Introduction

Logistics is concerned with getting the products and services where they are needed
when they are desired. It is difficult to accomplish any marketing or manufacturing
without logistical support. It involves the integration of information, transportation,
inventory, warehousing, material handling, and packaging.
The operating responsibility of logistics is the geographical repositioning of raw
materials, work in process, and finished inventories where required at the lowest cost
possible
The formal definition of the word logistics is: - it is the process of planning,
implementing and controlling the efficient, effective flow and storage of goods,
services and related information from the point of origin to the point of
consumption for the purpose of conforming to customer requirements.
Within the firm the challenge is to coordinate individual job expertise into an integrated
competency focused on servicing customers. In most situations the desired scope of
such coordination transcends the individual enterprise, reaching out to include
customers as well as material and service suppliers. Ina strategic sense, the senior
logistics officer leads a boundary spanning initiative to facilitate effective supply chain
relationships. The excitement of contemporary logistics is found in making the
combined results of internal and external integration one of the core competencies of an
enterprise. Throughout the history of mankind wars have been won and lost through
logistical strengths and capabilities or the lack of them. Even though the generals of the
past have understood the critical role of logistics it only in the recent past that the big
organizations have realized its role in the achievement of competitive advantage.
Arth Shaw in 1915 pointed out that: the relations between the activities of demand
creation and physical supply illustrate the existence of the 2 principles of
interdependence and balance. Failure to co-ordinate any one of these activities with its
group-fellows and also with those in the other group, or undue emphasis or outlay put
upon any one of these activities, it is certain to upset the equilibrium of forces which
mean efficient distribution. The physical distribution of the goods is a problem distinct
from the creation of demand. There are many ways of defining logistics but the
underlying concept might be defined as follows: Logistics is the process of
strategically managing the procurement, movement and storage of materials, parts
and finished inventory through the organization and its marketing channels in
such a way that current and future profitability are maximized through the costeffective fulfillment of orders.
Competitive Advantage
Effective logistics management can provide a major source of competitive advantage.
The bases for successes in the marketplace are numerous, but a simple model has been
based around the three Cs Customer, Company & Competitor. The source of
competitive advantage is found firstly in the ability of the organization to differentiate
itself, in the eyes of the customer, from its competition and secondly by operating at a
lower cost and hence at greater profit.

Seeking a sustainable competitive advantage has become the concern of every manager
who realizes the marketplace and it is no longer acceptable to assume that the goods
will sell themselves. An elemental, commercial success is derived either form a cost
advantage or a value advantage or, ideally both. The greater the profitability of the
company the lesser is the production of cost. Also a value advantage gives the product
an advantage over the competitive offerings. Successful companies either have a
productivity advantage or they have a value advantage or maybe a combination of the
two.
There are two main vectors of strategic direction that need to be examined:

PRODUCTIVITY ADVANTAGE

In many industries there will be a competitor who will be a low cost producer and will
have greater sales volume in that sector. This is partly due to economies of scale, which
enable fixed costs to spread over a greater volume but more particularly to the impact of
the experience curve.
It is possible to identify and predict improvements in the rate of output of workers as
they become more skilled in the processes and tasks on which they work. Bruce
Henderson extended this concept by demonstrating that all costs, not just production
costs, would decline at a given rate as volume increased. This cost decline applies only
to value added, i.e. costs other than bought in supplies. Traditionally it has been
suggested that the main route to cost reduction was by gaining greater sales volume and
there can be no doubt about the close linkage between relative market share and relative
costs. However it must also be recognized that logistics management can provide a
multitude of ways to increase efficiency and productivity and hence contribute
significantly to reduced unit costs.

VALUE ADVANTAGE

It is a clich that customers dont buy products they buy benefits. These benefits may be
intangible i.e. they relate not to specific product features but to such things as image and
reputation. Unless the product or service that we offer can be distinguished in some way
from its competitors there is a strong likelihood that the marketplace will view it as a
commodity and so the sale will tend to go to the cheapest supplier. Value
differentiation can be gained in numerous ways. When a company scrutinizes markets
closely it frequently finds that there are distinct value segments. In other words different
groups of customers attach different levels of importance to different benefits. The
importance of such benefit segmentation lies in the fact that often there are substantial
opportunities for creating differentiated appeals for specific segments. Adding value
through differentiation is a powerful means of achieving a defensible advantage in the
market. Equally powerful as a means of adding value is service. Increasingly it is the
case that markets are becoming more service sensitive and this poses a challenge in
management of logistics. It is important to seek differentiation through means other
than technology. A number of companies have responded to this by focusing upon
service as a means of gaining a competitive edge. Service in this context relates to the
process of developing relationships with customers through the provision of an

augmented offer. This augmentation can take many forms including delivery service,
after sales service, financial packages, technical support and so on.
This matrix is a useful way of examining the options available for value and
productivity advantage:

SERVICE
LEADER

COST
SERVICE
LEADER

COMMODITY
MARKET

COST
LEADER

&

In commodity market situations where a companys products are indistinguishable from

their competitors offerings the only strategy is to move towards being a cost leader or
towards being a service leader. Often the leadership route is not available. This
particularly will be the case in a mature market where substantial market share gains are
difficult to achieve.
Cost leadership strategies have been based upon the economies of scale, gained through
greater volume of sales. This is why market share is considered to be so important in
many industries. This cost advantage can be used strategically to assume a position of
price leader and make it difficult for high cost competitors to survive. This cost
advantage can come through effective logistics management. In many industries
logistics cost represents such a large part of total costs that that it is possible to make
major cost reductions through fundamentally reengineering logistics processes.
The other way to come out of the commodity quadrant of the matrix is to seek a strategy
of differentiation through service excellence. Customers ion all industries are seeking
greater responsiveness and reliability from suppliers; they are looking for reduced lead
times, just-in-time delivery and value added services that help them do a better job of
serving their customers.
GAINING COMPETITIVE ADVANTAGE THROUGH LOGISTICS
A firm can gain competitive advantage only when it performs its strategically
important activities (designing, producing, marketing delivering and supporting its
product) more cheaply or better than its competitors.
Value chain activity disaggregates a firm into its strategically relevant activities
in order to understand behavior of costs and existing and potential sources of
differentiation. They are further categorized into two types
(i) Primary - inbound logistics, operation outbound logistics, marketing and sales,
and service
(ii) Support infrastructure, human
development and procurement
3

resource

management,

technology

To gain competitive advantage over its rivals, a firm must deliver value to its customers
through performing these activities more efficiently than its competitors or by
performing these activities in a unique way that creates greater differentiation.
Logistics management has the potential to assist the firm in the achievement of both a
cost/productivity advantage and a value advantage. The under lying philosophy behind
the logistics concept is that of planning and coordinating the materials flow from source
to user as an integrated system rather than, as was so often the case in the past,
managing the goods flow as a series of independent activities. Thus under a logistics
management regime the goal is to link the marketplace, the distribution network, the
manufacturing process and the procurement activity in such a way that customers are
service at higher levels and yet at lower cost.
THE MISSION OF LOGISTICS MANAGEMENT
The mission is to plan and coordinate all those activities necessary to achieve desired
levels of delivered service and quality at lowest possible cost. Logistics must therefore
be seen as the link between the marketplace and the operating activity of the business.
The scope of the logistics spans the organization, from the management of raw
materials through to the delivery of the final product.
Materials flow

Suppliers

Procurements

Operations

Distribution

Customers

Requirements information flow

REASONS FOR LOGISTICS TO EXIST
Logistics management from this total system is the means whereby the needs of
customers are satisfied through the coordination of the materials and information flows
that extend from the marketplace through the firm and its operations and beyond that to
supplies.
For example for many years marketing and manufacturing have been seen as largely
separate activities within the organization. At best they have coexisted, at worst there
has been open warfare. Manufacturing priorities and objectives have typically been
focused on operating efficiency, achieved through long production runs, minimized
setups, changeovers and product standardization. On the other hand marketing has
sought to achieve competitive advantage through variety, high service levels and
frequent product changes.
In todays more turbulent environment there is no longer any possibility of
manufacturing and marketing acting independently of each other.
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It is now generally accepted that the need to understand and meet customer
requirements is a prerequisite for survival. At the same time, in the search for improved
cost competitiveness, manufacturing management has been the subject of massive
renaissance. The last decade has seen the rapid introduction of flexible manufacturing
systems, of new approaches to inventory based on materials requirement planning
(MRP) and just in time (JIT) methods, a sustained emphasis on quality.
Equally there has been a growing recognition of the critical role that procurement plays
in creating and sustaining competitive advantage as part of an integrated logistics
process.
In this scheme of things, logistics is therefore essentially an integrative concept that
seeks to develop a system wide view of the firm. It is fundamentally a planning concept
that seeks to create a framework through which the needs of the manufacturing strategy
and plan, which in turn links into a strategy and plan for procurement
LOGISTICAL INTEGRATION
Inventory Flow

Suppliers

Physical
distribution

Manufacturing
support

Procurement

Customers

Information Flow

INTEGRATED LOGISTICS
Logistics is viewed as the competency that links an enterprise with its customers
and suppliers. Information from and about customers flows through the enterprise
in the form of sales activity, forecasts and orders. As products and materials are
procured, a value added inventory flow is initiated that ultimately results in
ownership transfer of finished products to customers. Thus the process is viewed in
terms of two inter-related efforts, inventory flow and information flow.

Inventory Flow
The management of logistics is concerned with the movement and storage of materials
and finished products. Logistical operations start with the initial shipment of a material
or component part from a supplier and are finalized when a manufactured or processed
product is delivered to a customer.
From the initial purchase of a material or component, the logistical process adds value
By moving inventory when and where needed. Thus the material gains value at each
step.
5

For a large manufacturer, logistical operations may consist of thousands of movements,

which ultimately culminate in the delivery of the product to an industrial user,
wholesaler, dealer or customer.
Similarly for a retailer, logistical operations may commence with the procurement of
products for resale and may terminate with consumer pickup or delivery.
The significant point is that regardless of the size or type of the enterprise, logistics is
useful and requires continuous management attention.
In order to understand logistics it is useful to divide it into three areas.
Physical distribution
Manufacturing support
Procurement
Physical distribution
The area of physical distribution concerns movement of a finished product to the
customers. In physical distribution the customer is the final destination of the marketing
channel.
Unless the products are delivered where and when needed, a great deal of marketing
effort can be wasted.
All physical distribution systems have one feature in common: they link manufacturers,
wholesalers and retailers and ensure that the product is available.
Manufacturing support
The area of manufacturing support concentrates on managing W.I.P inventory as it
flows between the stages of manufacturing.
A Master Production Schedule is prepared and arrangements are made for timely
availability of materials, components, parts etc.
Manufacturing support has one significant difference when compared with physical
distribution.
Physical distribution attempts to satisfy the needs of the customers while manufacturing
support involves movement requirements that are under he control of the manufacturing
enterprise.
Procurement
Procurement is concerned with purchasing and arranging in-bound movement of
materials, parts and /or finished inventory from suppliers to manufacturing or assembly
plants, warehouses or retail stores.
Procurement is also known as purchasing and buying and in some cases inbound
logistics. Procurement s concerned with availability of the desired material assortments
where and when needed.
Within a typical enterprise, the three areas of logistics overlap. The prime concern of an
integrated logistical process is to coordinate overall value-added inventory movement.
The three areas combine to provide integrated management of materials.
6

Information flow
Information flow identifies specific locations within a logistical system that have
requirements. Information also integrates the three operating areas. The primary
objective of developing and specifying requirements is to plan and execute
integrated logistical operations. Within individual logistics areas, different
movement requirements exist with respect to size of order, availability of
inventory, and urgency of movement. The primary objective of information
sharing is to reconcile these differences.
Logistical information involves two major types of flows:
1. Coordination flows
2. Operation flows
1. Planning and coordination flows
Coordination is the backbone of the overall information system. Coordination
results in plans specifying:
Strategic objectives
Strategic objectives detail the nature and location of customers, which are
matched to the required products and services to be performed.
Capacity constraints
Capacity constraints coordinate internal and external manufacturing
requirements. Capacity constraints identify limitations, barriers, within basic
manufacturing capabilities and determine appropriate outsource requirements.
Logistical requirements
Logistics requirements specify the work that distribution facilities, equipment
and labour must perform to implement the capacity plan.
Inventory deployments
Inventory deployments are the interfaces between planning/coordination and
operations that detail the timing and composition of where inventory will be
positioned.
Manufacturing requirements
Manufacturing plans are derived from logistical requirements and typically
result in inventory deployment.

Procurements requirements
7

Procurements requirements schedule material and components for inbound

shipment to support manufacturing requirements. In retailing and wholesaling
situations, procurements involve manufacturing requirements.

Forecasting

Forecasting utilizes historical data, current activity levels, and planning

assumptions to predict future activity levels. Logistical forecasting is generally
concerned with relatively short term predictions.
The overall purpose of information planning/coordination flow is to integrate
specific activities within a firm and to facilitate overall integrated performance.
2. Operational flows
The second aspect of information requirements is concerned with directing
operations to receive, process, and ship inventory as required supporting
customer and purchasing orders. Operational requirements deal with

Order management
Order processing
Distribution operations
Inventory management
Transportation and shipping
Procurement

Differences between Supply chain management and Logistics management.

1. Supply chain management is a broader concept whereas Logistics management
is a narrower concept.
2. The concept of Supply chain management is relatively new whereas the concept
of Logistics management is relatively old.
3. Supply chain management is an extension of Logistics management.
4. Logistics management is primarily concerned with optimizing flows within the
organization whilst supply chain management recognizes that internal
integration by itself is not sufficient.
5. Logistics is essentially a planning orientation and framework that seeks to create
a single plan for the flow of product and information through a business. Supply
chain management builds upon this framework and seeks to achieve linkage and
co-ordination between processes of the other entities in the pipeline, i.e.
suppliers and customers, and the organization itself.
6. The focus of Supply chain management is upon the management of relationships
in order to achieve a more profitable outcome for all parties in the chain where
as the focus of Logistics management is upon the management of resources
within the organization.

Traditional Perspective
Traditionally most organizations have viewed themselves as entities that exist
independently from others and indeed need to compete with them in order to survive.
However such a philosophy can be self-defeating idf it leads to unwillingness to
corporate in order to compete. Behind this seemingly paradoxical concept is the idea of
supply chain integration.
Definition
Supply chain management is the management of upstream and downstream
relationships with suppliers and customers to deliver superior customer value at less
cost to the supply chain as a whole.
Explanation
The supply chain is the network of organizations that are involved through upstream
and downstream linkages, in the different processes and activities that produce value in
the form of products and services in the hands of ultimate consumer. Thus for example a
shirt manufacturer is a part of a supply chain that extends upstream through the weavers
of fabrics to the manufacturers of fibres, and downstream through distributors and
retailers to the final consumer. Each of these organizations in the chain are dependent
upon each other by definition and yet and yet paradoxically by tradition do not coorporate with each other.
Clearly this trend has many implications for logistics management, not the least being
the challenge of integrating and coordinating the flow of materials from a multitude of
suppliers, often offshore, and similarly managing the distribution of the finished product
by way of multiple intermediaries.
Origin
In the past it was often the case that relationships with suppliers and downstream
customers (such as distributors or retailers) were adversarial rather than co-operative. It
is still the case today that some companies will seek to achieve cost reductions or profit
improvements at the expense of their supply chain partners. Companies such as these do
not realize that simply transferring costs upstream or downstream does not make them
any more competitive. The reason for this is that ultimately all costs their way to the
final marketplace to be reflected in the price paid by the end user. The leading- edge
companies recognize the fallacy of this convectional approach and instead seek to make
the supply chain as a whole more competitive through the value it adds and the costs
that it reduces overall. They have not realized that the real competition is not company
against but rather supply chain against supply chain.
Figure 1 suggests that there is in effect an evolution of integration from the stage 1
position of complete isolation from the other business functions. An example would be
where production or purchasing does their own thing in complete isolation from the
other business functions. An example would be where production seeks to optimize its
unit costs of manufacture by long production runs without regard for the build-up of the
9

finished goods inventory and heedless of the impact it will have on the need for
warehousing space and the impact on working capital.
Stage 2 companies have recognized the need for at least a limited degree of integration
between adjacent functions, e.g. distribution and inventory management or purchasing
and materials control. The natural next step to stage 3 requires the establishment and
implementation of an and-to-end planning framework that will be fully described later
in this book.
Stage 4 represents true supply chain integration in that the concept of linkage and coordination that is achieved in stage 3 is now extended upstream to suppliers and
downstream to customers.

