Supply Chain Strategy

Edited and Compiled By

Dr. Chandrashekhar V. Joshi

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Strategic sourcing is the development and management of supplier relationships to acquire
goods and services in a way that aids in achieving the immediate needs of the business.

Sourcing is a process suitable for procuring products that are strategically important to the
firm.

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Specificity refers to how common the item is and, in a relative sense, how many
substitutes might be available.

For example, blank DVD disks are commonly available from many different vendors
and would have low specificity.

A custom-made envelope that is padded and specially shaped to contain a specific item
that is to be shipped would be an example of a high-specificity item.

A request for proposal (RFP) is commonly used for purchasing items that are more
complex or expensive and where there may be a number of potential vendors.

A detailed information packet describing what is to be purchased is prepared and

distributed to potential vendors.

The vendor then responds with a detailed proposal of how the company intends to meet
the terms of the RFP. A request for bid or reverse auction is similar in terms of the
information packet needed.

A major difference is how the bid price is negotiated. In the RFP, the bid is included in
the proposal, whereas in a request for bid or reverse auction, vendors actually bid on
the item in real time and often using Internet software.
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Vendor-managed inventory is when a customer actually allows the supplier to manage the
inventory policy of an item or group of items for them.

In this case, the supplier is given the freedom to replenish the item as they see fit. Typically,
there are some constraints related to the maximum that the customer is willing to carry, the
required service levels, and other billing transaction processes.

Selecting the proper process depends on minimizing the balance between the supplier’s
delivered costs of the item over a period of time, say a year, and the customer’s costs of
managing the inventory.

The Bullwhip Effect

In many cases, there are adversarial relations between supply chain partners, as well as
dysfunctional industry practices such as a reliance on price promotions.

Consider the common food industry practice of offering price promotions every January on
a product. Retailers respond to the price cut by stocking up, in some cases buying a year’s
supply—a practice the industry calls forward buying.

Forward buying is a term that refers to when a customer, responding to a promotion, buys
far in advance of when an item will be used.
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In forward buying nobody wins in the deal. Retailers have to pay to carry the year’s
supply, and the shipment bulge adds cost throughout the supplier’s system.

For example, the supplier plants must go on overtime starting in October to meet the bulge.

Even the vendors that supply the manufacturing plants are affected because they must
quickly react to the large surge in raw material requirements.

Exhibit below shows typical order patterns faced by each node in a supply chain that
consists of a manufacturer, a distributor, a wholesaler, and a retailer.

The retailer’s orders to the wholesaler display greater variability than the end-consumer
sales; the wholesaler’s orders to the manufacturer show even more oscillations; and,
finally, the manufacturer’s orders to its suppliers are the most volatile.

This phenomenon of variability magnification as we move from the customer to the

producer in the supply chain is often referred to as the bullwhip effect.

The effect indicates a lack of synchronization among supply chain members. Even a slight
change in consumer sales ripples backward in the form of magnified oscillations upstream,
resembling the result of a flick of a bullwhip handle.
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Because the supply patterns do not match the demand patterns, inventory accumulates
at various stages, and shortages and delays occur at others.

This bullwhip effect has been observed by many firms in numerous industries,
including Campbell Soup and Procter & Gamble in consumer products; Hewlett-
Packard, IBM, and Motorola in electronics; General Motors in automobiles; and Eli
Lilly in pharmaceuticals.

Bullwhip effect is seen when the variability in demand is magnified as we move from
the customer to the producer in the supply chain.

Continuous replenishment is a program for automatically supplying groups of items

to a customer on a regular basis.

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 Supply Chain Uncertainty Framework
The supply chain uncertainty framework is designed to help managers understand the
nature of demand for their products and then devise the supply chain that can best satisfy
that demand.

Many aspects of a product’s demand are important—for example, product life cycle,
demand predictability, product variety, and market standards for lead times and service.
Products can be categorized as either primarily functional or primarily innovative.

Because each category requires a distinctly different kind of supply chain, the root cause
of supply chain problems is a mismatch between the type of product and type of supply
chain.

Functional products include the staples that people buy in a wide range of retail outlets,
such as grocery stores and gas stations. Because such products satisfy basic needs, which
do not change much over time, they have stable, predictable demand and long life cycles.

Specific criteria for identifying functional products include the following: product life
cycle of more than two years, contribution margin of 5 to 20 percent, only 10 to 20
product variations, an average forecast error at time of production of only 10 percent, and
a lead time for make-to-order products of from six months to one year.
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Innovative products are products such as fashionable clothes and personal
computers that typically have a life cycle of just a few months.

Although innovation can enable a company to achieve higher profit margins, the
very newness of the innovative products makes demand for them unpredictable.

A stable supply process is where the manufacturing process and the underlying
technology are mature and the supply base is well established.

In contrast, an evolving supply process is where the manufacturing process and the
underlying technology are still under early development and are rapidly changing.

As a result, the supply base may be limited in both size and experience. In a stable
supply process, manufacturing complexity tends to be low or manageable.

