Supplier

store

Customer

Store Retail DC Wholesale

DC

Manufacturing Supplier

store

Customer

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3. What should be the relationship between those outsourced entities? Should it be

transactional (Just exchange of goods and services) or should it be long term partnership?

Strategic Approaches to Make or Buy Decisions

Some of the approaches adopted by successful firms in making the In-house or outsourced

decisions are

1. The value chain analysis

2. Identification of core activities and focusing resources to build capabilities in core

activities and outsource non-core activities ( also known as commodity activities)

1. Value Chain Analysis

Value chain is a framework (tool) developed by Michael porter. Using this framework all the

activities in a supply chain, involved in the transformation of raw materials to the final stage, is

classified into primary activities and secondary activities.

The primary activities include

Inbound logistics : Activities involved in the movement of raw materials in wards to the

firm

Operations: All the transformation activities taking place within the firm.

Outbound Logistics: Activities involved in the movement of finished goods outwards to

the firm.

Sales and Services: Sales and after sales activities

The secondary activities or support activities include

Procurement activities: Activities involved in purchasing raw materials and services

needed by the firm

Infrastructure: The facilities needed by the firm, the physical as well as the financial

infrastructure.

Technology: The technological know how and the expertise.

Human resource management.

The make decision steps

1. Consider a activity in the value chain.

2. The decision whether to perform the activity in-house or outsourced is based on the net

value created when done in-house and when outsourced.

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3. If the net value created (Total value created by the activity - Cost of performing the

activity ) is greater when outsourced then the activity is decided to be outsourced other

wise it is performed in-house.

2. Make or Buy decision based on Identification of Core and Non-core Activities.

The decision to identify selected processes as core processes and focus on improving those

can have a significant impact on the performance of a firm. So identification of the core

activities and focussing all the resources on to the core activity to achieve world class

capability in those activities could be a successful strategy. So the first capability that a firm

must achieve is the capability to identify core and commodity activities.

Identification of Core Activities

a. Business Process Route

b. Product architecture route

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 and supply chain management

focuses on fulfilment of customer order. While taking outsourcing decisions two out of these

three can be outsourced. Researchers are of the view that firms should identify and ensure

that it builds core competencies in at least one of these areas. HP and high end

pharmaceuticals have identified product innovation as their core in-house activity while

Nike, Benetton in house focus is on brand building and customer relationship while Wal-

Mart and Dell computers have in-house capability in supply chain management. While taking

make or buy decisions firm must make sure that in-house business processes give it enough

strategic power in the chain and do not allow other chain partners to dictate the terms of

value exchange in the chain. (eg. In PC business the power went to intel and Microsoft

though IBM was at a strategic point in product development initial which was lost and

became a peripheral player in this chain)

Product Architecture Route

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In the product architecture approach, the focus is on sub-system and components and the

make or buy decisions are taken at that level. The product is broken down into systems and

sub-systems and categorized 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 or attributes that are

considered important by the customer.

By keeping the strategic sub-systems internal, a firm can ensure that it can offer differentiated

product and can avoid being commoditized. Further the same kind of analysis is done for all the

major components in sub-systems. All those components where the firm is technologically ahead

of potential supplier 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 supplier

should be treated as a strategic partner. Example Tata motors realized that in diesel engine

technology it was far behind its suppliers and will never be in a position to catch up with them.

So it decided to buy diesel engines from FIAT and treat FIAT as a strategic partner.

Advantages and Disadvantages of OutSourcing

The decision to outsource by a firm is primarily based on the ability of the third party to increase

the supply chain surplus (Only those activities where third party can increase the value at a lesser

cost than the firm are outsourced). But along with the supply chain surplus the risk also increase

to the firm due to outsourcing. Both these aspects need to considered to understand the issue of

outsourcing

How do third Parties increase the supply chain surplus?

1. Capacity aggregation

2. Inventory aggregation

3. Transportation aggregation by transportation intermediaries.

4. Transportation aggregation by storage intermediaries

5. Warehousing aggregation

6. Procurement aggregation

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7. Information aggregation

8. Receivable aggregation

9. Relationship aggregation

10. Lower cost and higher quality

Capacity Aggregation

A third party can increase the supply chain surplus by aggregating demand across multiple firms

and gaining production economies of scale that no single firm can on its own. This is one of the

most common reason for outsourcing production in a supply chain. Dell outsources design and

production of the processors in its PC’s to Intel because Intel supplies many computer

manufacturers and gains economies of scale that are not available to Dell.

Inventory Aggregation

Third party can increase the surplus by aggregating inventories across a large number of

customers. Aggregation allows them to significantly lower overall uncertainty and increase

significantly less safety and cycle inventory than would be required if each customer decided to

carry inventory on his own. The third party performing inventory aggregation adds most to the

supply chain surplus when the demand from the customer is fragmented and uncertain.

Transportation aggregation by transportation intermediaries

A third party may increase the surplus by aggregating the transportation function to a higher

level than any shipper can on his own. FedEX, UPS etc are some of the examples of

transportation intermediaries that increase the supply chain surplus by aggregating transportation

across a variety of shippers. A transportation intermediary increases the supply chain surplus

when shippers are sending small packages or LTL ( Less than Truck Load) quantities to

customers that are geographically distributed.

Transportation aggregation by storage intermediaries

A third party that stores inventory can also increase the supply surplus by aggregating inbound

and outbound transportation. This form of aggregation is effective if the intermediary stocks

products from many suppliers and serves many customers, each ordering in small quantities.

This form of aggregation becomes less effective as the scale of shipment from a supplier to

customer grows.