Relationship building
It is apparent that supply chain management involves a significant change from the
traditional arm-length, even adversarial, relationships that so often typified
buyer/supplier relationships in the past. The focus of supply chain management is on
co-operation and trust and the recognition that properly managed the whole can be
greater than sum of its parts.
Thus the focus of supply chain management is upon the management of relationships in
order to achieve a more profitable outcome for all parties in the chain. This brings with
it some significant challenges since there may be occasions when the narrow selfinterest of one of the parties has to be subsumed for the benefit of the chain as a whole.
Whilst the phrase supply chain management is now widely used, it could be argued
that it should really be termed demand chain management to reflect the fact that the
chain should be driven by the market, not by suppliers. Equally the word chain should
be replaced by net work since there will normally be multiple suppliers and, indeed,
suppliers to supplier as well as multiple customers and customers customers to be
included in the total system.
Figure 2 illustrates this idea of the firm being at the centre of a network of suppliers and
customers.
Extending this idea it has been suggested that a supply chain could more accurately be
defined as:
A network of connected and interdependent organizations mutually and co-operatively
working together to control, manage and improve the flow of materials and information
from suppliers to end users.
Integrated log cycle
Network design

10

Customer service
SCM
- Dist channels
Supply Network Management Or Demand Network Management
The Phrase Supply Chain Management is widely used. It is a management of
upstream and downstream of relationships with suppliers and customers to deliver
superior customer value at less cost to the supply chain as a whole.
So supply chain management focuses on the management of relationships in order to
achieve a more profitable outcome for all parties in the chain. It is argued that it should
really be Demand Chain Management as a chain should be driven by the market, and
not by suppliers. So also the word chain should be replaced by network. Since there
will normally be multiple suppliers and, indeed, suppliers to suppliers as well as
multiple customers and customers customers to be included in the total system.
S = Supplier;
C = Customer;

SS = Suppliers Supplier;
CC = Customers Customer
TRANSPORTATION

Transport Functionality
Transportation is one of the most visible elements of logistics operations. Transportation
provides 2 major functions: product movement & product storage.
Product Movement
Whether the product is in the form of materials, components, assemblies, work-inprocess, or finished goods, transportation is necessary to move it to the next stage of the
manufacturing process or physically closer to the ultimate consumer. A primary
transportation function of product movement is moving up and down the value chain.
Since transportation utilizes temporal, financial, and environmental resources, it is
important that items be moved only when it truly enhances the product value.
Transportation involves the use of temporal resources because product is inaccessible
during the transportation process. Such product, commonly referred to as in-transit
inventory, is becoming a significant consideration as a variety of supply chain strategies
such as just in time and quick response practices reduce manufacturing and
distribution center inventories.
Transportation uses financial resources because internal expenditures are necessary for
private fleets or external expenditures are required for commercial or public
transportation.
Transportation uses environment resources both directly and indirectly.
In direct terms, it is one of the largest consumers of energy (fuel and oil) in the domestic
United States economy. In fact, it accounts for close to 67% of all domestic oil use.

11

Indirectly, transportation creates environmental expense through congestion, air

pollution and noise pollution.
The major objective is to move product from an origin location to a prescribed
destination while minimizing temporal, financial and environmental resource costs.
Loss and damage expenses must also be minimized. At the same time the movement
must take place in such a manner that meets customer demands regarding delivery
performance and shipment information availability.
Product Storage:
A less common transportation function is temporary storage. Vehicles make rather
expensive storage facilities. However, if the in-transit product requires storage but will
be moved again shortly (e.g. in a few days), the cost of unloading and reloading the
product in a warehouse may exceed the per-daily charge of storage in the transportation
vehicle.
In circumstances where warehouse space is limited, utilizing transportation vehicles
may be a viable option.
One method involves loading on the vehicle and then having it take an indirect route to
its destination. This is desirable when the origin or destination warehouse has limited
storage capacity.
A second method to achieve temporary product storage is diversion. This occurs when
an original shipment destination is changed while the delivery is in transit.
E.g. suppose a product is initially scheduled to be shipped from Chicago to Los
Angeles. However, if during the delivery process, it is determined that San Francisco is
in greater need of the product or has available storage capacity; the product could be
delivered to the alternative destination of San Francisco.
In short, although product storage in transportation vehicles can be costly, it may be
justified from a total cost or performance perspective when loading or unloading costs,
capacity constraints, or the ability to extend lead times are considered.
Principles
There are two fundamental principles guiding transportation management and
operations. They are economy of scale and economy of distance.
Economy of scale refers to the characteristic that transportation cost per unit of weight
decreases when the size of the shipment increases.
E.g. truckload shipments cost less per pound than less-than-truckload shipments. It is
also generally true that larger capacity transportation vehicles such as rail or water are
less expensive per unit of weight than smaller capacity vehicles like motor or air.
Transportation economies of scale exist because fixed expenses associated with moving
a load can be spread over the loads weight. The fixed expenses include administrative
costs of taking the order; time to position the vehicle for loading or unloading, invoicing
and equipment cost. These costs are fixed because they do not vary with shipment
volume.
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E.g. suppose the cost to administer a shipment is $ 10.00. Then the 1-pound shipment
has a per unit of weight cost of $10.00, while the 1,000 pound shipment has a per unit
of weight cost of $0.01. Thus, it can be said that an economy of scale exists for the
1000-pound shipment.
Economy of distance refers to the characteristic that transportation cost per unit of
distance decreases as distance increases.
e.g. a shipment of 800 miles will cost less than two shipments (of the same combined
weight) of 400 miles. Transportation economy of distance is also referred to a se
tapering principle since rates or charges taper with distance. The rationale of distance
economies is similar to that for economies of scale.
Longer distances allow the fixed expenses to be spread over more miles, resulting in
lower overall per mile charge.
These principles are important considerations when evaluating alternative transportation
strategies or operating practices. The objective is to maximize the size of the load and
the distance that is shipped while still meeting customer service expectations.
Transport Infrastructure
Transportation infrastructure consists of the rights-of-ways, vehicles, and carrier
organizations that offer transportation services on a for-hire or internal basis. The nature
of the infrastructure also determines a variety of legal and economic characteristics for
each mode or multimodal system. A mode identifies the basic transportation method or
form.
Modal Characteristics

RAIL NETWORK
Since olden times, railroads have handled the largest number of ton-miles. As a result of
the early establishment of a comprehensive rail network connecting almost all the cities
and towns, railways dominated the intercity freight tonnage till World War II and in
some cases of Europe, Asia and Africa they even connected the countries. This early
superiority enabled railways to transport large shipments very economically.
Railroads have come a long way, as we can see by just the US figures that 54.0% of
intercity transport in 1947 was by Railways, 39.2% in 1958, 36.4 % in 1980 and almost
37% in 1992. The period from 1950-1970 saw a tremendous decline in use of railways.
The capability to efficiently transport large tonnage over long distances is the main
reason railroads continue to handle significant intercity tonnage and revenue. Railroad
operations incur high fixed costs because of expensive equipment, right-of-way
(railroads must maintain their own track), switching yards, and terminals. However, rail
experiences relatively low operating costs. The replacement of steam by diesel power
reduced the railroads variable cost per ton-mile, and electrification offers potential for
more reductions. New labor agreements have reduced workforce requirements, further
decreasing variable costs
13

These days rail transport only focuses on transporting specific products, which are best,
suited to the requirement. Greatest railroad tonnage comes from raw material extractive
industries located at considerable distances. Despite problems, Rail fixed-variable costs
are still superior for long distances. Railroads basically concentrate on the container
traffic and are becoming more responsive of the customer needs, emphasizing bulk
industries and heavy manufacturing.
They have expanded their intermodal operations through alliances and motor carrier
ownership. Railroads are even concentrating on development of special equipment.
There are unit trains which are entire train carrying the same commodity, which are
bulk products such as coal or grain. Unit trains are faster, less expensive to operate and
quick as it can bypass rail yards and go direct to the products destination.
There are also various different types, such as articulated cars for extended Rail chassis,
double-stack railcars, have 2 levels of containers, thereby doubling the capacity of each
car. It also reduces chances of damage because of their design. These technologies have
are being applied by railroads to reduce weight, increase carrying capacity, and facilitate
interchange.
After a major decline till 1970, Railroads have emerged as a major mode of transport
once again since the early 80s because of revitalization of rail network. Evidence
suggests that Rail network will be used extensively once again in the 1990s and early
21st century.
MOTOR CARRIERS
Highway transportation has increased rapidly since the end of World War II. This is
because Motor carrier industry results from door-to-door operating flexibility and speed
of intercity movement. They are even flexible because they can operate on each and
every kind of roadways.
In comparison to railroads, motor carriers have relatively small fixed investments in
terminal facilities and operate on publicly maintained highways. Although the cost of
license fees, user fees, and tolls are considerable, these expenses are directly related to
the number of over-the-road units and miles operated.
The variable cost per mile for motor carriers is high because a separate power unit and
driver are required for each trailer or combination of tandem trailers. Labor
requirements are also high because of driver safety restrictions and the need for
substantial dock labor. Motor carriers are best suited to handle small shipments moving
short distances.
The characteristics of motor carriers favor manufacturing and distributive trades, short
distances, and high-value products. Motor carriers have made significant inroads into
rail traffic for medium and light manufacturing. This is also because of delivery
flexibility, tat they have captured a major chunk of the market. In short, the prospect for
maintaining a stable market share in highway transport remains bright.
This industry even has a few problems, and one of the primary difficulties relate to
increasing cost to replace equipment, maintenance, driver wages, and platform and dock
14

wages. Although accelerating, labor rates influence all modes of transport; motor
carriers are more labor-intensive, which causes higher wages to be a major concern.
One more threat for hire-motor carrier industry is over-the-road transportation by
shipper-owned trucks or by specialized carriers under contract to perform transport
services for shippers.
Since 1980, the industry segments have become more definitive since deregulation, and
include truckload (TL), less than truckload (LTL), and specialty carriers. TL segment
includes loads over 15,000 pounds that generally do not require intermediate stops for
consolidation. LTL segment of the industry loads less than 15,000 pounds that generally
requires stops at intermediate terminals for consolidation. Because of terminal costs and
relatively higher marketing expenses, LTL experiences a higher percentage of fixed
costs then TL.
These characteristics have caused extensive industry consolidation, since deregulation
has resulted in small number of relatively large carriers worldwide.
Specialty carriers include package haulers such as Federal Express and United Parcel
Service. These firms focus on specific requirements of the market or product. It is quite
apparent that highway transportation will continue to function as the backbone of
logistical operations for the foreseeable future.
WATER TRANSPORT
It is the oldest mode of transportation. First it was the sailing vessels, which was
replaced by steamboats in early 1800s and by diesel power in the 1920s.
Domestic water transportation involves the Great Lakes, canals, and navigable rivers.
In every country, fewer system miles exist for inland water than any other transportation
mode.
The main advantage of water transportation is the capacity to move extremely large
shipments. Water transport employs 2 types of vessels. Deep-water vessels, which are
generally designed for Ocean and Great Lakes use, & are restricted to deep-water ports
for access. In contrast, diesel-towed barges, which generally operate on rivers and
canals, have considerably more flexibility.
Water transport ranks between rail and motor carrier in the fixed cost aspect. Although
water carriers must develop and operate their own terminals, the right-of-way is
developed and maintained by the government and results in moderate fixed costs as
compared to railways and highways.
The main disadvantage of water transport is the limited range of operation and speed.
Unless the origin and destination are adjacent, supplement haul by rail or truck is
required. The capability to carry very high cargo at an extremely low variable cost
places this mode of transport in demand when low freight rates are desired and speed of
transit is a secondary consideration.
But, water transport on the other hand isnt all that flexible. Labour restrictions on
loading and unloading at docks create operational problems and tend to reduce the

15

potential range of available traffic. Also, a highly competitive situation has developed
between railroads and inland water carriers in areas where parallel routes exist.
Great lakes are concentrating towards transportation of bulk products while Deep-water
vessels transport a significant high volume of non-bulk items. Containerized cargo
facilitates vessel loading and unloading and enhances intermodal capability by
increasing the efficiency of cargo transfer between highway, rail and water.
Inland and great lakes will continue to be a viable option in future logistical systems
while the slow passage of inland river transport can provide a form of warehousing in
transit integrated into overall system design.
PIPELINES
Surprisingly, Pipelines are also one of the major form of transportation medium
throughout the world. In 1989, in USA over 53% of all crude and petroleum ton-mile
movements were through Pipelines.
In addition to Petroleum, other important product transported by pipeline is the natural
gas. Pipelines are owned and operated privately in most of the countries and many gas
companies act as both gas distributors and contract transportation providers. Pipelines
are also utilized for transport of manufacturing chemicals, pulverized dry bulk materials
such as cement, flour via hydraulic suspension, and sewage and water within cities and
municipalities.
Pipelines are very unique in nature compared to other types of transport, such as; they
operate on 24-hour basis, seven days a week, and are limited by commodity changeover
and maintenance. Unlike other modes, there is no empty Container or vehicle that
must be returned.
Pipelines have highest fixed cost and lowest variable cost among transport modes. High
fixed costs result from right-of-way, construction and requirements for control stations,
and pumping capacity. Since pipelines are not labour-intensive, the variable operating
cost is extremely low once the pipeline has been constructed. An obvious disadvantage
of these pipelines is that they are not flexible and are limited with respect to
commodities that can be transported.
Experiments regarding transport of solid products are still going on. Coal slurry
pipelines are proving to be economical over long distances but it concerns
environmentalists, as it requires massive quantities of water.
AIR TRANSPORT
Air transport is the newest and the least utilized mode of transport. Its major advantage
being its speed, which is accompanied by high costs. A coast-to-coast shipment via air
requires only a few hours contrast to days taken by other mean of transportation. The
high cost of transport can be traded off for high speed, which allows other elements of
logistical design, such as warehousing, inventory to be reduced or eliminated. But still
air transport remains more of a potential opportunity than a reality because it is very
much under utilized.