Stable manufacturing processes tend to be highly automated, and long-term supply

contracts are prevalent. In an evolving supply process, the manufacturing process
requires a lot of fine-tuning and is often subject to breakdowns and uncertain yields.
The supply base may not be reliable, because the suppliers themselves are going
through process innovations.

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 Differences between Stable and Evolving Supply Processes

Products that have different demand and supply uncertainties

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 Four Types of Supply Chain Strategies

Efficient supply chains These are supply chains that utilize strategies aimed at creating
the highest levels of cost efficiency. For such efficiencies to be achieved, non–value
added activities should be eliminated, scale economies should be pursued, optimization
techniques should be deployed to get the best capacity utilization in production and
distribution, and information linkages should be established to ensure the most efficient,
accurate, and cost-effective transmission of information across the supply chain.

Risk-hedging supply chains These are supply chains that utilize strategies aimed at
pooling and sharing resources in a supply chain so that the risks in supply disruption can
be shared. A single entity in a supply chain can be vulnerable to supply disruptions, but
if there is more than one supply source or if alternative supply resources are available,
then the risk of disruption is reduced.

A company may, for example, increase the safety stock of its key component to hedge
against the risk of supply disruption, and by sharing the safety stock with other locations
that also need this key component, the cost of maintaining this safety stock can be
shared. This type of strategy is common in retailing, where different retail stores or
dealerships share inventory.

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 Four Types of Supply Chain Strategies

Information technology is important for the success of these strategies because real-
time information on inventory and demand allows the most cost-effective
management and transshipment of goods between partners sharing the inventory.

Responsive supply chains These are supply chains that utilize strategies aimed at
being responsive and flexible to the changing and diverse needs of the customers.
To be responsive, companies use build-to-order and mass customization processes
as a means to meet the specific requirements of customers.

Agile supply chains These are supply chains that utilize strategies aimed at being
responsive and flexible to customer needs, while the risks of supply shortages or
disruptions are hedged by pooling inventory and other capacity resources. These
supply chains essentially have strategies in place that combine the strengths of
―hedged‖ and ―responsive‖ supply chains. They are agile because they have the
ability to be responsive to the changing, diverse, and unpredictable demands of
customers on the front end, while minimizing the back-end risks of supply
disruptions.

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Demand and supply uncertainty is a good framework for understanding supply
chain strategy. Innovative products with unpredictable demand and an evolving supply
process face a major challenge. Outsourcing is the act of moving some of a firm’s
internal activities and decision responsibility to outside providers.

Reasons to Outsource and the Resulting Benefits

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Logistics are Management Functions that support the complete cycle of material flow:
from the purchase and internal control of production materials; to the planning and
control of work-in-process; to the purchasing, shipping, and distribution of the finished
product.

Logistics companies now have complex computer tracking technology that reduces the
risk in transportation and allows the logistics company to add more value to the firm
than it could if the function were performed in-house.

Third-party logistics providers track freight using electronic data interchange

technology and a satellite system to tell customers exactly where its drivers are and
when deliveries will be made.

Framework for Supplier Relationships

In theory, outsourcing is a no-brainer. Companies can unload noncore activities, shed

balance sheet assets, and boost their return on capital by using third-party service
providers. But in reality, things are more complicated. It is often difficult to determine
what is core and noncore today, because situations change so quickly today.

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Green Sourcing

Being environmentally responsible has become a business imperative, and many firms are
looking to their supply chains to deliver ―green‖ results.

Green sourcing is not just about finding new environmentally friendly technologies or
increasing the use of recyclable materials. It can also help drive cost reductions in a variety
of ways, including product content substitution, waste reduction, and lower usage.

A comprehensive green sourcing effort should assess how a company uses items that are
purchased internally, in its own operations, or in its products and services. As costs of
commodity items like steel, electricity, and fossil fuels continue to increase, properly
designed green sourcing efforts should find ways to significantly reduce and possibly
eliminate the need for these types of commodities.

Another important cost area in green sourcing is waste reduction opportunities. This
includes everything from energy and water to packaging and transportation.

A great example of this is the redesigned milk jug introduced recently by leading grocery
retailers.

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 Six-Step Process for Green Sourcing

1.Assess the opportunity. For a given category of expense, all relevant costs need to be
taken into account. The five most common areas include electricity and other energy
costs; disposal and recycling; packaging; commodity substitution (alternative materials to
replace materials such as steel or plastic); and water (or other related resources).
These costs are identified and incorporated into an analysis of total cost (sometimes
referred to as ―spend‖ cost analysis) at this step. From this analysis, it is possible to
prioritize the different costs based on the highest potential savings and criticality to the
organization.
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2.Engage internal supply chain sourcing agents. Internal sourcing agents are those within
the firm that purchase items and have direct knowledge of business requirements, product
specifications, and other internal perspectives inherent in the supply chain.

These individuals and groups need to be ―on-board‖ and be partners in the improvement
process to help set realistic green goals. The goal of generating no waste, for example,
becomes a cross-functional supply chain effort that relies heavily on finding and developing
the right suppliers.

These internal managers need to identify the most significant opportunities. They can
develop a robust baseline model of what should be possible for reducing current and
ongoing costs.

