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  • Logistics and Supply Chain Management

    TEACHER: Hello, Student. We'll begin this Module by discussing the supply chain concept.

    STUDENT: Supply chain? Is this a completely new concept?

    TEACHER: While none of the components of the supply chain is new, the concept has only been recently established. The novelty consists in treating the aggregate of procedures and processes, which go from the acquisition of raw materials to the delivery of goods to customers, as being a single entity. The entity, like a chain, has many components or links. But, like a chain, it can not be stronger than the weakest of its links.

    STUDENT: I am a bit confused by the word "supply". In what sense is it used in "supply chain"?

    TEACHER: The basic idea of the supply chain concept is that the customer is the final objective of all business processes.

    The "supply" word in the name refers to the customer. It is the objective of the business to supply the customer with the goods and/or services the former sells. So, the final link of the supply chain is always the timely delivery to the customer of goods and/or services of the specified quality.

    STUDENT: OK, tell me about the links of a typical supply chain.

    TEACHER: The typical basic links or components of the supply chain are:

    * Obtaining the necessary raw materials, at the right time, in the right quantity and of the correct quality.

    * Producing the goods to satisfy customer demand with the required quality and in quantities that allow timely delivery without creating excessive inventory.

    * Delivering to customers where, when and in the quantities they expect according to the terms of sale.

    STUDENT: Sounds like a rather difficult task indeed!

    TEACHER: Well, actually the name of the game is interacting.

    The components of the supply chain are intimately related and mutually dependent. If the objective of efficiently and effectively supplying the customers is to be attained, all procedures and processes must be coordinated with each other.

    To get delivery of the right quantity of raw materials at the right time, we must know which finished goods we are expected to deliver to customers, at what time and in what quantity. We must have the plant capacity to produce these goods and the logistics in place: warehousing facilities for raw and finished goods and transportation.

    Using the name logistic exclusively for warehousing and transportation is coming out of fashion. In most companies it includes procuring (the process of purchasing) and the word is more and more used as synonym of the entire supply chain.

    STUDENT: If the name of the game is interacting, there must be a price of not interacting.

    TEACHER: Yes. It sounds obvious in hindsight, but until recently too many business acted without looking at the supply chain as an entity; too many still act this way.

    In these companies the key areas of Marketing, Purchasing, Production, Warehousing, Selling, and Transportation function without the necessary coordination. The results: inventory excesses of certain goods combined with lost sales due to stock-outs of other goods, production lines idle due to lack of raw materials, too much or too little warehousing facilities, etc.

    STUDENT: You make a good case for an effective managing the supply chain.

    TEACHER: I hope so, because there is no doubt that an efficient management of the supply chain is very important to achieve efficiency and profitability in a business over the short and long term. It is mandatory to continuously plan and execute the different procedures of the Chain, considering:

    * Customer demand (Sales Forecast).

    * The production capacity to meet this demand.

    * The purchasing of the needed raw materials.

    * The reception of those materials at the right moment, quantity and quality.

    * Warehousing and transportation facilities.

    STUDENT: Since you said that the objective of the chain is satisfying the customer, I guess the we must think that the customer is King... or Queen, of course.

    TEACHER. Please read the following two rules:

    Rule 1: the customer is always right.

    Rule 2: when the customer is wrong, Rule 1 applies.

    You probably saw this statement if you ever visited a Wal-Mart store. It is a slight exaggeration, but it contains a core of truth that too many businesses have ignored at their peril (unless they have monopoly power).

    Most companies nowadays operate in a buyer's, not a seller's, market. This means that they must produce and deliver exactly what the customers demand in competitive conditions of price, quality and timely delivery. In a word, their internal operations must be Customer Driven, or more exactly, Market Driven. They must respond quickly to fluctuations in demand and competitive situations. And to do that, guess what: good management of the supply chain is a must!

    STUDENT: OK, so we accept this basic philosophy. No major problem, right?

    TEACHER: Unfortunately it is not that easy. In managing the "Chain" we encounter several powerful conflicting interests which we will discuss not.

    Good supply chain management is a complicated technical problem for businesses that produce many products which include many raw materials for a market with fluctuating demand. But the technical problem can be solved relatively easily with the help of computers and specialized software.

    A more difficult part to solve is the human problem. This is not because human managers working on different parts of the supply chain are especially bad people; it is due to the fact that, as department heads, they actually have interests that are in conflict with those of the business as a whole.

    The Production point of view

    John Smith is the Production Manager at McEla, a soap manufacturer.. John is responsible for delivering finished goods (Bubbly® soap) of specified quality at minimum production cost.

    McEla produces six SKUs (Stock Keeping Units), that is, combinations of different sizes and fragrances. John has a single production line, which means that each time he changes from making one SKU to another, he must stop production to setup the line for the next SKU. This means lost time, and in turn higher production costs and lower factory efficiency.