16

The high cost of jet aircraft, coupled with erratic nature of freight demand, has limited
the assignment of dedicated planes to all-freight operations. However premium carriers
provide planes dedicated for freight operations. This premium service started off with
documents and has moved onto large parcels, which is an ideal service for firms with a
large number of high-value products and time-sensitive service requirements.
The fixed cost of air transport is low as compared to rails, water and pipeline. In fact,
air transport ranks second only to highway with respect to low fixed cost. Airways and
airports are maintained by public funds and terminals are by local communities. The
fixed costs of airfreight are associated with aircraft purchase and the requirement for
specialized handling systems and cargo containers. But the air freight variable cost is
extremely high as a result of fuel, maintenance, and labour intensity of both in-flight
and ground crews.
Since they require wide-open space, airports are generally not integrated with other
means of transport. However more all freight airports are being developed so as to
reduce conflict with passenger operations.
No particular commodity dominates the traffic carried by airfreight operations. These
operations are carried more on emergency basis than routine basis. Firms usually utilize
scheduled or non-scheduled air cargo movements when the situation justifies high cost.
Products with greatest potential for regular air movements are those having high value
or extremely perishable. When the marketing period for an item is extremely limited, air
transport comes into the picture, as it may be the only practical method for logistical
operations.
Transportation Hidden Costs
The physical distribution component of a major project, including transportation of raw
materials, project materials, machinery and equipment and such infrastructure facilities
as roads, vehicles etc., usually accounts for 20 to 30% of the total capital cost.
The general scarcity of various goods, unpredictable nature of the economy and
economic behavior on the part of the business community and the bureaucracy in India
make it all the more necessary for one to plan well ahead. In fact, planning of
transportation and infrastructure must be done well ahead of general planning, so that
resources spent on other parts of the project do not result in in - fructuous expenditure.
In developed countries, these facilities are already available in abundance or are
provided for well in advance. In developing countries, action is generally initiated only
after the project has been partially put through or when it becomes totally inescapable to
do so.
On the other hand, because of lack of these facilities, such problems are faced even
during construction.
Eg. Trucks get stuck in muddy roads, work sites remain unapproachable, and serious
vehicular accidents are caused near the project areas.
In developing countries, for the supervision of construction of a building, usually no
qualified individual is appointed for the co ordination and planning of transportation
infrastructure, which forms a major fraction of the total cost of a project running into
crores.
17

For a major project, the average total cost to the economy of a project costing Rs. 100
crores which is delayed by one year from the date of targeted completion is 39% more
than the original budgeted cost on account of the following:
1. The rate of interest on capital may be taken at nearly 12%.
2. The profit on income per year about 12%
3. The cost of depreciation on account of obsolescence or rusting without running of
the plant at 5%.
4. The cost of escalation of the project cost at 10%.
The cost of delay in the completion of the project would therefore be roughly about
Rs.11 lakhs per day or Rs. 3.25 crores per month. It would be worthwhile to educate
senior executives to recognize these facts, for this aspect of the project is usually
ignored by project authorities.
Project authorities do not hold themselves responsible for the transportation bottlenecks
and resulting delays. These delays are due to non-receipt of equipment, machinery, raw
materials etc. and these delays generally run into months. Due to such delays, the
project suffers heavy losses, which occur because of congestion in the ports, traffic
jams, railway restrictions etc. Therefore, it is financially more practical to obtain critical
equipment, machinery and raw materials, critical not from the point of view of
availability in the market but critical form the standpoint of transportation bottlenecksso that the likely delays are avoided.
A proper transportation planning of materials, therefore, may well save a project as well
as the economy form the ill effects of wasteful expenditure. At the same time it would
help speed up production.
Transportation Cost Elements
Following are the essential elements of transportation to be taken into account:
1. Transport Mode The most critical decision is the selection of appropriate mode
of transport. This fixes two basic elements of distribution function:
a) Transit time or time lapse between production and sale;
b) Level of transportation costs.
There is an inverse relationship between transit time and transport cost the lower the
transit time, the higher the transport cost. However, a decision that takes into account
only one cost factor cannot be justified. An evaluation of the effect of transit time on
other costs must also be considered. Unsold production represents a high cost, and the
longer the transit time, the higher the level of unsold production.
2. Inventory Costs A first class service to clients often requires immediate delivery
and, hence a higher level of inventory at the market centre. Economy, on the other hand,
calls for minimum inventory. The level of output held in stock is dictated bya) Transit time: If the time lapse between production and sale is longer, the level of
inventory becomes higher.
b) Sales pattern: If the pattern of sales is erratic, higher inventory levels are caused.

18

c) Production pattern: If the production pattern is erratic, higher inventory levels have
to be maintained to prevent stock outs.
Assuming that the sales and production patterns are largely fixed, the important
variable, which can influence stock, levels in transit time. As transit time is reduced, the
level of static stock can be reduced with accompanying stock reduction.
3. Transit Capital Capital can be released by changing the proportion of the total
output in transit. This can be done by adjusting the transit time. As transit time is
reduced, the quantity of goods in transit can be decreased with an associated reduction
in transit inventory costs. By realizing the capital cost of transit inventory and goods in
transit, capital commitments can be reduced, and more capital can be available for other
purposes.
4. Obsolescence - When a slow or erratic mode of transport is employed, a higher
level of inventory is necessary to ensure continuous, prompt delivery to the customer.
However, when designs change rapidly, obsolescence reduces the market value of the
products in store. Rapid advances in technology bring about swifter technical
obsolescence. Any goods in the pipeline realize a lower figure when new models are
introduced by a company or its competitors. Air distribution can overcome this
problem, and the effect of such obsolescence can be minimized.
5. Packaging The nature of packaging of a product is often determined by the mode
of its transport. E.g. Because of the dry conditions of carriage, short transit times and
minimum handling, air cargo generally requires much less packaging than other forms
of long distance transport. Goods dispatched by air may require only a dust cover or
even no cover at all. In some cases, savings on the packaging of sophisticated products
may more than pay for the actual transport charges. Less packaging may lead to other
advantages too. These include lower unpacking costs and lower chargeable weight for
freight.
6. Insurance Insurance risks are based on transit time as well as the possibility of
damages en route. With faster transit times, skillful handling, substantial reduction in
damage and greater security in transit, insurance premiums tend to fall substantially.
7. Breakages Cost of breakages is an important factor in any cost benefit analysis.
Because breakages may be indemnified by insurance companies, the true cost of
damage to cargos can easily be overlooked. In the first place, the vulnerability of
various products sent by different modes is reflected in the insurance premium. To
high premiums must be added the clerical work involved in establishing claims,
making replacements and the loss of customers goodwill. The replacements
themselves will be subject to the same hazards and premiums will require further
documentation.
Therefore, only that mode of transport must be selected which substantially reduces
real damage in transit. This calls for a selection of the routes which are more direct
and which avoid transshipment. Handling equipment must also be more
sophisticated. Containers can be used by shippers for door-to-door transportation,
thereby avoiding all handling of goods by the carrier.
8. Pilferage Many expensive administrative problems associated with breakages also
apply to pilferage. This problem is reduced for example, when door-to-door
containers are used, a fact which is again reflected in lower insurance rates.
19

9. Deterioration In many surface cargos, deterioration may be avoided only by

complicated and expensive packing to counteract mechanical shock, exposure to
weather or unfavorable temperature etc. Some cannot be stored at all, except at great
expense, and others deteriorate slowly.
Deterioration can be costly in terms of packing, stock losses and expensive
conditioning in store. It can only shut the door on many distant markets. A high
speed of transport and the frequency of services can overcome many of these
problems.
10. Transport Costs Transport can be divided into 3 phases:
(i) Delivery to docks, airport or railway station.
(ii) Transport from one terminal to another.
(iii) Delivery from the terminal to the consignees place.
In the cost-benefit analysis of the turnaround time of a companys delivery and
collection vehicles, their man hour costs can be significant. Some customers
may find this item to be more costly than the cost of the major journey.
Transport Elements:
Whether the movement of material and equipment is by rail, sea, air or road, adequate
facilities for their free flow to and from the factory must be ensured. The factors which
affect progress at the construction stage, and production and dispatches after
commission, have been discussed in the following paragraphs:
1) Terminal Facilities:
Terminal facilities are usually grudgingly provided. One reason for this is that any delay
or any in convenience caused to truck operators is not a loss to the project. It is treated
as a loss to the carrier. In some cases, this may be true. However, this usual incidence of
stoppage or regulation of the production process can be minimized, if not eliminated.
Often extreme stinginess is expressed in planning for these facilities, which include
storage space, and loading and unloading arrangements in a suitable area. If the storage
space is not adequate or if the traffic is exceptionally heavy, production suffers
inevitably. Since transport requirements of each project are different and depend on its
location, physical availability of infrastructure, etc, it is not advisable to prescribe one
uniform scale of terminal facilities. They must be worked out for an individual project
on the basis of its own specific requirements.
Storage, loading and unloading facilities, good quality roads, which are usable
throughout the whole year, and suitably, designed yard for railway wagons have to be
planned as a part of terminal facilities. It is also essential to pay special attention to the
maintenance of loading and unloading equipment, the design, location, length, height
and other features of loading and unloading platforms, etc., and the maintenance of
circulating area and roads where heavy vehicles ply.
The overall savings in transport rates would more than justify the expenditure incurred
on the provision of additional facilities. This ahs not been recognized by the planners of
individual projects.
20

For rail movement, not only sufficient number of loading lines, but also sufficient
number of marshalling, examination and holding lines must be planned for. These lines
must be suitably connected with one another to ensure smooth shunting operations. The
configuration of lines (yard designs) is more important than the number of lines in the
yard, for the requirements of prime mover (shunting engines) can also be cut down by a
suitable design of yard.
2) Vehicles:
An important feature of movement of finished products of major projects is the type of
vehicle used for movement. The vehicle dimensions, capacity. Type and its special
characteristics, if any, have to be examined with the reference to the quality and
quantity of goods to b moved. In case of sea transport---- the size, speed and the type of
ship, in case of road movement---- capacity, moving dimensions and speed of the trucks
and in case of rail movement---- the capacity, type and general availability of wagons
must be closely examined.
Planned movement on any section must be taken into account utilisation of the existing
sectional capacity, the expected general growth in traffic on the section, and the possible
future identifiable streams of new traffic. If movement on a saturated section is
inevitable, line capacity of the section must be increased.
3) Prime Movers:
The motive power utilized for the internal handling of vehicles and transportation to
destinations is another important component of the total movement system. In the case
of rail movement, locomotives required for the shunting and marshalling of wagons
within the plant must be of such weight, horsepower and performance characteristics as
will match the specific tasks of shunting and reception and dispatch of wagons. In case
of road movement, suitable design and layout of conveyors and mechanical loaders can
reduce the drudgery of manual labour and make pre-despatch and post-receipt handling
operations more efficient.
4) Routes And Sectional Capacity:
Another important aspect of transport planning is the routes for streams of traffic, viz.,
roadways, railways, waterways and airways. The routes or pathways must have
adequate capacities. Generally speaking, because of lack of understanding of the
transportation subject, executives take it for granted that capacity of routes is unlimited.
A very important but invisible component of movement activity is sectional capacity,
which is dependant on permissible sectional speed and other characteristics of a section.
In turn, sectional speed depends on the geometrics of the road (track, sea route, road
surface, carriage way, gradients and curves, etc.).
Over a section of railways or roadways between two stations A and B, only a limited
number of wagons, trucks or vehicles can be pushed through, depending on the
availability of terminal facilities to handle these vehicles, the facilities to enable
vehicles to move on the section, and availability of sufficient number of vehicles.
Unless sufficient capacity is developed on each of the different routes to move the
21

vehicles, the additional number of vehicles provided would not necessarily lead to
higher levels of transport availability. On the contrary, movement may become more
sluggish.
5) Transit Time:
The relative locations of a plant and the customers or suppliers determine largely the
transit time for raw materials, spare parts and finished products. Transit time generally
never receives adequate attention in the panning of major projects. There is a general
impression that, if need be, transit time can be drastically cut at any time by air-lifting a
consignment. Apart from the fact that the neglect of transportation planning leads to an
overall higher cost of transportation, in practice, reduction in transit time actually
achieved may not justify the heavy cost of air transport. Rough estimates of transit time
from unreliable sources are generally utilized for planning movements of goods.
Although more detailed information sources may be readily available. It is essential
therefore, that executives understand clearly the difference between:
(a)
(b)
(c)
(d)
(e)
(f)

Normal transit time under normal conditions;

Normal transit time under abnormal conditions;
Optimal transit time;
Most optimistic transit time
Most pessimistic transit time; and
Desirable transit time.
Because the importance of transit time is not adequately recognized, it is not
realistically provided for. Major projects suffer from the heavy delays even before the
commencement of construction because of the non-availability of construction
equipment and machinery in time. The existing bottlenecks in the fields of
transportation are almost always ignored. Construction schedules, inventories,
warehousing facilities, order processing or production schedules, etc., are generally
planned without the recognition of the inevitable delays that flow from these
bottlenecks.
6) Weigh Bridge:
Another usually neglected aspect of industrial transportation activity is the factory
weigh bridge. Weigh bridges ion factories are generally inaccurate, if not actually out of
order. It is seldom appreciated that the losses continuously occurring on this single
piece of factory equipment and general inefficiency, which results from its ineffective
and inefficient management, can be easily avoided by proper advance planning.
Executives ignore the usual traffic jams at factory gates slow down receipts and
dispatches, which, in turn, indirectly affect output. The relative advantages of various
types of weigh bridges must be properly appreciated by executives, and a weigh bridge
which will handle the anticipated volume of traffic expeditiously must be selected.
7) Distribution pattern
The pattern of movement of the finished produced by road or rail must be planned
properly. For example, when the requirements of the number of rail wagons are to be
worked out, it is not sufficient to take the average lead or distance for the whole country
for calculating fleet requirements. it is also not sufficient to use the figure of the existing
average lead of general goods ,or even that pertaining to a specific commodity.
22

However, when it comes to actually transport, because of imprecise pre-planning, the

manufacturer wants the commodity carrier to transport goods to anywhere and
everywhere n the country. This presents a problem. The manufacturer provides
information to the common carrier about the quantity o goods to b \e marketed. But
detailed information must be supplied to the carrier so that the carrier can plan the
movement in entirety.
8) Nature of product
Another aspect, which is often disregarded by project managements as well as common
carrier, is the variability arising out of the specialized nature of products to be moved.
The generally low level of sophistication in transport planning in the country had made
it difficult for the planners to appreciate the fact that transport capacity is influenced by
the nature of goods, their packing and other specialized requirements, such as special
handling equipment.etc.
Freight Rate Structure
Freight rates of any mode of transport are based on the following principles:
1. Freight should the actual cost of transport operation. The actual cost of operation
depends on the following factors:
a) Fixed costs - Freight should cover interest on capital, depreciation, registration and
insurance expenses of a vehicle, if applicable, general upkeep of the vehicle,
administration overheads, and expenditure on other fixed facilities, etc.
b) Semi-fixed costs - Freight should cover the salary of the driver, cleaner, conductor
and miscellaneous maintenance expenses, which vary partially with the running of
the vehicle.
c) Vehicle Utilization - A transporter is interested in getting maximum mileage out of
his vehicle by moving it at top speed to cover the distance in as short a time as
possible.
i. If the consignments loaded or the route covered is not conducive, the transporter
would quote a higher freight rates.
ii. Higher freight rates are also quoted when vehicles are detained at terminals either
for certain formalities, terminal congestion in busy ports or at factory gates, or
while waiting for loading or unloading operations. Terminal detentions are
invariably accounted for in the freight rates themselves, but they are normally not
noticed at all.
iii. Freight rates are quoted higher if there an expectation of obtaining a return trip
with a load or if considerable empty movement of vehicles is involved after
unloading.
iv. Vehicle Utilization is affected by the nature of goods. Hazardous goods that are
likely to cause damage to the other consignments or the vehicle itself attract higher
freight rates.
v. Consignments, which can be loaded less by weight in a vehicle, attract higher unit
freight rate since they yield poor utilization of the vehicle.
23