In the case of procuring new equipment, for example, the baseline model would include not
just the initial price of the equipment as in traditional sourcing, but also energy, disposal,
recycling, and maintenance costs.

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3.Assess the supply base. A sustainable sourcing process requires engaging new and
existing vendors. As in traditional sourcing, the firm needs to understand vendor
capabilities, constraints, and product offering.

The green process needs to be augmented with formal requirements that relate to green
opportunities, including possible commodity substitutions and new manufacturing
processes. These requirements need to be incorporated in vendor bid documents or the
request for proposals (RFPs).

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4. Develop the sourcing strategy. The main goal with this step is to develop
quantitative and qualitative criteria that will be used to evaluate the sourcing process.
These are needed to properly analyze associated costs and benefits. These criteria need
to be clearly articulated in bid documents and RFPs when working with potential
suppliers so that their proposals will address relevant goals related to sustainability.

5. Implement the sourcing strategy. The evaluation criteria developed in step 4

should help in the selection of vendors and products for each business requirement.
The evaluation process should consider initial cost and the total cost of ownership for
the items in the bid.

So, for example, energy-efficient equipment that is proposed with a higher initial cost
may, over its productive life, actually result in a lower total cost due to energy savings
and a related lower carbon footprint. Relevant green opportunities such as energy
efficiency and waste reduction need to be modeled and then incorporated into the
sourcing analysis to make it as comprehensive as possible and to facilitate an effective
vendor selection process that supports the firm’s needs.

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6. Institutionalize the sourcing strategy. Once the vendor is selected and contracts
finalized, the procurement process begins.

Here, the sourcing and procurement department needs to define a set of metrics against
which the supplier will be measured for the contract’s duration. These metrics should be
based on performance, delivery, compliance with pricing guidelines, and similar factors.

It is vital that metrics that relate to the company’s sustainability goals are considered as
well.

Periodic audits may also need to be incorporated in the process to directly observe
practices that relate to these metrics to ensure honest reporting of data.

A key aspect of green sourcing, compared to a traditional process, is the expanded view of
the sourcing decision. This expanded view requires the incorporation of new criteria for
evaluating alternatives.

Further, it requires a wider range of internal integration such as designers, engineers, and
marketers.

Finally, visualizing and capturing the green sourcing savings often involve greater
complexity and longer payback periods compared to a traditional process.
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 Total Cost of Ownership

Total cost of ownership is an estimate of the cost of an item that includes all the costs
related to the procurement and use of the item, including disposing of the item after its
useful life.

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TCO actually draws on many areas for a thorough analysis. These include finance (net
present value), accounting (product pricing and costing), operations management
(reliability, quality, need, and inventory planning), marketing (demand), and information
technology (systems integration). It is probably best to approach this using a cross-
functional team representing the key functional areas.

Example 1: Total Cost of Ownership

Consider the analysis of the purchase of a copy machine that might be used in a copy
center. The machine has an initial cost of $120,000 and is expected to generate income of
$40,000 per year. Supplies are expected to be $7,000 per year and the machine needs to
be overhauled during year 3 at a cost of $9,000. It has a salvage value of $7,500 when we
plan to sell it at year 6.

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Example 1: Solution

Analysis of the Purchase of an Office Copier

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 Measuring Sourcing Performance

Two common measures to evaluate supply chain efficiency are inventory turnover and
weeks of supply.

These essentially measure the same thing. Weeks of supply is the inverse of inventory
turnover times 52. Inventory turnover is calculated as follows:

The cost of goods sold is the annual cost for a company to produce the goods or
services provided to customers; it is sometimes referred to as the cost of revenue. This
does not include the selling and administrative expenses of the company.

The average aggregate inventory value is the average total value of all items held in
inventory for the firm valued at cost. It includes the raw material, work-in-process,
finished goods, and distribution inventory considered owned by the company.

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 Measuring Sourcing Performance

In many situations, particularly when distribution inventory is dominant, weeks of

supply is the preferred measure. This is a measure of how many weeks’ worth of
inventory is in the system at a particular point in time. The calculation is as follows:

A firm considers inventory an investment because the intent is for it to be used in the
future. Inventory ties up funds that could be used for other purposes, and a firm may
have to borrow money to finance the inventory investment.

The objective is to have the proper amount of inventory and to have it in the correct
locations in the supply chain. Determining the correct amount of inventory to have in
each position requires a thorough analysis of the supply chain coupled with the
competitive priorities that define the market for the company’s products.

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Example 2 and Solution: Inventory Turnover Calculation

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 Video

https://www.youtube.com/watch?v=CBLbXTypInA

Exercises

1. What recent changes have caused supply chain management to gain importance?

2. Describe the differences between functional and innovative products.

3. What are characteristics of efficient, responsive, risk-hedging, and agile supply chains?
Can a supply chain be both efficient and responsive? Risk-hedging and agile? Why or why
not?

4. Why is it desirable to increase a company’s inventory turnover ratio?

5. Describe how outsourcing works. Why would a firm want to outsource?

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Thank You

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