    STUDENT: Obviously, John has got his priorities right!

    TEACHER: When the only concern is lower unit production cost we run into problems. Sure, since John's bonus increases as his unit production cost goes down, it is no wonder that he always favors very long production runs of each SKU, thus minimizing time lost to setup the line for a change of SKU. Now think about it, please. What is the danger of John's approach?

    STUDENT: John's efforts to lower production costs are laudable, but I can imagine that his actions also may cause finished goods inventories to go up, taking up expensive warehouse space and costing money in financing high inventories.

    TEACHER: Exactly. But this is not John's problem; he is not responsible for these elements of cost. His only concern is production cost and quality.

    OK, and what do you think about the level of the raw materials inventory?

    STUDENT: At first sight, the more raw materials in stock the better... at least for John!

    TEACHER: Correct. To keep production running, John needs to be continuously supplied with raw materials. This is a legitimate need. So John keeps asking the Purchasing department to keep raw materials inventories high.

    This is certainly a good way to make sure that he never has to stop production for lack of materials. Also, if not done properly, a good way to waste money invested in excess inventory. But again, this is not one of John's problems.

    STUDENT: And what is the point of view of purchasing in that respect?

    TEACHER: Peter Willis, the Purchasing manager, is more than happy to accommodate John. This is because his suppliers give him better prices the larger the orders he places are. And because by keeping raw material inventories high, he minimizes the risk of being blamed for a stock-out of a material if a supplier fails to deliver on time.

    Since Peter is rewarded for purchasing at the lowest unit costs, and never causing a production stop for lack of raw materials, he cooperates with John in keeping raw material inventories high; he says "it is a safe and wise policy". Rather expensive in finance costs but not one of Peter's problems.

    STUDENT: I assume the Sales people also have a particular point of view.

    TEACHER: Yes. A typical Sales Manager's statement: "I want no stock- outs of finished goods... but don't ask me for an accurate forecast!"

    We may mention many examples of this type of situation. Gus Venda is the Sales Manager; he is interested in high finished good inventories so that he never misses a sale. Of course, he is rewarded on a commission basis, and he hates to miss a sale.

    Sure, he prepares a Sales Forecast. But the customers not always order the products in the quantity and specific SKUs Gus anticipated. With high inventories of the complete line of SKUs, Gus' mistakes in forecasting are of no consequence to sales volume, as would be the case if production and inventories were closely adjusted to his forecasts.

    STUDENT: Sorry, I am still missing what the problem is. Every department head you mentioned is happy with the situation. The company does not lose sales due to stockouts. Customers are happy because they always timely receive what they order. So?

    TEACHER: A key element in a company's cost structure is often forgotten: the cost of capital! All department heads and the customer may be happy, but the company's profits (the bottom line) are affected due to an excessive cost of capital.

    And who is interested in the bottom line? Well, in most companies, only top management is rewarded and recognized according to the bottom line. Yes, nowadays some companies are becoming aware of the shortcomings of their management incentive systems. They are implementing new ones, the latest based on the EVA™ (Economic Value Added) concept.

    An important factor in the overall results of a business is the cost of capital, in the form of owners' property or borrowed money. The self-centered attitudes of the department managers are in conflict with the excessive cost of capital they cause.

    STUDENT: Nevertheless, all those department heads had the right goals: produce at lower cost, not lose sales, keep customers happy, etc.

    TEACHER: True. everyone has a good point, but the key is Balance!

    Let's not make mistakes. John, Peter and Gus have a point; production costs should be as low as possible, customers should receive whatever they order without undue delay. But the name of the game here is balance. The conflicting factors must be continuously adjusted and balanced to achieve optimum results, NOT for the parts, but for the whole: the business.

    Good software helps... but good managers working together are still the key to success

    There are "tools" to help getting close to that ideal balance for the conflicting factors; basically software products specifically designed to help manage the supply chain. We'll talk about them later. But let's point out here two basic facts:

    No software can work alone. A management team is needed that clearly understands the need of reaching the optimum compromise between production costs and efficiency, buying at the best price, satisfying the customer at all times, and the financial cost of investments in inventory and warehousing.

    The team must include the highest level: department heads and, ideally, the General Manager as chairperson. Too often this all-important task is delegated to lower level employees who can not make the important decisions nor negotiate the delicate compromises that are necessary.

    To quote a famous business executive: "Forecasting is difficult, but forecasting the future... that's impossible!".

    He was joking, of course, but he joked to make a point: knowing in advance what is going to happen in the future is very, very difficult, and many times, impossible. So, why bother to forecast the future sales of a business?