2. Traffic Bearing Capacity:

An age-old consideration for the freight rates is the doctrine of what traffic can bear.
Transportation adds place utility to goods, for it makes them marketable at another
place. However, after the addition of the cost of transport, the price of goods should be
still attractive to the buyer.
3. Public Use:
Freight rates all over the world are governed on human grounds that items of public use
should be made available to the common man at the cheapest rate. For example,
foodgrains and salt are carried at rock-bottom prices, sometimes even at those, which do
not cover the actual cost of operation.
4. Government Policies:
Freight rates are often framed on the basis of government objectives, which aim at
serving certain points such as promotion of certain type of trade, development of
certain industries, etc. In such cases, freight rates are either depressed to promote the
particular traffic or hiked to discourage particular traffic.
5. Reasonable Profit:
The transporter must provide for a reasonable profit after covering the cost of
operations and capital investment. This margin must give not only return of investment
but also compensate him for the entrepreneurial time and effort he puts in, but also
provide sufficient funds for future development of his enterprise.
Intermodal
Chart
ROAD TRANSPORT
Road transport forms an essential part of any transport activity, whether rail, sea or air.
It is essential as a supplementary and complementary mode of transport to complete
movement by other modes of transport. Eg. From one terminal i.e. the railway station
the goods have to be carried to the destination like an area by road.
Road transport offers certain advantages like
i. Door to door service to customers which neither rail nor neither sea nor air
transport can offer.
ii. On per unit basis, the cost of making a road is 1/6th that of laying a railway line.
iii. Capital investment in case of railways is much less then railways designed to carry
equivalent quantum of traffic.
iv. Road transport provides employment to six million persons (two million direct and
four million indirect)
There are negative points also to be viewed like:

24

i. As much as 6200 crores are collected in dues but only 10% of this revenue is used
for development of roads, which a disadvantage as road transport is till not well
organized.
ii. Road transport industry is not come of age in India, as there are very few
companies, which own the entire fleet of trucks. Single vehicle owners operate
most of the road transport.
There is a system of associates, who pool in their vehicles and other resources and share
the benefits of vehicle contribution. The associates operate from different cities. An
associate in one city, say, Mumbai, watches the interest of his counterpart in Delhi.
Together they operate as a team. They minimize expenses on the maintenance of a
branch office at the out-station and yet give the identity of a single branch operator.
Problems in Road Transport:
Road transport faces a number of problems. This is evident from the following facts:
1) There is an occasional storage of diesel fuel in the country.
2) Vehicle availability in the country has been problematic. With the recent entry of a
number of manufacturers, the situation has improved to some extent.
3) The cost of components and accessories, such as tyres and batteries, has escalated
tremendously.
4) The Octroi and police check posts are to many, resulting in heavy detention to road
vehicles.
5) The present Motor Vehicle Act regulating the issue of licenses and permits and
movement of vehicles is very restrictive. It was decades ago to control and regulate
traffic. The current requirements of traffic are for development. There are persistent
demands from various transport associations for suitable amendments of the Motor
Vehicle act. But they do not seem to receive due attention.
6) Conditions on Indian road are very bad and hazardous. They tend to reduce speed of
vehicles, which leads to wastage of natural transport capacity.
7) Roadside maintenance and service facilities have not developed though found
necessary.
8) The system of national, zonal and state permits restricts free growth of road
transport but the system has to be followed.
Transportation Network Design Options
Classical economists neglected the importance of facility, location and overall network
design Economists, when originally discussed supply demand relationships, facility,
location and transportation cost differentials were assumed to be non existent or equal
among competitors.

The number, size, geographical relationship of the facilities are used to perform
logistics operation directly affect customer service capabilities and cost.
Network design primary responsibility of logistics.
Typical logistics facilities are manufacturing plants, warehouses, gross dock
operations and retail stores.

Determining
(i) How many of each facility are required
(ii) Their geographic location
25

(iii) The work to be performed at each is a significant part of network design.

In specific situations facility operations may be outsourced to service specialists.
No matter who does the actual work, all facilities must be managed as an integral
part of a firms logistical network.
You have a network for internal customers, external customers as well as suppliers.
Suppliers should be made to understand what their commitment is and follow it. You
have to co-exist with your suppliers and share information with them.
Network design must take into account geographical location because a great deal
of variation exists between different geographical markets. If you set up your base in a
place where your demand is high then after a while the demand shifts and come from
another location, then again you are in a dilemma.
In a dynamic, competitive environment
Product assortment
Customer supplies
Manufacturing requirements
All of the above are constantly changing. However re-location of all logistics facilities
at one time is inconceivable. Relocation or redesign of specific facilities is possible.
Over a period of time, all facilities should be evaluated, to determine if their location is
desirable.
Selection of a superior location network can provide the first step.
Your network of facilities forms a structure from which logistical operations are
performed. Your network should incorporate transportation and information. Specific
work tasks related to network design are processing customer orders, management of
inventory, material handling.
LOGISTICS PLANNING PROCESS
To match the changing environment in the logistics due to the changes in the markets,
competitors, suppliers and technology, there is a need for a systematic planning and
design methodology to formally include the relevant consideration and effectively
evaluate the alternatives.
Methodology
The logistics relational and operating environment is constantly changing. Even for the
established industries, a firm's markets, demands, costs and service requirements change
rapidly in response to the customer and competitive behavior. Just as no ideal logistical
system is suitable for all enterprises the method for identifying and evaluating
alternative logistics strategies can vary extensively. However there is a general process
applicable to most logistics design and analysis situations. The process can be
segmented into three phases: problem definition and planning, data collection and
analysis, and recommendations and implementation. The following discussion describes
each phase and illustrates the types of issues encountered.

26

PHASE I: PROBLEM DEFNITION AND PLANNING

Phase 1 of logistics system design and planning provides the foundation for the entire
project. A thorough and well-documented problem definition and plan are essential to
all that follows.
1. Feasibility Assessment
The process of evaluating the need and desirability for change is referred to as
feasibility assessment and it includes the activities of situational analysis, supporting
logic development, and cost benefit estimation. The objective of doing so is to
understand the environment, process, and performance characteristics of the current
system and to determine future estimation.
a) Situational analysis: The purpose of the situational analysis id to provide senior
management with the best possible understanding of the strengths and weaknesses of
the existing logistics capabilities for both current and future environment. The
situational analysis is the performance of measures and characteristics that describe the
current logistics environment through:

Internal review: Internal review is necessary to develop a clear understanding

of existing logistics by covering the overall logistics process as well as each logistics
function with respect to its stated objectives and its capabilities to meet those
objectives. It profiles historical performance, data availability, strategies, operation
and tactical policies and practices. All major resources such as workforce, equipment,
facilities, relationships and information are examined. The comprehensive review
attempts to identify the opportunities that might motivate or justify logistics system
redesign or refinement. Assessment must consider the process (physical and
information flows through the value added chain), decisions (logic and criteria
currently used for value chain management), and key measures for each major
logistics activity. These measurements focus on the key performance indicators and
the firms ability to measure them.

Market assessment & competitive evaluation: the objective is to document

and formalize customer perceptions and desires with regard to the changes in the
firms logistical capabilities. Its the review of the trends and service demands
required by customers by the use of interviews with the selected customers or through
customer5 surveys. The assessment focuses on the external relationships with the
suppliers, customers (wholesalers and retailers) and consumers (final consumer). The
assessment not only considers trends in requirements and processes but also the
enterprise and the competitors capabilities.

Technology Assessment: it focuses on the application and capabilities of the

key logistics technologies, including transportation, storage, material handling,
packaging, and information processing. The assessment considers the firms
capabilities in terms of current technologies and the potential for applying new
technologies. The objective of the assessment is to identify advancements that can
provide effective trade offs with other logistics resources such as transportation and
inventory.
b) Supporting logic development: The second feasibility assessment task is
development of a supporting logic to integrate the findings of the internal review,
27

external assessment and technology study. Supporting logic development builds on

this comprehensive review in three ways
First - supporting logic development forces a critical review of the potential
opportunities for logistics improvements and a determination of whether additional
investigation is justified, using logistics principles such as tapering principle,
principle of inventory aggregation. The resulting benefits or costs should be clearly
identified.
Second - it critically evaluates current procedures and practices using
comprehensive, factual analysis and evaluation that isnt influenced by opinion and
thus help in identifying areas with improvement potential which in turn provides a
foundation to determine the need for strategic adjustment. The deliverables of this
evaluation process include classification of planning and evaluation issues prioritized
into primary and secondary categories across short and long range planning horizons.
Third - the process of developing supporting logic should include clear
statements of potential redesign alternatives such as
Definition of current procedures and systems
Identification of the most likely system design alternatives based on leading
industry and competitive practices
Suggestion of innovative approaches based on new theory and technologies
The alternatives along with being practical should also challenge the existing
practices. Flow diagrams and /or outline illustrating the basic concepts associated
with each alternative are constructed, which frame opportunities for flexible logistics
practices, clearly outline value added and information flow requirements and provide
a comprehensive overview of the options. A recommended procedure requires the
manager responsible for evaluating the logistical strategy to develop a logical
strategy to develop a logical statement and justification of potential benefits.
Using customer service concept and logistics integration logic and methodology,
the manager should commit to paper the most attractive strategy alternatives.
c) Cost benefit estimate: The final feasibility assessment is a preplanning estimate of
the potential benefits of performing a logistics analysis and implementing the
recommendation. Benefits should be categorized in terms of:
Service improvements - It includes results that enhance availability, quality or
capability. Improved sciences increase loyalty of existing customers and may also
attract business.
Cost reduction - Cost reduction benefits may be observed in two forms:
First, they may occur as a result of a one time reduction in financial or managerial
resources required to operate the existing system for e.g. Reduction in capital
deployed for inventory and other distribution related assets
Second, cost reductions may be found in the form of out - of - pocket or variable
expenses. For e.g. new technologies for material handling and information processing
often reduce variable cost by allowing more efficient procedures and operations.
Cost prevention - Cost prevention reduces involvement in programs and
operations experiencing cost increases. Any cost prevention justification is based on
28

an estimate of future conditions and therefore is vulnerable to some error for e.g.
many material handling and information technology upgrades are at least partially
justified through financial analysis of the implications of future labor availability and
wage levels.
In the final analysis, the decision to undertake in depth planning will depend on
how convincing the supporting logic is, how believable estimated benefits are, and
whether estimated benefits offer sufficient return on investment to justify
organizational and operational change. These potential benefits must be balances
against the out 0- of pocket cost required to complete the process.

2. Project Planning: Logistics system complexity requires that any effort to identify
and evaluate strategic or tactical alternatives must be planned thoroughly to provide a
sound basis for change. Project planning involves five specific items:
a) Statement of objectives: The statement of objectives documents the cost and service
expectations for the logistics systems revisions. Its essential that they be stated
specifically and in terms of measurable factors. The objective fine market or industry
segments, the time frame for revisions, and specific service levels. For e.g., desired
delivery of 98 percent of all orders within 48 hours after the order is placed, minimal
customer shipments from secondary distribution centers, back orders held for a
maximum of five days, etc. specific definitions of these objectives direct system design
efforts to ache9ice explicit performance levels. Total system cost can then be
determined.
b) Statement of constraints: The second project planning consideration concerns
design constraints. On the basis of the situational analysis, its expected that senior
management will place restrictions on the scope of permissible system modifications
depending on the specific circumstances of individual firms. But constraints can affect
the overall planning process for e.g. one restriction common to distribution system
design concerns the network of manufacturing facilities and their product mix
assortment which the management often holds constant for logistical system redesign as
there are large financial investments in existing production facilities. The purpose of
developing a statement of constraints is to have a well-defined starting point and overall
perspective for the planning effort. The statement of constraints defines specific
organizational elements, buildings, systems, procedures, and/or practices to be retained
from the existing logistical system.
c) Measurement standards: Such standards direct the project by identifying the cost
structures and performance penalties and by providing a means to asss success.
Management must stipulate guidelines for each category as a prerequisite to formulation
of a plan. It is important that the standards adequately reflect total system performance
rather than a limited, sub optimal focus on logistics functions. Once formulated, such
standards must be held constant throughout system development. An important
measurement requirement is to quantify a list of assumptions that underlie or provide
the logic supporting the standards. Measurement standards should include definitions of
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how cost components such as transportation are calculated and also relevant customer
service measures and method of calculation must also be included.
d) Analysis procedures: Analysis techniques range from simple manual methods to
elaborate computerized decision support tools. For e.g., models incorporating
optimization ort simulation algorithms for evaluating and comparing alternative
logistics warehouse networks. Once the project objectives and constraints are defined,
planning must identify alternative solution techniques and select the best approach.
Selection an analysis technique must consider the information necessary to evaluate the
project issues and options
e) Project work plan: On the basis of feasibility assessment, objectives, constraints and
analysis technique, a project work plan must be determined and the resources and time
required for completion identified. The alternatives and opportunities specified during
the feasibility assessment provide the basis for determining the scope of the study. In
turn the scope determines the completion time. One of the most common errors in
strategic planning is to undere4stimate the time required to complete a specific
assignment. Overruns require financial expenditures and reduce project credibility.
There are a number of PC based software packages available to structure projects,
guide resource allocation, and measure progress.
PHASE II: DATA COLLECTION AND ANALYSIS
Once the feasibility assessment and project plan are completed, phase 2 focuses on data
collection and analysis. This includes activities to (1) define assumptions and collect
data, and (2) analyze alternatives
1) ASSUMPTIONS AND DATA COLLECTION:
This activity builds on the feasibility assessment and project plan to develop detailed
planning assumptions and identify data collection requirements. Specific tasks are as
follows
a) Define analysis approach and techniques: The most common techniques are
analytical, simulation and optimization
The analytical approach uses standard numerical methods, such as those available
through spreadsheets, to evaluate each logistics alternative. For e.g., spreadsheet
availability have increases the use of analytical tools for distribution applications
A simulation approach can be likened to a wind tunnel for testing logistics
alternatives. Simulation is widely used, particularly when significant uncertainty is
involved. The testing environment can be physical (a model material handling system
that physically illustrates product flow in a scaled down environment) or numerical
(such as a computer model of a material handling environment that illustrates product
flow on a computer screen) current software makes simulation one of the most cost
effective approaches foe dynamically evaluating logistics alternatives
Optimization uses linear or mathematical programming to evaluate alternatives and
select the best one. Because of its powerful capabilities, optimization is used

30

extensively for evaluating logistics network alternatives such as the number and
location of the distribution centers.
b) Define and review assumptions: Assumptions definition and review build on the
situation analysis, project objectives, constraints and measurements standards. For
planning purposes, the assumption defines the key operating characteristics, variables
and economies of current and alternative systems. Assumptions generally fall into three
classes:
Business assumptions - They define the characteristics of the general environment
including relevant market, consumer, and product trends and competitive actions,
within which an alternative logistics plan must operate. They are generally outside the
ability of the firm to change.
Management assumptions define the physical and economic characteristics of the
current or alternative logistics environment and are generally within the firms ability to
change or refine. Typical assumptions include a definition of alternative distribution
facilities, transport modes, logistics processes and fixed and variable costs.
Analysis assumption defines the constraints and limitations that must be included to fit
the problem to the analysis technique. These assumptions frequently concern problem
size, degree of analysis detail and solution methodology.
The elements of assumption categories are as follows
BUSINESS ASSUMPTIONS
1. Scope: Definition of business units and product lines to be included
2. Alternatives: Range of options that can be considered
3. Market Trends: Nature and magnitude of change in market preferences and
buying patterns
4. Product Trends: Nature and magnitude of change in market preferences and
buying patterns particularly with respect to package size and packaging.
5. Competitive actions: Competitive logistics strengths, weaknesses and strategies.

