Chapter 10
Managing the Supply Chain
In This Chapter
Breaking down the supply chain’s structure
Selecting the right supply chain strategy
Understanding causes of and solutions to the bullwhip
Boosting supply chain performance
You may have heard the saying “You’re only as strong as your weakest link.” Nothing is truer for a company’s supply chain — the businesses that provide the materials that you need to do business. Sometimes, the failure of just one supplier can drastically affect your ability to deliver quality goods and services to your customers in a timely manner.
The importance of efficient supply chain management has significantly increased as companies outsource more and more functions that go into their products and services. In the past, companies were traditionally vertically integrated, meaning that they produced a great majority of the components in their products. Today, however, firms now take on a horizontal structure, with many suppliers providing the products and services that once were done in-house. The costs associated with the purchase of goods and services now makes up a large portion of a firm’s cost of goods sold. By efficiently managing this supply chain, a firm can realize big savings and make a significant impact on its bottom line. For more on vertical integration and how business evolved into its current structure, see Chapter 11.
Among the most well-known businesses that are thriving in part because of smart supply chain decisions are Toyota, which made suppliers an integral part of its operations as part of its quest to get lean; Walmart, which relies on suppliers to keep shelves stocked with products at the lowest possible prices; and Dell Computer, which rose to market dominance by managing its supply chain to provide components quickly to fuel a custom manufacturing model. The importance of a reliable supply chain to businesses has even prompted many universities to establish supply chain management majors.
In this chapter we describe the basic structure of supply chains and point out how you can establish a supply chain that meets the particular needs of your product. We also explain supply chain dynamics and reveal the major issues that arise from these dynamics. But don’t worry; we tell you how to prevent and manage these issues, too, and even highlight a few methods that real companies are using to bring suppliers into the fold of their business to strengthen the supply chain.
Seeing the Structure of Supply Chains
Most supply chains have a basic structure that resembles the pyramid shape of a typical organizational chart. Here, one person is in charge. Several people report to the head honcho, and each of these people has direct reports as well, and the chain of command continues down to line workers. In a supply chain, the main business — also known as the original equipment manufacturer (OEM), a general term that describes the organization that makes the end product for customers — is supported by supply tiers that become increasingly specialized as you move down the structure. That is, Tier 1 suppliers provide the most refined, market-ready components for the end product — whether the business sells widgets or services. Tier 2 suppliers provide direct support to Tier 1 companies and so forth down the layers. Figure 10-1 represents a real supply chain.
Illustration by Wiley, Composition Services Graphics
Figure 10-1: Supply chain network.
Tier 1 suppliers receive support from their suppliers, companies that enable them to provide materials or services to their customers. From the OEM’s perspective, the suppliers to the Tier 1 suppliers are Tier 2 suppliers; yet these companies are Tier 1 suppliers to the OEM’s Tier 1 suppliers. Sounds like the old “Who’s on First” scenario, right? Well, this support system continues with Tier 3 suppliers supporting Tier 2 suppliers and so on. And the chain eventually leads to the raw material providers.
In this section, we describe the tiered structure of a supply chain and point out how support services link into a company’s supply chain.
Getting through the tiers
It’s important for the OEM to determine how many tiers it wants to manage. As you progress down the chain, management of suppliers (and the suppliers of the suppliers’ suppliers) can get pretty complicated. A business may have only a few Tier 1 suppliers but many more Tier 2 and Tier 3 suppliers. As you can see, the number of suppliers grows quickly.
Most OEMs rely on their Tier 1 suppliers to manage the lower layers of the supply chain. However, very large and successful companies such as Toyota have been known to work with Tier 2 suppliers, lending their quality expertise to help improve the quality of products delivered to Tier 1 suppliers.