Warehousing aggregation

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A third party may increase the supply chain surplus by aggregating warehousing needs over

several customers. The growth in surplus is achieved in terms of lower real estate costs as well as

lower processing costs within the warehouse. Savings through warehousing aggregation arise if

the supplier’s warehousing needs are small or if its needs fluctuate over time.

Procurement aggregation

A third party increases the supply chain surplus if it aggregates procurement for many small

players and facilitates economies of scale in production and inbound transportation. Procurement

aggregation is most effective across many small buyers but is not likely to be a big factor in a

situation with a few large customers.

Information aggregation

A third party may increase the surplus by aggregating information to a higher level than can be

achieved by a firm performing the function in house. All retailers aggregate information on

products from many manufacturers in a single location. This information aggregation reduces the

search cost for customers.

Receivable aggregation

A third party may increase the supply chain surplus if it can aggregate the receivables risk to a

higher level than the firm or it has a lower collection cost than the firm. Collecting receivables

from each retail outlet is a very expensive proposition for a manufacturer. Given that a retailer

buys from many manufacturers , the power of each manufacturer to collect is also reduced.

Receivable aggregation is likely to increase the supply chain surplus if retail outlets are small

and numerous and each outlet stocks products from many manufacturers that are all served by

the same distributor.

Relationship Aggregation

An intermediary can increase the supply chain surplus by decreasing the number of relationships

required between multiple buyers and sellers. Relationship aggregation increases the supply

chain surplus by increasing the size of each transaction and decreasing their number.

Relationship aggregation is most effective when many buyers sporadically purchase small

amounts at a time but each order often has products from multiple suppliers.

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Lower costs and higher quality

A third party can increase the supply chain surplus if it provides lower cost or higher quality

relative to the firm. If these benefits come from specialization and learning, they are likely to be

sustainable over the longer term.

Three factors affect the increase in surplus that a third party provides: scale, uncertainty, and the

specificity of assets.

The affects are summarized below

Specificity of Assets Involved in Function

Low High

Firm Scale Low High growth in Surplus Low-medium growth in surplus

High Low Growth in surplus No growth in surplus

Demand uncertainty

for the firm

Low Low-medium growth In

surplus

Low growth in surplus

High High growth in surplus Low-medium growth in surplus

Specificity of assets involved in Function means whether the function or the activity of the firm

requires specific kind of assets. If specific assets are required then advantage ( or the growth in

supply chain surplus) of aggregation is low.

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Factors affecting the make or buy decisions

RISKS OF USING A THIRD PARTY

Firms must evaluate the following risks when they move any function to a third party.

1. The process is broken

2. Underestimation of the cost of coordination

3. Reduced customer/ supplier contact

4. Loss of internal capability and growth in third-party power.

5. Leakage of sensitive date and information

6. Ineffective contracts.

The process is broken

The biggest problem arises when a firm outsources supply chain functions simply because it has

lost control of the process. Introducing a third party into a broken supply chain process only

makes it worse and harder to control. The first step should be to get the process under control,

then do a cost-benefit analysis, and only then decide on outsourcing.

Considerations favouring MAKING Considerations favouring BUYING

Cost considerations ( less expensive to make) Limited production facility

Desire to integrate plants Cost consideration ( less expensive to buy)

Productive use of excess plant capacity to

help absorb fixed overhead.

Small volume requirement

Need to exert direct control over production

and / or quantity

Supplier’s research and specialized know

how

Design secrecy required Desire to maintain stable work force

Unreliable suppliers Desire to maintain multiple source policy

Desire to maintain a stable work force Indirect managerial control considerations

Procurement and Inventory considerations

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Underestimate the cost of coordination

Coordination between the firm and the outsourced partners requires a lot of effort and time, and

can lead to huge losses if not properly executed. This is especially true if firm plans to outsource

specific function to different third parties. Nike had a coordination problem with i2 technologies

where Nike blamed i2 for it loss of $100 million on inventory management glitches ( mistakes)

that it attributed to the supply chain planning software from i2. I2 in turn blamed the problems on

Nike’s execution of the software. Clearly insufficient coordination between the two firms played

a role in this failure.

Reduced customer / supplier contact.

The presence of an intermediary can lead to the loss of contact with the customer/ supplier.

Sometimes the gain achieved by outsourcing the activity would be much less that the gain the

firm would have achieved with better customer/supplier relationship arising from direct contact

with them.

Loss of internal capability and growth in third party power

A firm may choose to keep a supply chain function in-house if outsourcing will significantly

increase the third party’s power. HP and Motorola have moved most of their manufacturing

activity to third party but are reluctant to move either procurement or design, even though

manufacturers have developed both capabilities.

Leakage of sensitive data and information

There is always the danger of leakage of critical information like the demand or intellectual

property, industry critical knowledge etc to the firm’s competitors when third party is used. Strict

use of ‘Firewall’ (Security measures that ensure no leakage) within the third party is a solution

but this would increase the specificity of asset there by limiting the potential of the third party to

create surplus.

Ineffective contracts

Contracts that significantly reduce the gains from outsourcing can be called ineffective contracts.

An example is cost-plus pricing contracts: Here the third party has no incentive to reduce cost

hence the responsibility of reducing costs falls back on the firm itself so where is the advantage

of outsourcing. Another example is contracts that specify that the third party always holds a

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certain level of inventory always. Such a contract will reduce the incentive of the third party to

take steps that reduce inventory. In such cases it is better for the firm to insist on certain service

level and leave the third party more freedom with regard to the amount of inventory. The third

party then has an incentive to work on reducing the inventory required to provide a given level of

service

********************END OF PART 1***************************