MANAGEMENT ASSUMPTIONS
Markets: Demand patterns by market area, product and shipment size
Distribution Facilities: Locations, operating policies, economic characteristics and
performance history of current and potential distribution facilities.
Transportation: Transportation rates for movement between potential and existing
distribution facilities and customers
Inventory: Inventory levels and operating policies for each distribution facility
ANALYSIS ASSUMPTION
1. Product Groups: Detailed product information aggregated to fit within the scope
of analysis 1. Technique.
2. Market Areas: Customer demand grouped to aggregate market areas to fit the
scope of analysis techniques
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c) Identify data resources: The process of data collection begins with a feasibility
assessment. A fairly detailed specification of data is required to formulate or fit the
analytical technique. For situations when data are extremely difficult to collect or
when the necessary level of accuracy is unknown, sensitivity analysis can be used to
identify data collection requirements. For e.g. an initial analysis may be completed
using transportation costs estimated with distance based regressions. The types of
data required in a logistical design n study can be divided into three classes: business
assumptions, management assumptions and analysis assumptions. The majority of
data required in a logistical study can be obtained from internal records. Although
considerable searching may be needed, most information is generally available.
- The first major data category is sales and customer orders. The annual sales
forecast and percentage of sales by month, as well as seasonality patterns are
necessary for determining logistics volume and activity levels. Historical samples of
customer order invoices are also needed to determine shipping patterns by market and
shipment size. The combination of aggregate measures of demand and detailed order
profiles of projects the requirements that the logistics system must be capable of
satisfying. Specific customer data are also required to consider the cost and time
associated with moving the products across distance. Customers and markets ate often
aggregated by location, type, size, order frequency, growth rate, and special logistical
services to reduce analysis complexity.
For integrated channel analysis, its necessary to identify and track the costs
associated with manufacturing and purchasing. Its often necessary to consider the
number and location of plants, product mix, production schedules and seasonality.
Identification of policies and costs associated with inventory transfer, reordering, and
warehouse processing, inventory control rules and product allocation procedures. For
each of the current and the potential warehouse, the operating costs, capacities,
product mix, storage levels and service capabilities should be established.
Transportation data requirements
Transportation data requirements include the number and type of modes utilized,
modal selection criteria, rates and transit times, and shipping rules and policies.
For most logistics analysis applications, a select amount of future market data is
useful for evaluating future scenarios. Although the management may be able to
prepare a consolidated sales forecast it is difficult to prepare a market-by-market
projection of sales. There can be two solutions to this problem.
1. Usage of demographic projections that correlate highly with sales can help the
company to estimate future demand levels and hence determine future logistics
requirements. Secondary data published by various government agencies can also
provide a data bank of environmental information
2. Keeping a watch on the competitors strategies and capabilities by documenting
competitive logistical system designs and flows can be helpful in providing
competitive benchmarks that compare customer service capabilities, distribution
networks and operating capabilities.
d) Collect Data
Once the data sources have been identified the company can start assembly of
required data and conversion of that data to an appropriate format for the analysis
tool. To avoid errors like overlooking data that does not reflect major components of

32

logistical activity or collection of data from a misrepresentative time period, the data
collection process should be properly documented.
e) Collect Validation Data
The objective of validation is to increase management credibility regarding the
analysis process and to ensure that the results of the analysis accurately reflect reality.
It is important to ensure that a through investigation is conducted into analytical
results based on data that might not accurately reflect the past.
2) ANALYSIS
The analyst uses the technique and data from the previous activity to evaluate
logistics strategic and tactical alternatives. The process of analysis includes
a) Define analysis questions
This involves defining specific analysis questions concerning alternatives and the range
of acceptable uncertainty. The questions build on research objectives and constraints by
identifying specific operating policies and parameters. For e.g.: In the case of inventory
analysis questions might focus on alternative service and uncertainty levels.
b) Complete and validate baseline analysis
The second task completes the baseline analysis of the current logistics environment
using the appropriate method or tools. Results are compared with validation data
collected previously to determine the degree of fit between historical and analytical
findings. The comparison should focus on identifying significant differences,
determining sources of possible errors and identifying and correcting them.
c) Complete alternative analysis
An evaluation of systems alternatives should be accomplished either manually or
electronically to determine the relevant performance characteristics of each alternative.
d) Complete sensitivity analysis
In this phase uncontrollable factors like demand, factor cost or competitive actions are
varied to assess the ability of potential alternatives to operate under a variety of
conditions. Sensitivity analysis in conjunction with an assessment of potential scenario
probabilities is then used in a decision tree to select the best alternative.
PHASE III - RECOMMENDATIONS & IMPLEMENTATIONS
Phase III operationalize planning and design efforts by making specific management
recommendations and developing implementation plans.

a) Recommendations
Alternative and sensitivity analysis results are reviewed to determine recommendations
to management. There are four steps in this part of the phase namely: 1. Identify the Best Alternative
Performance characteristics and conditions for each alternative must be compared to
identify the two or three best options. The decision tree analysis should identify the

33

best alternative i.e.: The one that meets the desired service objectives at the minimum
total cost.
2. Evaluate Costs and Benefits
A Cost Benefit analysis compares the alternatives for a base period and then projects
comparative operations across a particular planning horizon. Potential benefits such
as cost reduction; service improvement and cost prevention are identified and
quantified. In other words when evaluating the potential of a particular logistical
strategy an analysis comparing present cost and service capabilities with projected
conditions must be completed for each alternative.
3. Develop a Risk Appraisal
Risk Appraisal considers the probability that the planning environment will match the
assumptions. It also considers the potential hazards related to system changeover.
Risk related to adoption of a selected alternative can be quantified using sensitivity
analysis. For e.g.: Assumptions can be varied and the resulting influence on system
performance for each alternative can be determined. The end result of a risk appraisal
provides a financial evaluation of the downside risk if the planning assumptions fail
to materialize. Risks related to system changeover such as unanticipated delays, a
series of contingency plans etc can also be quantified and a series of contingency
plans could be tested to determine their possible impact.
4. Develop Presentation
The final step in this procedure is a presentation to the management / submission of a
report that identifies specific operating and strategic changes, provides qualitative
reasons for suggesting these changes and then quantitatively justifies the changes in
terms of service, expenses, asset utilization or productivity improvements.
b) Implementation
The actual plan or design implementation is the final process activity. An adequate
implementation procedure is the only means to obtain a tangible return from the
planning process. This broadly includes four phases.
1. Define Implementation Plan
The implementation plan has to be defined in terms of the individual events, their
sequence and their dependencies. The planning process may initially develop at a
macro level. But it must ultimately be refined to provide individual assignment
responsibility and accountability. Plan dependencies identify the interrelationships
between events and thus define the completion sequence.
2. Schedule Implementation
The implementation plan is scheduled based on the assignments identified in the
previous stage. The schedule must allow adequate time for acquiring facilities and
equipment, negotiating agreements, developing procedures and training.
3. Define Acceptance Criteria
The criteria for evaluating the success of the plan are then developed. The Acceptance
Criteria should focus on service improvements, cost reduction, improved asset
utilization and enhanced quality. Although the acceptance criteria may focus on the
area / function which was the main focus for the Plan, it should also take a broad

34

perspective that focuses on total logistics system performance rather than the
performance of an individual function.
4. Implement
The final task is actual implementation of the plan or design. Implementation must
include adequate controls to ensure that performance occurs on schedule and that
acceptance criteria are carefully monitored.
PLANNING THE INVENTORY RESOURCES
Planning is extremely important when it comes to inventory resources. The lack of
planning can be costly to the firm either because of the carrying and financing costs of
excess inventory or the lost sales from inadequate inventory. The inventory
requirements to support production and marketing should be incorporated into the
firms planning process in an orderly fashion.
The production side
Every product is made up of a specified list of components. The planner must realize
the different mix of components in each finished product. Each item maintained in
inventory will have a cost. This cost may be based on volume purchases, lead time for
an order, historical agreements or other factors. Each component can be assigned a
value. Once the mix is known and each component has been assigned a value, the
planner can calculate the materials cost.
The marketing side
The second step in inventory planning involves a forecast of unit requirements during
the future period. The marketing department should also provide pricing information so
that higher profit items can receive more attention.
Inventory database
An important component of inventory planning involves access to an inventory
database. It is a structured framework that contains the information needed to
effectively manage all items of inventory, from raw materials to finished goods. This
information includes the classification and amount of inventories, demand for the items,
cost to the firm for each item, ordering costs, carrying costs and other data.
The task of inventory planning can be highly complex. At the same time it rests on
fundamental principles. In doing so we must understand and determine the optimal lot
size that has to be ordered. The EOQ (economic order quantity) refers to the optimal
order size that will result in the lowest total of order and carrying costs and ordering
costs. By calculating the economic order quantity the firm attempts to determine the
order size that will minimize the total inventory costs.
An examination of the two curves reveals that the carrying cost curve is linear i.e. more
the inventory held in any period, greater will be the cost of holding it. Ordering cost
curve on the other hand is different. The ordering costs decrease with an increase in
order sizes. The point where the holding cost curve i.e. the carrying cost curve and the
ordering cost curve meet, represent the least total cost which is incidentally the
economic order quantity or optimum quantity.

35

The EOQ can be calculated with the help of a mathematical formula. Following
assumptions are implied in the calculation:
1. Constant or uniform demand- although the EOQ model assumes constant demand,
demand may vary from day to day. If demand is not known in advance- the model
must be modified through the inclusion of safe stock.
2. Constant unit price- the EOQ model assumes that the purchase price per unit of
material will remain unaltered irrespective of the order offered by the suppliers to
include variable costs resulting from quantity discounts, the total costs in the EOQ
model can be redefined.
3. Constant carrying costs- unit carrying costs may very substantially as the size of the
inventory rises, perhaps decreasing because of economies of scale or storage
efficiency or increasing as storage space runs out and new warehouses have to be
rented.
4. Constant ordering cost- this assumption is generally valid. However any violation in
this respect can be accommodated by modifying the EOQ model in a manner similar
to the one used for variable unit price.
5. Instantaneous delivery- if delivery is not instantaneous, which is generally the case;
the original EOQ model must be modified through the inclusion of a safe stock.
6. Independent orders- if multiple orders result in cost saving by reducing paper work
and the transportation cost, the original EOQ model must be further modified. While
this modification is somewhat complicated, special EOQ models have been
developed to deal with it.
These assumptions have been pointed out to illustrate the limitations of the basic
EOQ model and the ways in which it can be easily modified to compensate for them.
The formula for the EOQ model is:
2 M Co
S Cc
Where M = is the annual demand
Co is the cost of ordering
Cc is the inventory carrying cost
S = is the unit price of an item.
Limitations of the EOQ formula1. Erratic changes usages- the formula presumes the usage of materials is both
predictable and evenly distributed. When this is not the case, the formula becomes
useless.
2. Faulty basic information- order cost varies from commodity to commodity and the
carrying cost can vary with the companys opportunity cost of capital. Thus the
assumption that the ordering cost and the carrying cost remains constant is faulty
and hence EOQ calculations are not correct.
3. Costly calculations: the calculation required to find out EOQ is extremely time
consuming. More elaborate formulae are even more expensive. In many cases, the
cost of estimating the cost of possession and acquisition and calculating EOQ
exceeds the savings made by buying that quantity.
4. No formula is a substitute for common sense- sometimes the EOQ may suggest that
we order a particular commodity every week (six-year supply) based on the
assumption that we need it at the same rate for the next six years. However we have
to order it in the quantities according to our judgement. Some items can be ordered

36

every week; some can be ordered monthly, depends on how feasible it is for the
firm.
5. EOQ ordering must be tempered with judgement- Sometimes guidelines provide a
conflict in ordering. Where an order strategy conflicts with an operational goal,
order strategy restrictions should be developed to permit honouring the goal.
Quantity discounts: In the EOQ analysis, it has been assumed that material prices and
transportation costs were constant factors for the range of order quantities considered.
In practice, some situations occur in which the delivered unit cost of a material
decreases significantly if a slightly larger quantity than the originally computed EOQ is
purchased. Quantity discounts, freight rate schedules and price increases may create
such situations. These additional variables can also be included in the formula.
Determining ordering point
In the EOQ model, the leas time for the procurement material is assumed to be zero.
Consequently the ordering point for replenishment of stock occurs when the level of
inventory drops down to zero. In view of instant replenishment of stock, the level of
inventory jumps to the original level from zero level. This is well illustrated in the
following diagram:
However, in real life situations, one never encounters a zero lead-time. There is always
a time lag from the date of placing an order for materials and the date on which the
materials are received. As a result, the ordering level is always at the level higher than
zero. If the firm orders the goods when the inventory level reaches the reorder point, the
firm will never run out of goods. The decision on how much stock to hold is generally
referred to as Order point problem that is how low should the inventory be depleted
before it is reordered.
The two factors that determine the appropriate order point are the:
a) Procurement or delivery time stock (inventory needed during the lead time) and;
b) The safety stock, which is the minimum level of inventory that is held as a
protection against shortages.
Reorder point = Normal consumption + safety stock during leadtime.
In summary, the efficiency of the replenishment system affects how much delivery time
is needed.
Determination of level of safety stock involves a basic trade-off between the risk of
stock-out, resulting in possible customer dissatisfaction and lost sales, and the increased
costs associated with carrying additional inventory. The following diagram represents
this better:
Reorder level = (Average daily usage rate) x (Lead time in
days)
Safety stock

37

When the wage rate and/or lead-time vary, then the reorder level should naturally be at a
level high enough to cater to the production needs during then procurement period and
also to provide some measure of safety for at least partially neutralizing the degree of
uncertainty.
How much should the magnitude of safe stock be?
It depends on the degree of uncertainty surrounding the usage rate and lead-time. It is
possible to a certain extent of to quantify the values that usage rate and lead-time can
take along with the corresponding chances of occurrences known as probabilities.
These probabilities can be ascertained based on the previous experiences and the
judgmental ability of executives. Based on the above values and estimated stock out
costs and carrying costs of inventory it is possible to work out the total cost associated
with different levels of safety stock. Higher the quantity of safety stock, the lower will
be the stock-out cost and the higher will be the incidence of carrying costs. Thus the
reorder level will call for a trade-off between stock out costs and carrying cost. The
reorder level will be such that the total stock out cost and the carrying cost will be at its
minimum.
Cost of carrying inventory
Carrying material in inventory is expensive. A number of studies indicated that
annual cost of carrying a production inventory averaged approximately 25% of
value of the inventory. The escalating and volatile cost of money has escalated
annual inventory carrying cost to a figure between 25% - 35% of the value of
inventory. The following five elements make up this cost:
1) Opportunity cost (12% -20%)
2) Insurance cost (2% 4%)
3) Property taxes (1% - 3%)
4) Storage costs (1%- 3%)
5) Obsolescence and deterioration (4% - 10%)
Total carrying cost (20% - 40%)
Let us briefly look into these costs:

the
the
the
the

Opportunity cost of invested funds

When a firm uses money to buy production material and keeps it in the inventory, it
simply has this much less cash to spend for other purposes. Money invested in external
securities or in productive equipment earns a return for the company. Thus it is logical
to charge all money invested in inventory an amount equal to that it could earn
elsewhere in the company. This is the opportunity cost associated with inventory
investment.
Insurance cost
Most firms insure the assets against possible losses from fire and other forms of
damage.
Property taxes
This is levied on the assessed value of a firms assets, the greater the inventory value,
the greater the asset value and consequently the higher the firms tax bill.
Storage costs
The warehouse is depreciated every year over the length of its life. This cost can be
charged against the inventory occupying the space.
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Obsolescence and deterioration