Linking in support services
A company’s supply chain may extend beyond the suppliers that contribute components for a specific product or service. The distribution network is also a critical component of many supply chains and ensures that products get to the customer. For example, Amazon relies on United Parcel Service (UPS) to deliver customer orders quickly and reliably. This distribution function is outside the core competency of most companies, so it’s often an important support service. (Find more on outsourcing in Chapter 17.)
Keep in mind that the tiered structure of a supply chain also applies to service-based commodities. For example, in order for a financial lender to provide a customer with a mortgage, the company performs a series of operations that involve other businesses. In this case, the mortgage lender is the OEM. To approve a loan, the company utilizes several other business (Tier 1 suppliers), which may include a credit reporting agency to determine whether a customer is creditworthy, a title company to confirm there are no other claims to the property, a property appraiser to assess the value of the property, and a surveyor to determine property lines and infringements. Each of these Tier 1 suppliers for the OEM may require its own set of suppliers; these are the OEM’s Tier 2 suppliers.
An OEM or end customer is often unaware of every supplier involved with the commodity being purchased. Figure 10-2 illustrates this mortgage supply chain.
Illustration by Wiley, Composition Services Graphics
Figure 10-2: The mortgage service supply chain.
Service supply chains have different requirements from their manufacturing cousins because service supply chains have no way to inventory their services. In other words, a mortgage provider and its suppliers can’t perform its functions until a property has been identified for purchase.
In Chapter 7, we point out that companies in a service supply chain must manage demand variability by maintaining excess capacity, which often means having employees work overtime.
Service-based companies can smooth the demand for their suppliers’ services by pulling as much as they can forward in the process. For example, mortgage companies often recommend that clients get preapproved for a mortgage before they find the property they want to purchase. This takes the time crunch off of the resources in the process.
Aligning the Supply Chain with Business Strategy
One size doesn’t fit all when it comes to building a supply chain. Each company needs to consider its goals and business strategy when designing a supply chain. Companies also need to account for the cultural aspects of their suppliers because communication is key to any successful relationship. Language barriers and the meaning of different phrases can vary across cultures, leading to misunderstandings in directions. Management of both a company and its suppliers must work toward the same goals and objectives, and both must understand what is expected.
In this section, we describe the relationship between a product or service and a company’s business strategy and point out how this relationship influences the supply chain.
Defining product demand
Before developing a supply chain, a company needs to understand the nature of the demand for its products (find more on demand in Chapter 6). The supply chain needs for a product with stable demand (a well-established or mature product) are different from those for a product with less predictable demand (an innovative product).
Functional products typically have a demand stream that’s well-known and predictable. For your local grocery store, these products include staple food products such as breakfast cereals and milk. Functional products typically have a long product life cycle, meaning that the products don’t change dramatically over time. Functional products also often have low profit margins because they’re considered a commodity, and many substitutions (generic products) are available.
Innovative products, on the other hand, are new and often revolutionary products that have a demand stream that’s not well-known and unpredictable. Innovative products are characterized by variable demand, shorter product life cycles, and higher profit margins. Examples of innovative products include most consumer electronics, computer games, and fashion apparel.
Choosing the right supply chain strategy
Depending on the type of product that a business sells, supply chain development may take on one of two basic looks. Here are the primary supply chain categories:
Efficient supply chain: Usually a make-to-stock (MTS) producer that draws from a large finished goods inventory. Functional products usually benefit from an efficient supply chain because demand for these products is stable, allowing the company to maintain inventory with minimal risk of overstocking or being left with inventory that doesn’t sell.
Responsive supply chain: Usually produces make-to-order (MTO) products. With their high demand variability, innovative products benefit from responsive supply chains that can deliver products quickly without maintaining a finished goods inventory. Flip to Chapter 8 for a discussion of the risks associated with inventory.
We describe MTS and MTO production strategies in Chapters 5 and 11.
Figure 10-3 illustrates how a product’s demand influences supply chain choice.
Illustration by Wiley, Composition Services Graphics
Figure 10-3: Choosing a supply chain strategy.