    The answer is that it is possible to forecast future sales, while certainly not to the exact figures, with reasonable approximation. We must forecast with the maximum possible exactness, because this is the basis of a good supply chain management.

    STUDENT: OK, and who forecasts, and based on what?

    TEACHER: In most companies, the sales forecast is the responsibility of the Marketing people, with input from other departments, especially from Sales. The key inputs they use to reach the final figure are:

    * The sales history of the product line and particular SKUs, meaning the sales figures for past periods.
    * A projection of the tendencies observed in those periods.
    * Pricing, and promotion and advertisement budgets for the period.
    * Estimate of the competition actions for the same items as above.
    * Foreseen changes in the purchasing habits of the consumers.
    * Indirect competition estimate: some products are very different, but one can be easily replaced by the other one (tea vs. coffee, orange vs. apple juice, etc.)
    * The expected changes in consumer spendable income; this may not be too important for soap, but certainly for other products like home appliances, TV sets, etc.

    STUDENT: I guess it is possible to use math or software to help in forecasting.

    TEACHER: As we said, forecasting is not an exact science. A lot of insight, educated guessing and a little bit of luck are needed. But we still can get useful help from specialized software.

    Not that the software has any mysterious intelligence; it simply does the calculations which would be too slow and cumbersome to do by hand, applying standard mathematical forecasting methods.

    These methods, called time series apply basically to the analysis of past sales history and tendencies and their projection into the future.

    Statistical methods by themselves are naive models; the results must be adjusted according to the other non-mathematical elements listed above.

    STUDENT: What is the next step after we have a forecast?

    TEACHER: Once we know (or so we think!) how much we will sell of each product during the period or periods we are forecasting, we have the basic input for the supply chain management.

    We will call these figures "effective market demand". Effective meaning that the customers would not only "like" to purchase the product, but that they are able to.

    Once we have these figures, our first concern is finding out if we can timely produce the required quantities. We have to look at our production facilities, a procedure called "capacity planning".

    Capacity Planning: adjusting our capacity to the sales forecast... or the other way around!

    The Production management has the responsibility of planning its operations according to the sales forecast. Here we see at once why it is so important to have a good forecast in order to be efficient. There are several actions that can be taken based on a forecast:

    * increase capacity.

    * or to the contrary, limit our sales forecast to our production capacity (which in turn possibly means reducing our promotion and advertising budget).

    * negotiate contracts with other manufacturers (Toll packers) if our capacity is insufficient.

    * if we have excess capacity, we may increase our promotion and advertisement budget to reach a higher level of sales; or we may reduce our capital investment by diminishing capacity.

    All these actions must be initiated long before the actual forecasted period begins, and mean expenditures and/or commitments which may be difficult to cancel. Again; forecasting is difficult, but essential.

    STUDENT: Fine, we have a forecast and we have established that we can produce the forecasted quantity. What is next?

    TEACHER: No we will develop The Production Plan.

    Once we have achieved a good forecast, and are sure that we can produce the goods or get them from a toll packer, it is time to prepare a detailed Production Plan.

    A forecast usually includes an extended range period and is broken down into shorter ones. As an example, we may estimate the total sales for the next 3 years broken down as follows:

    * Yearly figure for year 1, 2 and 3

    * Quarterly figures for Year 2
    * Monthly figures for Year 1
    * Year one's first quarter, broken down into weeks

    Obviously, we may expect higher accuracy in the more immediate periods than in the ones farther away in time. But the long range forecast is needed for projects that take time to implement (say, building a new production line).

    For the shorter run, the forecast is needed to prepare a detailed production plan: how much to produce in each period, with which machines or production lines, length of the production runs for each SKU, etc.

    Yes, we can use computers for production planning. We can feed the machine a model of our plant, and let it work with our forecast to help us achieve the best possible production plan. Specialized software is available for this task, or a business may develop a model of their unique plant in-house.

    Now, Student, you tell me which is the next link of the chain.

    STUDENT: I only have to look at the illustration: it is Material Requirement Planning (MRP).

    TEACHER: Based on our production plan, we now can find out which production materials we will need, when, and how much of each. This includes all components (or "ingredients") as well as packaging materials and any other element we may need to produce the goods.

    This process is called MRP, for Material Requirement Planning.

    Done properly and with a good forecast and production plan as a basis, MRP will allow us to keep in stock all needed components. But we will have on hand the quantity we need, and no more. We will get delivery of the components shortly before we use them. In short, we will keep our materials inventory as low as possible without affecting the production plan.

    A caveat: the acronym MRP, originally meaning only Material Requirement Planning, is now also used to mean Manufacturing Requirement Planning. In the latter sense, it includes both the Plant Capacity as well as the Materials required for a production plan.