In most inventory operations, a certain percentage of the stock spoils, is damaged, is
pilfered, or eventually becomes obsolete. A certain number always takes place even if
they are handled with utmost care.
Generally speaking, this group of carrying costs rises and falls nearly proportionately to
the rise and fall of the inventory level.
Moreover, the inventory level is directly proportional to the quantity in which the
ordered material is delivered. Hence costs of carrying inventory vary nearly directly
with the size of the delivery quantity. This relationship is illustrated as follows:
(Carrying Cost per year) = (Average inventory value) x (Inventory carrying cost
as a % of inventory value)
Origin purchase
Buyer incurs the freight cost and product risk when the product is in transit.
EOQ EXTENSIONS:
While the EOQ formulation is relatively straightforward, there are some other factors
that must be considered in actual application. The most important and persistent
problems are those related to various adjustments necessary to take advantage of social
purpose situations and utilization characteristics.
1. Volume transportation rate: In the EOQ formulation, there was no consideration
for the impact of transportation cost on order quantity. The transportation cost from the
origin to the inventory depot is incurred by the seller. However if the ownership is
transferred at the origin, the impact of the transportation rates on the total cost must be
considered when determining the order quantity. As a general rule, greater the quantity,
lesser will be the volume transportation rate because many sellers tend to give a
discount when the goods are bought in a larger size (both by the truck and rail). Thus all
other things being equal, an enterprise will want to buy goods in large quantities to
maximize transportation economies. Such quantity may be larger than the actual
quantity determined by EOQ. Increasing the size of the order has a two fold impact
on the inventory:
It increases the inventory carrying cost
It provides better transportation economies.
Finally, two factors regarding inventory cost under costs of origin purchase are:
The transit inventory is a part of the enterprises average inventory and therefore
subjected to an appropriate charge.
The transportation cost should be added to the price of the goods purchased to
assess the value of the goods tied up in inventory. Thus the inventory carrying
cost should be assessed on the combined cost of the item and transportation.
2. Quantity Discounts
Purchase quantity discounts represent an EOQ extension. If the discount at any
associated quantity is sufficient to offset the added cost of maintenance less the reduced
39

cost of ordering, then the quantity discount offers a viable alternative. It should be noted
that quantity discounts and volume transportation rates each effect later purchase
quantities. However, this does not mean that the lowest total cost purchase will always
be a large quantity.
EOQ Adjustments
A variety of special situations can occur that will require adjustments to basic EOQ
model. Some of them are:
Production lot size (most economical quantity from manufacturing
perspective)
Multiple item purchase.
This describes situations when more than one product is bought concurrently, so
that quantity and transportation discounts must consider the impact of the
product combinations.
Limited capital (limited capital budget limitations for total inventory
investment)
Private trucking (influences order quantity since it represent a fixed cost
once the decision is made to replenish the product.)
If the enterprise decides to use its own truck, it should fill the truck regardless of
the value calculated by the EOQ. Transporting a half empty truck does not make
any sense.
Inventory Related Definitions
This includes definitions related to an inventory management policy.
1) INVENTORY POLICY: It consists of guidelines concerning what to purchase
or manufacture when to take action and in what quantity. It also deals with the
inventory positioning and placements in plants and distribution centers. E.g some
plants may maintain stock at a plant and hence postpone the inventory positioning.
The second inventory policy element concerns inventory management strategy. One
approach is to manage inventory at each distribution center independently. The other
extreme deals with inventory interdependence across distribution sites by managing
inventory centrally. Centralized inventory management requires more coordination
and communication.
(2) Service level: It defines the performance objectives that the inventory function
must be capable of achieving. It can be defined in terms of the following:
(a) Order cycle time: the time taken to complete from the time of placing the order
to the payment for the goods received. It can also be defined as the elapsed time
between the release of a purchase order by a customer and the receipt of the
corresponding shipment.
(b) Case fill rate: it can be defined as the percentage of cases or units ordered that
can be shipped as 4requested. For e.g. 95% case fill rate indicates that on an
average, 95 cases out of 100 could be filled from available stock. The remaining
5 will be back ordered or deleted.
(c) Line fill rate: % of order lines that could be filled completely. Each time on an
order is a request for an individual product, so an order may have multiple lines.
E.g. if a customer order is received requesting 80 units of product A and 20 units
of product B, the order is of 100 cases and 2 lines. If there are 75 units of

40

product A available and all 20 of product B, the case fill would be 95% (75+20)/
(80+20) and the line fill rate would be 50%.
(d) Order fill: it is a % of customer orders that could be filled completely. In the
above example, the order could not be filled completely filled, so the resulting
order fill would be zero.
The inventory function is a major element of the logistics process that must be
integrated in order to meet the service objectives. To improve service level, once can
increase the inventory. Other approaches would be faster transportation modes, better
information mgmt, or alternative sources of supply.
Average inventory: this consists of the materials, components, WIP and finished
products typically stocked in logistical facilities. Average inventories include cycle,
safety stock and in transit inventory components.
Cycle inventory: it is also known as base stock. It can be defined as the % of the
inventory that results from the replenishment process. Cycle inventory can also be said
to result when in order to reduce unit purchase costs (or increase production efficiency),
the number of units purchased (or produced) inventory from to which the lot size is
applied. It may be more economical to order the product in a large size than to order it
in small batches. At the beginning of a performance cycle, the stock level is at the
maximum level. However daily customer demands stock to be withdrawn from the
inventory until it reaches zero. Prior t this, a replenishment order must be given. The
amount ordered for replenishment is called the order quantity. The average inventory
held as a result of the order process is referred to as base stock, which is also called as
the lot size stock. Usually the base stock equals to one half of the order quantity.
Safety stock inventory: It has been explained on pg 6
Transit inventory: this represents the stock that is either moving or awaiting movement
in transportation vehicles. This portion of the total inventory is also known as pipeline
inventory. It can also be defined as the materials moving forward but not yet received. It
is necessary to achieve order replenishment. Transit inventory represents real assets and
must be paid for even though it is not accessible or usable. There has typically been a
high degree of uncertainty associated with transit inventory because shippers were
unable to determine where a transport was located or when it was likely to arrive. While
satellite communications have somewhat reduced this uncertainty.
Shippers bill have limited accessibility to such information. Increased focus on smaller
order quantities, more frequent order cycles and just in time strategies have resulted in
transit inventory becoming a larger percentage of the total inventory assets. As a result,
greater attention is paid to reducing the amount of transit inventory and its associated
uncertainty.
Formulating inventory policy
Inventory turnover is a widely used performance measure that reflects the liquidity
of a firms inventory and the speed with which inventory is converted into sales.
This indicates the number of times the inventory is sold or turned over during a
stated period.
Inventory turnover ratio =
Cost of goods sold
41

Average inventory value

e.g, if the firms annual cost of goods sold = Rs.5, 00,000 and its average inventory
value = Rs.50,000, the inventory turns over 10 times. If the cost of goods sold rises
to Rs.10, 00,000 and the value of the inventory remains as it is, the turnover ratio
jumps to 20.
Inventory turnover is related to actual sales. Hence high inventory levels are not
penalized if the sales are very high and low inventory levels are not rewarded, if the
sales are low. If the inventory turnover is high, it means that the inventory is kept in
stock for a less period of time and hence it is more liquid. The cash flow needed to
finance the inventory also decreases as the number of inventory turnover increases.
A high level of sluggish inventory amounts to unnecessary tie-up of funds, reduced
profits and increased costs. If these inventories are written off, it will adversely
affect the Working capital and liquidity position of the firm. However, if the
inventory level is maintained at a very low level (inventory turnover high), then it
may result into frequent stock outs, which means the firm replenishes its inventory
in small lot sizes. This may be costly to the firm.
Elements of logistics Management
Inventory planning methods use a common information base to co-ordinate inventory
requirements across multiple locations or stages in the value added chain. Planning
activities may occur at the plant warehouse level to coordinate inventory allocation and
delivery to multiple distribution centers. Planning may also occur to coordinate
inventory requirements across multiple channel partners such as manufacturers and
retailers.
Two inventory planning methods are:
a) Fair share Allocation
b) Distribution requirement planning.

Fair share Allocation

It is a simplified inventory management planning method that provides each distribution
facility with an equitable or Fair share of available inventory from a common source
such as a plant warehouse.
Example of a fair share allocation
Plant warehouse
Inventory 600 units.

Distribution center 1

Distribution center 2

Distribution center 3

___________________
Inventory 50 units
Daily use 10 units

_____________________
Inventory 100 units
Daily use 50 units

_____________________
Inventory 75 units
Daily use 75units

42

The above figure illustrates the network structure, current inventory levels and daily
requirements of three distribution centers served by a common plant warehouse. Using
fair share allocation rules, the inventory planner determines the amount of inventory
that can be allocated to each district center from the available inventory at the plant
warehouse. For this example assume that it is desirable to retain 100 units at the plant
warehouse, hence 500 units are available for allocation.
Formula
DS =
Where,
DS = common days supply for distribution center inventory.
Aj = inventory units to be allocated from plant warehouse.
Ij = inventory in units for distribution center j
Dj = daily demand for distribution center j.
n = number of distribution centers.
In this example, DS = 500 + (50+100+75)
10 + 50 +15
= 500 + 225
75
= 9.67 days
Hence the fair share allocation indicates that each distribution center should be brought
up to 9.67 days of stock. The amount to be allocated to each distribution center is
determined by:
Aj = (DS Ij ) x Dj
Dj
Aj = amount allocated to distribution center j.
Ds = days supply that each distribution center is brought up to Ij and Dj are as above.
The amount allocated to distribution center 1 in this case:
A1 = (9.67 50/10) x 10 = (4.67) x 10 = 46.7 ~ 47 units.
However fair share allocation does not consider site-specific factors such as differences
in performance cycle time, EOQ, safety stock requirements.
SKU (Stock keeping unit it is a specific item purchased by the customer including
colour and size uniqueness.)
Distribution requirement planning (DRP)
It is a more sophisticated approach that considers multiple distribution stages and the
characteristics of each stage. It is a logical extension of MRP, although there is one
fundamental difference between the two.
MRP is determined by a production schedule that is defined and controlled by
the enterprise. On the other hand, DRP is guided by customer demand, which is
not controllable by the enterprise.
So, while MRP generally operates in a dependent demand situation, DRP
operates in an independent environment where uncertain customer demand
determines inventory requirements. The manufacturing requirements planning

43

component coordinates the scheduling and integration of materials into finished

goods.
MRP controls inventory until manufacturing or assembly is complete. DRP then
takes coordination responsibility once finished goods are received in the plant
warehouse.

The fundamental DRP planning is the schedule, which coordinates requirements

across the planning horizon. There is a schedule for each SKU and each distribution
facility. Schedules for the same SKU are integrated to determine the overall
requirements for replenishment facilities such as the plant warehouse. The schedules
are developed using weekly time increments known as buckets. The schedule
reports current on-hand balance, safety stock, performance cycle length and EOQ.
Distinction between DRP and MRP
DIFFERENCE BETWEEN MRP AND DRP
MRP

DRP

Guiding factor

Guided
by
schedules

Control of the firm

Under control of the firm

Not under control of the firm

Demand situation

Operates
in
demand situation

dependant

Operates in independent
demand situation

Area of operation
and coordination

Coordinates scheduling and

integration of materials into
finished goods

Coordinates demand between

outlets and supply sources

Stage
functioning

Controls inventory until

manufacturing and assembly
is complete.

Controls and coordinates

inventory after manufacturing
and assembly of finished
goods

of

production

Guided by customer demand

The figure below shows the areas of functioning of MRP and DRP. MRP plans the
procurement of raw materials as per their requirements, right from the first stage till the
final assembly.
After the goods have been manufactured, DRP plans the distribution of finished goods
from the plant warehouse to the wholesalers and retailers till it reaches the customer.
The integrated model seeks to combine these two areas. Taking into
consideration the requirements of both MRP and DRP, it provides
integrated planning.
44

CUSTOMERS

DISTRIBUTIO
N CENTER

DISTRIBUTION
CENTER

DISTRIBUTION
CENTER

DISTRIBUTION
CENTER

DISTRIBUTION
CENTER

DISTRIBUTION
CENTER

REGIONAL
WAREHOUSE

REGIONAL
WAREHOUSE

PLANT WAREHOUSE

FINAL ASSMEBLY
(MANUFACTURING)

SUB ASSEMBLY B

SUB ASSEMBLY C

SUB ASSEMBLY A

PART A

PART C

PART D

PART B

RAW MATERIALS

45

SUB ASSEMBLY D

PART E

DRP Benefits And Constraints

An inventory management system such as DRP offers a number of benefits for
management. The major organizational beneficiaries include marketing and
logistics.
The major marketing benefits are:
Improved service levels that increase on time deliveries and decrease
customer complaints.
Improved and more effective promotional and new product introduction
plans.
Improved ability to anticipate shortages so that marketing efforts are not
expended on products with low stock.
Improved inventory coordination with other enterprise functions, since DRP
facilitates a common set of planning numbers.
Enhanced ability to offer customers a coordinated inventory management
service.
The major logistics benefits are:
Reduced distribution center freight costs resulting from coordinated shipments.
Reduced inventory levels, since DRP can accurately determine what product is
needed and when.
Decreased warehouse space requirements because of inventory reductions.
Reduced customer freight costs as a result of fewer back orders.
Improved inventory viability and coordination between logistics and
manufacturing.
Enhanced budgeting capitability, since DRP can effectively simulate inventory
and transportation requirements under multiple planning scenarios.
The constraints of DRP are:
Inventory planning systems require accurate and coordinated forecasts for each
distribution center. The forecast is necessary to direct the flow of goods through
the distribution channel. To the extent that this level of forecast accuracy is
possible, inventory-planning systems operate well. However, this requires
forecasts for each distribution center and SKU as well as adequate lead-time to
allow product movement. However there are 3 potential sources for error exist.
The forecast itself may be wrong, it may have predicted demand at the wrong
location, or it may have been predicted demand at the wrong time.
Inventory planning requires consistent and reliable performance cycles for
movement between the distribution centers. While variable performance cycles
can be accommodated through safety lead times, performance cycle uncertainty
reduces planning system effectiveness.
Integrated planning is subject to system nervousness and frequent rescheduling,
because of production breakdowns and delivery delays. The system nervousness
leads to fluctuations in capacity utilization, rescheduling cost, and confusion in
deliveries. This is intensified by the volatile operating environment
characteristic of distribution. Uncertainties such as supply transportation
performance cycles and vendor delivery reliability can cause an extremely
nervous DRP system.
DRP is not the universal solution for inventory management.
46