You can implement a responsive supply chain for functional products under certain circumstances. Because responsive supply chain companies don’t maintain inventory, they must be able to quickly produce the products needed. These companies must embrace the lean principles described in Chapter 11.
A major supply chain mismatch is an innovative product trying to operate in an efficient supply chain, although many companies find themselves in this situation. This pairing is especially common in markets where companies find that the life cycle of their products are rapidly decreasing, such as mobile phones. (How many versions of the iPhone exist?)
Efficient supply chains tend not to serve innovative products well because they benefit from long production runs that result in the buildup of inventory. If a product’s demand is highly variable and unknown, this inventory presents a sizable risk (see Chapter 8 for details on inventory risk).
When a firm sells both functional and innovative products, designing a successful supply chain gets tougher. In this case, the firm may have different supply chains for different product offerings.
Just be aware that not all the vendors in a firm’s supply chain need to operate exclusively as an efficient or responsive supplier. For example, a consumer electronics firm may require that its Tier 1 suppliers be responsive to accommodate the variability in demand. However, because a particular supplier can provide a certain component to more than one firm, the supplier may operate according to the efficient approach because its demand variability can be reduced across multiple customers.
Exploring the Bullwhip Effect
The layered structure of a supply chain (shown in Figure 10-1) generates variability in the supply chain that increases with each new layer, a dynamic known as the bullwhip effect. Figure 10-4 illustrates the bullwhip effect.
Illustration by Wiley, Composition Services Graphics
Figure 10-4: Supply chain variability escalation.
In Figure 10-4, the consumer demands product from the retailer, the retailer places an order with the wholesaler, and the wholesaler in turn orders from the factory. Farther down the supply chain line, the factory, experiencing an increase in demand, places an order with an equipment supplier for machines to increase its production capacity. The escalation in the demand variability is the result of several policies that locally seem to be sensible but, when examined from a systematic point of view, result in the bullwhip chaos.
The bullwhip effect exists in all supply chains — it’s the root of the boom and bust cycles that occur in many industries — and it can be devastating if not properly managed. Fortunately, you have ways to manage the bullwhip and minimize its impact. Find out more about these maneuvers later in this section.
Figure 10-5 shows actual data for the machine tool supply chain. The GDP in this graph looks relatively stable compared to the variability experienced in the demand for automobiles and the supply chain for automobiles. Figure 10-5 shows that the variability in orders for machine tools is even greater than for automobiles. This makes practical sense because automotive manufacturers purchase machine tools to assemble automobiles. When demand for automobiles increases, the firm may desire to increase capacity and go out and place orders for more machines to assemble the autos. Just like the end of a bullwhip can exceed the speed of the sound barrier, resulting in a sharp “crack” while the handle of the whip is moving more slowly, relatively small changes in GDP resulting in noticeable changes to auto demand can be magnified into far more dramatic changes for machine tool demand. Hence the term bullwhip.
Illustration by Wiley, Composition Services Graphics
Figure 10-5: The machine tool supply chain.
Variability in demand makes managing business operations difficult. Planning capacity, managing inventory, and making staffing decisions are tough when you’re riding the demand roller coaster of the bullwhip, especially as you move along the supply chain away from the customer. (Find more on how to manage capacity and inventory in Chapters 7 and 8.)
In the next section, we point out what causes the bullwhip effect and how you can keep your supply chain bullwhip-free.
Finding the bullwhip triggers
The bullwhip effect is triggered by several different causes. We describe four of the most prevalent causes here.
Delivery delays and pipeline inventory
Delivery delay, also called lead time, is the span of time between when an order is placed and when it’s received. If you don’t maintain sufficient inventory, you need to account for the time it takes your suppliers to produce and/or deliver goods.
For example, consider a beer supply chain in a city hosting the Super Bowl for the first time. During the week before the game, end customers purchase the beer from a local retailer. By Tuesday, when supplies of beer on the shelf get low, the retailer places an order with the wholesaler. When the wholesaler receives the order from the retailer, it prepares the beer for shipment and ships it. Processing the order and delivering it to the customer take time. This time is considered the delivery delay.