    Now let me tell you about a very beneficial and useful "Explosion"

    Formula Explosion is the name of a procedure which consists in multiplying the "formula" of a product by the quantity to be produced in a specific period. The result of the explosions of the individual formulae is consolidated to obtain the total "gross" need of components. Formula is the name given to a list with the quantity of each input needed to produce a unit of final or intermediate product.

    The Formula Explosion: Formula times Quantity to be Produced = Gross Material Requirement

    A simple example:

    Our production plan for January calls for making:

    * 100 T (metric tons) of Crushed Garlic (CG), and
    * 100 T of Minced Onion (MO)
    * The formula for 1 T of Crushed Garlic is
    * salt = 0.3 T
    * dehydrated garlic = 0.2 T /
    * water = 0.5 T

    "Exploding" this formula (multiplying it by 100) we get the gross requirements for 100 T of product:

    * salt: 30 T
    * dehydrated garlic: 20 T
    * water: 50

    * The formula for 1 T of Minced Onion is
    * salt = 0.3 T
    * dehydrated onion = 0.4 T
    * water = 0.3 T

    * Exploding this formula times 100 we get the gross requirements for 100 T of product:

    * salt: 30 T
    * dehydrated onion: 40 T
    * water: 30 T

    Consolidating the gross requirements for both products, we need:

    * salt: 60 T
    * dehydrated garlic 20 T
    * dehydrated onion: 40 T, and
    * water: 80 T

    These are the gross material requirements for a specific period.

    STUDENT: What's the meaning of gross?

    TEACHER: We call the calculated requirements "gross" because they do not necessarily coincide with the quantities we need to purchase. This is because we may have in stock materials that are available to be used when the January production plan is executed.

    Therefore, our next step in managing the MRP part of the supply chain is calculating the net material requirements. These will be the quantities we have to order from our suppliers.

    How much shall we purchase (order) for the period planned?

    We will use the gross requirements for dehydrated onion (40 T) calculated above, as the basis for our next example.

    Our materials inventory ledger has the following entries for dehydrated onion:

    * The actual physical quantity on hand (60 T)

    * The quantity on order from our suppliers (20 T)

    * The quantity already committed for specific production plans (60 T)

    For each material there is an item called "security stock level". This is quantity always reserved for "emergencies", like a supplier failing to deliver on time, or a sudden change in the production plan calling for higher quantities.

    * In our example, the security level of d/onion is 15 T.

    Calculating the net material requirements

    This is the calculation of the net requirements:

    * On hand 60T
    * plus On order 20T
    * = 80T
    * less Committed 60T
    * = 20T
    * less Security level 15T
    * = 5T Available

    This means that we have 5T available for use in our production plan for January. Since we had calculated a gross requirement of 40T, we need to order 35T for delivery in time for the January plan.

    STUDENT: I imagine that the situation is very fluid, and that there is a need for frequent revision of plans.

    TEACHER: You are correct. Since we must accept that forecasting is, if not impossible, certainly difficult, and that actual sales will always deviate somewhat from our production plan, we should be as flexible as possible in adapting to these deviations.

    Understanding the concept that the supply chain is an entity of inter-related parts, and realizing that they should be managed as such, is an important step in achieving that flexibility at minimum cost.

    If the process described is frequently repeated according to changes in customer demand, we will be able to adjust production and inventories accordingly.

    A good supply chain management team, with an adequate software as a tool, will certainly attain important savings in capital costs and other expenses.

    STUDENT: And what about computer software tools for managing the supply chain?

    TEACHER: If you think of Boeing or General Motors, you can imagine what it means to efficiently manage the supply chain if you have dozens of models, hundreds of thousands of parts, and continuous engineering changes that modify the "formula" of your final products.

    But even a company with a much simpler product structure needs the help of computer to accomplish the desired end.

    MRP software is available from different suppliers. To name a few: SAP, PeopleSoft, J.D.Edwards. Actually, as a result of the merger and acquisition process in the software industry, PeopleSoft and J.D.Edwards -formerly individual companies- are now product lines of ORACLE.

    The MRP software is a part of a more comprehensive software packages offered by these and other suppliers. The name of these packages is ERP, for Enterprise Resource Planning. ERP packages are able to coordinate operations and planning of all and every process of an enterprise.

    I'd like to tell you something about the Just in Time (JIT) concept.

    JIT is a revolutionary concept. It means that a company will receive the inputs for the production line at exactly the moment when they are needed. No materials inventory will exist. The savings in inventory investment, warehousing and materials handling are obvious.

    Since the customers will demand the same, JIT also applies to supplying the customer with products just when they need them.

    No need to say that full JIT is very difficult to implement. But competitive pressures are driving most companies to try and get as close to JIT as they can. With the help of computers and good management teams, plus the purchasing power to cajole its suppliers to cooperate, many firms have been able to implement JIT.


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