Question 16
Logistical Organization And Development: 3 Stages Of Evolution
Prior to the 1950s,functions now accepted as logistics were generally viewed as
facilitating or support work. Organizational responsibility for logistics was dispersed
throughout the firm. This fragmentation often meant that aspects of logistical work were
performed without cross-functional coordination, often resulting in duplication and
waste information was frequently distorted or delayed and lines of authority and
responsibility were typically blurred. Managers recognizing the need for total cost
control began to reorganize and combine logistics functions into a single managerial
group. Structuring logistics as an integrated organization first appeared in the 1950s.
The motivation behind functional aggregation was the belief that grouping
logistics functions into a single organization would increase the likelihood of
integration. The paradigm (model) was that functional proximity would facilitate
improved understanding of how decisions and procedures in one area affect
performance in other areas. The belief was that eventually all functions would begin to
work as a single group focused on total system performance. This integration paradigm,
based on organizational proximity, prevailed throughout a thirty-five year period.
However, by the mid 1980s, it was becoming increasingly clear that the paradigm of
functional aggregation might not, in final analysis, offer the best approach to achieve
integrated logistics. For many firms, the ink had barely dried on what appeared to be the
perfect logistics organization, when new and far more pervasive rethinking of what
constituted the ideal structure emerged.
Almost overnight, the emphasis shifted from function to process. Firms began to
examine the role logistical competency could play in the overall process of creating
customer value. This ushered in new thinking regarding how to best achieve logistical
performance. To a significant degree, the focus on process reduced the pressure to
aggregate functions into all encompassing organization units. The critical question
became not how to organize individual functions but rather how to best manage the
overall logistical process. The challenges and opportunities of functional disaggregation
and information driven integration began to emerge.
The mission of logistics is to position inventory when and where it is
required to facilitate profitable sales. This supportive work must be performed around
the clock and typically throughout the world, which means that logistics needs to be an
integral part of all processes. The ideal structure for logistics would be an organization
that performs essential work as part of the processes it supports while achieving the
synergism of cross functional integration.
Information technology introduced the potential of electronic integration as
contrasted to physically combining logistics functions. Using information technology to
coordinate or orchestrate integrated performance allows the responsibility for work
itself to be distributed throughout the overall organization. Integration requires that
logistics combine with other areas such as marketing and manufacturing. For example,
rather than focusing on how to relate transportation and inventory, the real challenge is
to integrate inventory, transportation, new product development, flexible manufacturing
and customer service. in order to achieve overall organizational integration, a firm must
combine a wide variety of capabilities into new organizational units. This means that
the traditional single function department must be assimilated in a process. Such
assimilation often requires the traditional organizational structure be dissaggregated and
then recombined in new and unique ways in one sense, such a functional disaggregation
may appear to come full circle back to the early days of fragmented single-function
47

departments. However, the critical differences in the emerging organization model are
widespread availability of unbridled information. The new organization format is
characterized by an extremely different culture concerning how information is managed
and shared.
Understanding the organizational development process permits logistics
managers to evaluate the firms current state of organization and plan changes that can
be accommodated.

FIG: LOGISTICS ORGANIZATION DEVELOPMENT CYCLE

Stages of functional organization

Figure illustrates a traditional organizational structure with dispersed logistical

functions.. the initial belief was that integrated performance would be facilitated by
grouping logistical functions normally spread throughout the traditional organization
into a single command and control structure.. It was felt that these functions would be
better managed, trade-offs better analyzed, and least-Total cost solutions better
identified if all logistics work was integrated into one organization. In order for
operational integration to occur, managers had to believe that performance could be
improved.
Without this belief, they would continue To emphasize structure as opposed to
management practice.
While the idea of functional integration is logical and appeals to common sense, it is not
always supported by other unit managers. It is natural that any attempt to reposition
management authority and responsibility will meet resistance. Many logistics
48

executives can provide examples of how attempts to reorganize were met with rivalry
and mistrust--- not to mention accusations of empire building. Traditionally, in
organizational structures, financial budgets follow operational responsibility. Likewise,
power, visibility, and compensation result from managing large head counts and
substantial budgets. Logistical reorganization, therefore, was typically seen as a way for
logistical managers to gain power, visibility and compensation at the expense of other
mangers. This also was ample reason for other managers to protect their power by
resisting logistics functional integration. As a result, unified logistical organizations
faces considerable resistance. But in an increasing number of firms, benefits were
sufficient to empower reorganization. The resulting evolution typically involved three
stages of functional aggregation.
STAGE 1 ORGANIZATION

The initial attempt at grouping logistical activities emerged during the late 1950s and
early 1960s. Organizations with even a minimal degree of formal unification emerged
only after senior management became committed to the belief that improved
performance would result. The typical evolutionary pattern was for two or more
logistics functions to be operationally grouped without significant change in the overall
organization hierarchy. Such initial aggregation Occurred at both the staff and line
levels of organization.. Seldom were organization Units engaged in purchasing and
physical distribution integrated during this initial development stage.
Figure illustrates a typical stage 1 organization. Although completely separate, physical
distribution and material management units serve to aggregate related functions. As the
potential of integrated logistics developed recognition within an enterprise, one or two
clusters of unified operations emerged. In the marketing area, the cluster typically
centered around customer service. In the manufacturing area, concentration was usually
on inbound materials or parts procurement.. However, with few exceptions, most
traditional departments were not changed and the organization hierarchy was not altered
significantly. For the most part, stage 1 organizational change involved grouping
functions within the traditional domains of marketing and manufacturing. The notable
49

deficiency of stage 1 organization was a failure to focus direct responsibility for

inventory.
For example, initial physical distribution organizations typically controlled
warehousing, transportation and order processing. Few stage 1 organizations had direct
responsibility to manage trade-offs between transportation and finished inventory
deployment.

STAGE 2 ORGANIZATION

As the overall enterprise gained operational experience with unified logistics and cost
benefits, a second stage of organization began to evolve. Figure illustrates stage 2,
which began to emerge in the late 1960s and early 1970s. The significant feature of
stage 2 was that logistics was singled out and elevated to a position of higher
organizational authority and responsibility. The motivation was simple: Positioning
logistics at a higher organization level increased the likelihood of strategic impact.
Independent status allowed logistics to be managed as a core competency. A likely
candidate for elevated status was physical distribution in firms where customer service
performance was critical to overall success. The grocery manufacturing business was an
example where materials management often increased in operational authority and
responsibility because inbound materials and production was a major portion of product
costs. Thus the focal group that was elevated to higher organizational prominence in the
stage 2 organizations typically depended on the nature of the enterprises primary
business. The example in the figure illustrates a situation wherein physical distribution
was restructured and elevated.
In order to establish stage 2 organizations, it was necessary to reassign functions and
position the newly created organization at a higher level within the overall enterprise
structure. In the stage 2 organization, the concept of a fully integrated logistics unit was
not achieved. Rather, integration was focused on either physical distribution or
50

materials management. This failure to synthesize logistical management into an

integrated system was due in part to a preoccupation with the performance of specific
functions, such as order processing or purchasing, which were perceived as essential to
traditional operations. A second limiting factor to total integration was the lack of cross
functional logistical information systems.. As a general rule, organizational
integration reflected the information systems capability of the firm.
A significant point about the stage 2 organizations is that integrated physical
distribution and/or materials management began to gain acceptance among financial,
manufacturing, and marketing counterparts. The other corporate officers viewed these
integrated organization as something more than purely reactive efforts aimed at cost
reduction or containment. In the stage 2 organizations, it was common for the integrated
unit to become a primary contributor to business strategy. The stage 2 organization is
readily observable in industry today and may well remain the most adopted approach to
logistical facilitation.
STAGE 3 ORGANIZATION

Stage 3 organizations emerged in the 1980s the logistical renaissance began. This
organizational structure sought to unify all logistical functions and operations under a
single senior manager. Stage 3 organizations, having the comprehensive nature, were
and continue to be rare. However, the trend at the stage 3 level of organization
structuring is clearly to group as many logistical planning and operational functions as
practical under single authority and responsibility. The goal is the strategic management
of all materials and finished product movement and storage to the maximum benefit of
the enterprise.
The rapid development of logistical information systems provided an impetus for stage
3 organizations. Information Technology became available to plan and operate systems
that fully integrated logistical operations. Several aspects of the stage 3 organizations
justify further discussion.
First, each area of logistics purchasing, manufacturing support and physical
distribution is structured as a separate line organization. The lines of authority and
responsibility directly enabled each bundle of supportive services to be performed
51

within the overall integrated logistical effort. Since areas of operational responsibility
are well defined, it is possible to establish manufacturing support as an operational unit
similar to purchasing and physical distribution. Each of these units is operationally selfsufficient. Therefore, each can maintain the flexibility to accommodate critical services
required by its respective operational area. In addition, since overall logistical activities
can be planned and coordinated on an integrated basis, operational synergies between
areas can be exploited.
Second, five capabilities grouped under logistical support are positioned as operational
services. This common service orientation is the mechanism to integrate overall
logistical operations. It is important to stress that logistical support is not a staff
organization. Rather, the group manages the day-to-day logistics work, which is
structured with matrix accountability for direct liaisons between physical distribution,
manufacturing support, and purchasing operations.
Third, logistical resource planning embraces the full potential of management
information to plan and coordinate operations. Order processing triggers the logistical
system into operation and generates the integrated database required for control.
Logistical resource planning facilitates integration. The plans are based on
product/market forecasting, order processing, inventory status, and capacity strategy to
determine overall requirements for any planning period. On the basis of identified
requirements, the planning unit operationalizes manufacturing by coordinating
production scheduling, capacity planning, and materials requirement planning.
Finally, overall planning and controllership exist at the highest level of the stage
3 organization. These two efforts serve to facilitate integration. The planning group is
concerned with long-range strategic positioning and is responsible for logistical system
quality improvement and reengineering. The logistical controller is concerned with
measurement of cost and customer service performance and with provision of
information for managerial decision-making. The development of procedures for
logistical controllership is one of the most critical areas of integrated logistical
administration. The need for careful measurement is a direct result of the increased
emphasis placed on customer service performance. The measurement task is extremely
important because of te large operating and capital dollar expenditures involved in
logistics.
The stage 3 logistical organization approach offers a single logic to guide the efficient
application of financial and human resources from material sourcing to customer
delivery. As such a stage 3 organization, stage 3 logistical positions a firm to manage
trade-offs between purchasing, manufacturing support, and physical distribution.
STAGE FOUR: A SHIFT IN EMPHASIS FROM FUNCTION TO PROCESS.
Interdependent of functional aggregation or disaggregation it is clear that organizations
are struggling to position their operating capabilities to better support oriented process
management. Mckinsey Consultants, frank Ostroff and Doug Smith proposed
architecture to illustrate how functional hierarchical vertical organization to transition to
become a process oriented horizontal model.
The concept of 21st century organization is envisioned as the result of three factors:
development of a highly involved work environment with self directed work teams
(SDWT) as a vehicle to empower employees to generate maximum performance;
second, improved productivity that results from managing processes rather than
functions (this notion has always rested at the core of integrated logistics) and third, the
rapid sharing of adequate information that allows all facets of organization to be
integrated.
52

The essence for the argument for radical restructuring is that the traditional evolutionary
concept of organization change is not sufficient to stimulate major breakthroughs in
service or productivity. Rather, traditional change shifts the balance of centralization
and decentralization or realigns operating structure between customers territories or
products without any serious redesign of the basic work process. Because such
restructuring typically assumes that functional organizations will continue to perform
the basic work, little or no difference in actual practice results. In essence, companies
are refocusing old business practices rather than designing new, more efficient
processes.
The challenges of managing logistics as a process are three fold. First all effort must be
focused on value added to the customer. an activity exists and is justified only to the
extent that it contributes to customer value. Therefore, a logistical commitment must be
motivated by a belief that customers desire a specific activity to be performed.
Logistical managers must develop the capacity to rethink externally. Second, organizing
logistics as part of process requires that all skills necessary to complete the work be
available regardless or functional organization. Organizational grouping on the basis of
selected functions can artificially separate natural workflows and create bottlenecks.
When horizontal structures are put in place, critical skills need to be put into position to
ensure that required work is accomplished. Finally, work performed in a process context
should stimulate synergism. With systems integration, the design of work as a process
means that overall organizational trade-offs is structured to achieve maximum output
for minimum input investment.
The radical changes proposed by the shift from functional to process orientation have
mixed messages for managers involved in logistics. On the positive side, general
adoption of a process orientation builds on the basic principles of systems integration.
At the core of integrated logistics is a commitment to functional excellence in the
context of contribution to process performance. A general shift in managing logistics as
a process means that it will be positioned as a central contributor to all initiatives that
focus on new product development, customer order generation, fulfillment and delivery.
The overall trend of process integration expands the operational potential and impact of
logistics.
STAGE 5: BEYOND STRUCTURE: VIRTUALITY AND ORGANIZATIONAL
TRANSPARENCY
It is highly unlikely that the attention being given to process will end management s
quest for the ideal logistical organization. While several different scenarios concerning
the organization of the future are technologically feasible, one of the most intriguing is
speculation
That formal hierarchical command and control organization structure will be replaced
with an informal electronic network often referred to as a virtual organization. The word
virtual implies an underlying existence without formal recognition. In other words, a
virtual organization, whether it is a total enterprise or a specific core competency, would
exist as a provider of integrated performance but not as an identifiable unit of in terms
of the formal organization structure of their membership critical activities in an
integrated fashion. These work teams could be transparent in terms of the formal
organization structure of their membership. In other words, formal organization charts
may not be related to actual workflow. In fact, logistics organizations of the future could
not be characterized by functional disaggregation throughout the organization in an
attempt to focus on workflow rather than structure.