While the order is being shipped, the retailer continues to sell beer; as stock disappears, the retailer orders even more beer from the wholesaler on Thursday. The wholesaler in turn experiences a decrease in inventory and places additional orders with the brewers. The factory, located in Germany in this case, has a long lead time to ship the beer, which may inspire the wholesaler to order even more beer as inventory decreases in order to avoid empty shelves in other cities.
The greater the delivery delay, the more prone your supply chain is to the bullwhip effect because orders increase across the supply chain as everyone waits for delivery. If all participants in the supply chain don’t account for the pipeline orders (outstanding orders) and continue to order normally as inventory is depleted, when the ordered shipments start arriving, the participants will end up overshooting their desired inventory levels and decrease future orders. This leads to large variation in demand experienced throughout the supply chain.
Be sure to modify the basic inventory equations in Chapter 8 to include orders that have been placed but not received by customers. For example, in a periodic inventory review system, the amount of inventory that a firm should order is revealed by this formula:
Amount to Order = Demand · Lead Time + Safety Stock – Amount on Hand – Amount on Order
Order batching
Depending on how frequently you order from your supplier, your supply chain will likely experience varying levels of bullwhip effect. Placing frequent orders for small quantities is better (creates less bullwhip) than placing larger orders less frequently. Figure 10-6 shows demand for a product at a retailer. The demand is continuous (not constant) over the month, and the retailer places orders with its supplier once per month. This creates very inconsistent demand for the supplier over time.
Illustration by Wiley, Composition Services Graphics
Figure 10-6: Order batching.
The demand stream to the supplier can be smoothed if, instead of once a month, the retailer places an order to the supplier every week.
Sales and price discounts
Many supply chain experts believe that promotional price discounts and sales are the worst marketing ploys ever created when it comes to managing a supply chain. When things you use and buy on a regular basis go on sale, a bullwhip effect often occurs because sales create a boom-and-bust cycle. Lots of product moves during the promotional period, which is followed by lower levels of sales. This cycle ripples through the supply chain.
Promotional sales also lead to retail outlets running out of inventory, which means that customers hoping to purchase the product on sale can’t get it. If offered, customers can wait in line at the customer service counter to receive a rain check for the product, but in most cases, customers leave disappointed, with a lower opinion of the operation.
Another unintended consequence of promotional sales, especially if a company offers them frequently, is that customers come to expect a sale, and they won’t purchase items unless they’re on sale. Companies also believe that they must offer the sales to attract customers.
Shortage gaming
Shortage gaming occurs when customers place multiple orders for a product with one or more suppliers or when they place an order for more than what they want. Customers often do this if they know inventory will be in short supply.
Consider the release of a hot new product such as a video game. You know you must have it the day it’s released to the public and realize that it may be in short supply. So you place a preorder with several retailers, knowing that you’ll purchase only one and will cancel orders from the others (or you may buy every item and resell them on some Internet site for a profit).
This double or phantom ordering creates a false demand picture for the product provider. Demand can often be exaggerated, leading the producer to increase output. This very real problem occurs often in businesses where shortages are expected, and the effect ripples throughout the supply chain. Many companies, especially those in the retail industry, have tried to combat this by making the customer place a small deposit on ordered items.
Dodging the bullwhip
Most companies are aware of the bullwhip effect and the damage it can inflict on their business. Yet many managers still fall into the traps that trigger bullwhips, which are described in the previous section. Here, we introduce basic techniques for avoiding the bullwhip effect. These techniques may seem simplistic, but many companies don’t follow them.
Sharing information
Demand exists at every level of a supply chain, but the only demand that really matters is the end customer’s demand for the final product. As shown in the tier structure presented in Figure 10-1, every tier should be aware of the end customer demand (sometimes called pull-through) and not just of the orders placed by its upper tier. Businesses at each tier should also be aware of the pipeline (outstanding) inventory.
Technology systems, such as point-of-sales product scanning and vendor-managed inventory, make sharing these information points fairly painless. We describe these systems in the later section Improving Supply Chain Management.
Aligning your supply chain
Reducing the number of suppliers and the number of tiers in your supply chain can facilitate better communication and decrease the oscillation that creates the bullwhip effect. The restaurant industry has reduced the number of Tier 1 suppliers, which facilitates communications because restaurants have only one supplier they need to communicate with. Another advantage is that the Tier 1 suppliers may supply many restaurant chains, allowing them to reduce the overall variability they experience in demand. Pharmacies have long benefited from the same structure, with specialized wholesalers (Tier 1 suppliers) that stock medicines and medical devices from all the manufacturers.
Implementing an everyday-low-price policy
Promotional sales are a major contributor to the bullwhip effect. To avoid it, successful retailers such as Walmart have adopted the everyday-low-price strategy. If you look at your local Walmart’s weekly advertisement, you may notice that many, if not most, of the products in the ad are listed at their normal prices.
This marketing approach is quite useful. Customers may actually think they’re getting a price discount when they’re not, and Walmart can strategically advertise products they have in excess inventory with the hope that consumers will see the low price and come into the store to purchase the product.
However, the Walmart approach may not work for some products and industries. Recently, one major retailer, suffering from lackluster sales, embarked on an everyday-low-price strategy. Instead of participating in the weekly sales and discount coupons that its competitors use, this retailer started to offer its products at a low fixed price and had monthly special pricing on certain items. Unfortunately, this strategy didn’t have the desired effect. But why? Most consumers refuse to buy many products unless they’re on sale, and this has an effect on how retailers promote and advertise their products. This appears to be the trend in the fashion retailing and cosmetics industries.
Establishing long-term contracts with suppliers
Many successful companies have made their supply chain an integral part of their core business processes. Toyota’s treatment of its supply chain is a major contributor to its success. The best way to embrace your suppliers is to establish long-term relationships with them. This long-term relationship makes the supply chain vested in your success and helps align the goals of both companies.
In Chapter 11 we point out that lean companies view their suppliers as an extension of their company. One way to embrace the supplier is with long-term contracts based on shared goals and shared performance standards. Long-term purchase contracts give the supplier confidence to invest in long-term improvements, knowing that the revenue stream will be available. To be successful, though, this relationship depends on mutual trust between the buyer and the supplier.
Long-term contracts also make suppliers vested in the contracting company’s success. Most suppliers realize that improvements in their products and processes potentially improve the customer company’s position in the market, increasing sales and leading to increased demand for the supplier’s products.
Improving operational efficiency
The supply chain is only as good as its weakest link. Therefore, improving the processes of your supply chain companies improves your operations. (See Part I of this book for info on how to improve processes.)
Improving your processes and your supply processes reduces your delivery lead times and helps reduce the pipeline inventory. The reorder point and desired inventory levels are a direct function of your delivery lead time. As you reduce this lead time, you can reduce the total amount of inventory in your process. Reducing this pipeline inventory lessons the bullwhip effect described earlier.
Improving Supply Chain Management
Most companies know that designing and maintaining a strong and reliable supply chain is vital to profitability and long-term survival. In this section we describe how to improve supply chain management through better communication, accountability, and inventory management. (Find out why a strong supply chain matters to a lean organization in Chapter 11 and how to manage supply chain inventory in Chapter 8.)
Communicating better
Through modern information technology, companies are now able to share two critical data points with their suppliers: actual customer demand and the amount of inventory on hand.
Fortunately, modern scanners used at retail outlets enable suppliers to access consumer demand instantaneously. Your local grocery store probably utilizes this scanning system — to tally your order and to facilitate stock-replenishment orders. That is, companies can use this point of sale (POS) information to trigger the ordering of inventory (covered in Chapter 8).
In addition, if suppliers can access a company’s POS data, they can anticipate when you’ll likely place an order before you actually place it! The bar coding of inventory facilitates this constant monitoring throughout the supply chain. Concepts such as collaborative planning, forecasting, and replenishment (CPFR) strive to increase supply chain integration by increasing the visibility of demand at every point on the supply chain.
Outsourcing inventory management
More and more companies are putting the responsibility of inventory management on their suppliers. This practice, known as vendor-managed inventory (VMI), is quite common in major retailers.
Here’s how it works: A major retailer gives a certain amount of shelf space in its store to a supplier, which keeps its products stocked there. Armed with the retailer’s POS data, the supplier can restock its products without direct involvement by the retailer. This saves the retailer time and money because it avoids the job of managing the inventory.
VMI requires trust in a supplier. For VMI to work, a company must give the supplier access to sales information so it can restock the shelves as necessary. In many cases, especially retail, the supplier also supplies competitor retailers. Given actual sales and inventory levels, the supplier could inadvertently (or possibly on purpose) provide sales data to the competition. So trust and integrity are necessary conditions for a sound relationship that benefits both parties.
In addition, a company must be certain that the supplier knows how to efficiently manage inventory. (Hey, perhaps you should provide a copy of this book to your suppliers!) And the supplier must have the technical capability to perform VMI. Its computer systems and programs need to be compatible with the partner company to enable the necessary information exchange to execute VMI.
For more suggestions on how a firm can manage supply chain inventory, see Chapter 8.
Simplifying the chain by consolidating shipments
Managing a supply chain can get complicated quickly. From the OEM standpoint, the more Tier 1 suppliers that are involved, the more time someone must spend coordinating them. Many companies try to minimize the number of suppliers they use.
For example, consider a restaurant’s dependence on food distributors. The burger joint down the street needs many separate items to prepare and serve a meal consisting of a cheeseburger, fries, and drink. If the restaurant uses a different supplier for each component, imagine the traffic jam of delivery trucks that’d amass around the facility! Figure 10-7 shows all the deliveries a restaurant would require from different suppliers, each providing different items to the restaurant.
Illustration by Wiley, Composition Services Graphics
Figure 10-7: The restaurant supply chain.
In the restaurant business, supply chains no longer rely on multiple suppliers with specialty support. All-in-one restaurant supply companies have emerged to simplify the material management process for restaurants. This new Tier 1 supplier purchases core supplies from specialty suppliers (now Tier 2 suppliers) and delivers them in one shipment to the restaurant, as shown in Figure 10-8. Reducing the complexity of the supply chain eases the burden on restaurant management to keep ingredients and supplies in stock, and, because fewer trucks are making deliveries, this simplification decreases traffic congestion at the facility and the number of deliveries the restaurant must receive.
Another method for simplifying a supply chain, cross-docking, reduces a company’s inventory levels and the need for warehouse space. Cross-docking is a logistics network approach used to minimize warehousing costs and reduce inventory. This is a popular process for big retailers and grocery store chains.
Illustration by Wiley, Composition Services Graphics
Figure 10-8: Simplified restaurant supply chain.
Figure 10-9 shows how cross-docking works. The OEM maintains a shipping dock where supplier trucks arrive and park. The trucks are unloaded, and instead of placing the inventory in a storage warehouse, the goods are placed directly on the firm’s truck (or another supplier’s truck), which delivers the inventory directly to the facility. The end delivery truck may contain goods from multiple suppliers.
Cross-docking reduces pipeline inventory and also the need for warehouse space. It functions similarly to the simplified restaurant supply chain shown in Figure 10-8, but cross-docking leaves direct control over suppliers in the hands of the OEM instead of an all-in-one middleman supplier.
Illustration by Wiley, Composition Services Graphics
Figure 10-9: Cross-docking.