53

THE NEED FOR INTEGRATION

Integration is required not just within the organization but integration upstream with
suppliers and distributors and customers. This integration is logistical rather than
vertical; in other words we do not imply ownership or domination of the supply chain
but rather that there is a greater emphasis on the linkage of organizations through
information.
The whole nature of logistics management has been dramatically changed by the
information technology revolution. Information systems have now become the driving
force pressurizing companies to reconsider their relationships with customers as well as
suppliers. It is no longer possible to manage the business as if it were in a vacuum with
no interconnections with other organizations.
By process integration we mean collaborative working between buyers and suppliers,
joint product development, common systems and shared information. For some
companies such ideas are yet unthinkable and yet the signs are clearly pointing to a
future where it will be the extent and quality of supply chain, integration that will
determine market place performance.
However in many industries the concept of process integration is increasingly
accepted. For e.g. Over the last decade there has been a significant change in the way
many car manufacturers in Western Europe have changed from fragmented, transaction
focused businesses to highly integrated and relation ship based supply chains.
Question 17
LOCATION APPLICATIONS
Plant and distribution center location is a common problem faced by logistics managers.
Increased production economics of scale and reduced transportation cost have focused
attention on distribution centres.
In recent years, location analysis has been further extended to include logistics channel
design as a result of global sourcing and marketing decisions. Global operations
increase logistics channel decision complexity, design alternatives and related logistics
cost.
LOCATION DECISIONS
Location decision focus on selecting the number and location of distribution centres.
Typical management questions: How many distribution centers should the firm use and where should they be
located?
What customers or market areas should be serviced from each distribution
center?
Which product lines should be produced or stopped at each plant or distribution
center?
What logistics channels should be used to source material and serve
international markets?
What combination of public and private distribution facilities should be used?
LOCATION ANALYSIS TECHNIQUES
Location analysis problems are very complex and data intense. Complexities are created
because of the number of locations multiplied by the alternative location sites
multiplied by the stocking strategies for each location. Data intensity is created because
the analysis requires detailed demand and transportation information. The techniques
used are:
54

 Analytic techniques
Optimization or linear programming techniques
Simulation techniques
Analytic techniques: they generally describe methods that identify the center of gravity
of logistics geography. A center of gravity method is appropriate for locating a single
distribution plant or center. A number of methods both mathematical and non
mathematical can be applied to a problem of a single location. The cost and complexity
of the technique is to be matched to the difficulty of the problem.
In the following example technique employed is evolved from analytic geometry.
The model is based on Cartesian co-ordinates, where the horizontal axis is labeled as
the x-axis, and the vertical axis is labeled as the y-axis. The figure below illustrates such
a coordinate system.
Any given point in the quadrant can be identified with reference to x and y coordinates.
Taken together, these co-ordinates define unique points. The figure below illustrates the
x and y co-ordinates of Detroit, Michigan, Columbus, Ohio. The co-ordinates for
Detroit are 3.5 and 3. the co-ordinates of Columbus are 3.8 and 2. the x and y coordinate system can be used to calculate the distance between any two points on the
plane using the Pythagoras theorem.
By use of this basic system of orientation, it is possible to replicate the geographic
market area in which the distribution centre is to be located.
This method to solve the location problem determines the ideal co-ordinate position of
the distribution warehouse on the basis of distance, weight or a combination of both.
The computation is a weighted average of the distance, weight or combined factors,
with the warehouse location as the dependent variable. The algebric solution may use
either the weighted average x and y co-ordinate or the median location. The median
location uses the coordinate location with half the demand on each side. The formulae
of this calculation depend on the independent variables expressed in the location
measure. The problem is in a manner such that identical service standards exist for all
potential distribution warehouse locations. The objectives are to minimize
transportation cost.
Transportation cost are a function of time, weight and distance. Historically, in
mathematical techniques it is not possible to consider all the factors together. The 4
solution methods that consider combination of factors are:ton center solution
mile center solution
ton mile center solution
time ton mile center solution
Ton center solution: the location point represents the center of gravity or movement
in market area. The assumption is that the center of movement represents the least cost
location. In Ton center solution only weight is given consideration. All demand
locations are plotted on the co-ordinate plane and identified by subscripts. To express
tonnage requirements to each demand center, annual tonnage is reduced to standard
units. Once each demand location is defined and the total units load to each demand
center are known, the best warehouse location can be determined.
The location solution is found by adding the products of location and delivery
frequency to each demand center from the x- co-ordinate and dividing the total number
55

of units. The process is requested from the y co-ordinate. The result is a location in
terms of x and y for the distribution warehouse. The final location solution indicates the
point that provides the balance of weight between destinations over a specific period.

X,Y= unknown co-ordinate values of the warehouse.

Xn,Yn= delivery locations, designated by the appropriate script.
Fn= annual tonnage to each destination, expressed as standard trailors.
Mile center solution: this determines the geographical point that minimizes the
combined distance to all demand centers. The assumption underlying the solution is that
delivery costs are solely a function of distance. Therefore, if distance is minimized a
least cost location is determined. The basic deficiency of this omission of weight and
time considerations.
The mile center solution cannot be determined by solving for the weighted average coordinate location along each dimension. It requires a iterative process to detmine an
increasingly improved warehouse location. This optimum location is determined by
utilizing the general formula for the length of a straight line between two points.
The procedure:
The solution uses initial X and Y co-ordinates to initiate an iterative process that refines
the previous mile center warehouse X,Y location co-ordinates. The location problem
is solved when the incremental charges in the co-ordinates are within the acceptable
range of the initial or previous values.
Example: initial values of X and Y are 30 and 40 respectively. The location solution is
obtained by using these values to determine the new warehouse co-ordinates.
New values X=36 and Y=43. The new values indicate a shift, therefore the procedure is
not complete
For next iteration the most recent values are used X=36 and Y=43. If the
iteration results in values X=36 and Y=43 then the difference is minimal or zero, the
problem is optimized.
Tolerance range= +/- 1 mile on X and Y co-ordinates.
Therefore 4 square mile area.
Xk,Yk= co-ordinate values of the warehouse for iteration k.
Xi,Yi= demand point, designated by the appropriate subscript.
di= distance between each demand point (Xi,Yi) and warehouse location for iteration k.
Ton Mile Center Solution: it combines the variables of weight and distance in
selecting warehouse locations. This solution considers the frequency of delivery to each
destination in when selecting a warehouse location. This solution also requires an
iterative process since the distance between demand point and warehouse is included.
Where Yk,Xk= co-ordinate values of the warehouse for iteration k.
Xi,Yi= demand pint designated by the appropriate subscript.
Fi= annual tonnage to each demand point, expressed as standard.
di= distance between each demand point (Xi,Yi) and warehouse location for iteration k.

56

Time Ton Mile Center Solution: it includes all factors influenced by cost. Costs
are a function of time weight and distance. The warehouse site derived as a product of
this solution is a least cost location. The procedure for selecting the solution is iterative
because time and distance factors are differentiated from a given ware house location.
Xk,Yk= unknown co-ordinate value of a warehouse
Fi= annual tonnage to each location expressed as a standard trailers, identified by the
appropriate subscript.
Mi= delivery location differentiated in terms of miles per minute from the initial
warehouse location to each new location until the iterative process is complete.
Mi considers both distance and time to all demand points from the warehouse location
for each iteration.
Mi=dn
tn

=distance
time

FACILITIES LOCATION DECISIONS

Plant location decisions
Managers goal when locating facilities and allocating capacity should be to maximize
the overall profitability of the resulting supply chain network. The following
information must be available before the design decision can be made
Location of supply sources and markets
Location of potential facilities sites
Demand forecast by market
Facility, labor, and material cost by site
Transportation cost between each pair of sites
Inventory cost by site as well as function of quantity
The fundamental trade off managers space when making facilities decision is between
the cost of the number, location and type of facility(efficiency) and the level of
responsiveness that these facilities provide the companys customers (Internal as well as
External)
A firms competitive strategy has a significant impact on network design decisions
within the supply chain. Firms focusing on cost leadership will tend to find the lowest
cost location for their manufacturing facilities even if that means locating very far from
the market they serve.
Firms focusing on responsiveness will tend to locate facilities closer to the market and
may select high-cost location if this choice allows the firm to react quickly to changing
market needs.
Global supply chain networks can best support their strategic objectives with facilities
in different countries playing different roles. For example, Nike has production facilities
located in many countries in Asia. He facilities in China and Indonesia focus on cost
and produce the mass-market, lower-priced shoes for Nike. In contrast, facilities in
Korea and Taiwan focus on responsiveness and produce the higher-priced new designs.
The differentiation allows Nike to satisfy a wide variety of demands in the most
profitable manner.
The following is the classification of possible roles for various facilities in a global
supply chain network.
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Offshore facility-low cost facility for export production: - an offshore facility serves
the role of being a low-cost supply source for markets located outside the country where
the facility is located. The location selected for an offshore facility should have low
labor and other costs to facilitate low-cost production.
Source facility- low cost facility for global production: - A source facility also has
low cost as its primary objective, but its strategic role is broader than that of an off
shore facility. A source is often a primary source of product for the entire global
network. Source facilities tend to be located in places where production costs are
relatively low, infrastructure is well developed, and skilled workforce is available.
Server-facility regional production facility: - A server facilitys objective is to
supply the market where it is located. A server facility is built because of tax incentives,
local content requirement, tariff barriers, or high logistics costs to supply the region
from elsewhere.
Contributor facility- regional production facility with development skills.: - A
contributor facility serves the market where it is located but also assumes responsibility
for product customization, process improvements, product modification or product
development.
Outpost facility- regional production facility built to gain local skill: - An outpost
facility is located primarily to obtain access to knowledge or skills that may exist within
a certain region.. Given its location, it also plays a role of server facility. The primary
objective remains one of being a source of knowledge and skills for the entire network.
Lead facility facility that leads in development and process technologies: a lead
facility creates new products, processes, and technologies for the entire network. Lead
facilities are located in areas with good access to a skilled workforce and technological
resources.
Focused attention on Distribution Center due to increased production, economy of scale
and reduced transportation cost.
Technology wise:
Characteristics of available production technologies have a significant impact on
network design decisions. If production technology displays significant economies of
scale, few high capacity locations are most effective. This is the case in the manufacture
of computer chips, in which factories require a very large investment. As a result, most
companies build few chip production facilities, and each one they build has a very large
capacity.
In contrast, if facilities have lower fixed costs, many local facilities are preferred
because this helps lower transportation costs. For example, bottling plants for coca cola
do not have a very high fixed cost. To reduce transportation cost, coca cola sets up
many bottling plants all over the world, each serving its local market.
Flexibility of production technology affects the degree of consolidation that can be
achieved in the network. If the production technology is very inflexible and product
requirements vary from one country to another, a firm has to set up local facilities to
serve the market in each country. Conversely, if the technology is flexible, it becomes
easier to consolidate manufacturing in a few large facilities.
Transportation wise:

58

The fundamental trade-off for transportation is between the cost of

transporting a given product (efficiency) and the speed with which that product is
transported (responsiveness)
Transportation has a large impact on both responsiveness and efficiency. Faster
transportation, whether in form of different modes of transportation or different
amounts being transported, allows a supply chain to be more responsive but reduces its
efficiency. The type of transportation a company uses also affects the inventory and
facility locations in the supply chain. For example: Dell flies components from Asia
because doing so allows the company to lower the level of inventory it holds. Clearly,
such a practice increases responsiveness but decreases transportation efficiency because
it is more costly than transporting parts by ship.
The role of transportation in a companys competitive strategy figures prominently
when the company is considering the target customers needs. If a firms competitive
strategy targets customers that demand a very high level of responsiveness and that
customer is willing to pay for this responsiveness then a firm can use transportation as
one driver for making the supply chain more responsive. The opposite is true as well. If
a companys competitive strategy targets customers whose main decision criterion is
price, then the company can use transportation to lower the cost of the product at the
expense of responsiveness.
As a company may use both inventory and transportation to increase responsiveness or
efficiency, the optimal decision for the company often means finding the right balance
between the two.
Also,
The companies can gain economies of scale when a product is manufactured or stored
in only one location; this centralization increases efficiency however the cost reduction
comes only at the expense of responsiveness, as many of a companys customer maybe
located far from the production facility. The opposite is also true. Locating facilities
close to customers increases the number of facilities needed and consequently reduces
the efficiency. However, if the customer demands and is willing to pay for the
responsiveness that having numerous facilities adds, then this facilities decision helps
meet the companys competitive strategy goals.
There are also many instances, in which the pricing schedule yield economies of scale,
with prices decreasing as lot size is increased. This form of pricing is very common in
business to business transactions. A discount is lot size based if the pricing schedule
offers discounts based on quantity orders in a single lot. A discount is volume based if
the discount is based on the total quantity purchased over a giver period, regardless of
the number of lots purchased over a given over that period. Two commonly used
discount based schemes are
All units quantity discounts
Marginal unit quantity unit discount or multi block tariffs.
Companies must also decide what a facilitys capacity to perform its intended function
or functions will be. A large amount of excess capacity allows the facility to be very
flexible and to respond to wide swings in the demands placed on it. Excess capacity,
however costs money and therefore can decrease efficiency. A facility with little excess
capacity will likely be more efficient per unit of product it produces then one with a lot
of unused capacity. The high utilization capacity will, however , have difficulty
responding to demand fluctuations. Therefore, a company must take a balanced trade
off to determine the right amount of capacity to have at each of its facilities.

59

Typical decisions of location decisions

Deciding where a company will locate its facilities constitutes a large part of the design
of the supply chain. A basic trade off here is whether to centralize to gain economies of
scale or decentralize to become more responsive by being closer to the customer.
Companies must also consider a host of issues related to various characteristics of the
local areas in which the facility may be situated. These include: Macro economic factors
Strategic factors
Quality of workers
Cost of workers
Cost of facilities
Availability of Infrastructure
Proximity to customers and the rest of the network
Tax effects
Distribution centers- how many and where??????????
When deciding upon locational decision a manager basically decides upon suppliers,
plants, ware houses and markets. There may also be other facilities such as super
stockists, consolidation centers or transit points.
SUPPLIERS

PLANTS

WAREHOUSES

MARKETS

Besides locating the facilities a manager must also decide how market may be allocated
to ware houses and how ware houses will be allocated to plants. The allocation decision
can be altered on a regular basis as different costs change and markets evolve. When
designing the network, both location and allocation decisions are made jointly.
In some cases, companies want to design supply chain networks, in which a market is
supplied from only one factory. This is commonly known as the capacitated plant
location model with single sources. Companies may impose this constraint because it
lower the complexity of coordinating the network and requires less flexibility from each
Facility.
A much more general form of the plant location model needs t be considered if the
entire supply chain network from the supplier to the customer must be designed.
Consider a supply chain in which suppliers send materials to factories that supply ware
houses that supply markets. Location and capacity allocation decision has to be made
for both factories and ware houses. Multiple ware houses may be used to satisfy
demand at a market, the multiple factories may be used to replenish warehouses.

60

Supply chain design decision should be evaluated for a variety of future scenarios that
reflect the underlying uncertainty. Accountings for uncertainty relieve the managers to
built extra capacity in to supply chain network and make the available capacity more
flexible in terms of the markets that can be served. If capacity is flexible, demand can
be reallocated within the supply chain network to react best to changing demand, prices,
costs, and / or exchange rates. If capacity is inflexible, production cannot be changed in
response to change in condition. The presence of flexibility thus increases potential
profits.
Customer / market- to be served from each distribution center.
Firms must consider the response time customers desire when designing their supply
chain methods. Firms that target customers who can tolerate a large response and
require few locations and can focus on increasing the capacity of each location. In
contrast, firms that customers who value short response time need to locate close to
them. These firms must have many facilities, with each location having low capacity.
First, a decrease in the response time customers desire increases the number of facilities
required in the network.
For example customers are unlikely to come to a convenient store if they have to travel
a long distance to get there. It is thus best for a convenient store chain to have many
stores distributed in an area so that most people have convenience stores close to them.
In contrast, customers shop for larger amount at super market and are willing to travel
longer distances to get to one. Thus, super market chains tend to have stores that are
much larger tan convenient stores and not as densely distributed.
If a firm is delivering product to customers, use of rapid means of transportation allows
it to build fewer facilities and still provide a short response time. However, this option
increases transportation cost. Moreover, there are many situations in which the presence
of a facility close to a customer is important. For example a coffee shop is likely to
attract customers who live or work nearby. No faster mode of transport can serve as a
substitute and be used to attract customers that are far away.
Use of logistics channel- for material sources:
The procurement cycle occurs at the manufacturer/supplier interface and
includes all processes necessary to ensure that materials are available for manufacturing
to occur according to schedule. During the procurement cycle, the manufacturer orders
the components from suppliers that replenish the component inventories. The
relationship is quite similar to that between a distributor and manufacturer, with one
significant difference: whereas retailer or distributor orders are triggered by uncertain
customer demand, component orders can be determined precisely once the
manufacturer has decided what the production schedule will be. Component orders are
dependent on the production schedule. Of course, if a suppliers lead times are long, the
supplier has to produce to forecast because the manufacturers production schedule may
not be fixed that far in advance.
In practice, there are several tiers of suppliers, each producing a component for the next
tier. A similar cycle would then flow back from one stage to the next. The processes are
shown as below

PROCUREMENT CYCLE
61

Order based on
manufacturers
production
schedule or

Receiving at
manufacturer

Component manufacturing
and transporting and/or
shipping

Supplier
production
scheduling

A firm can vary supply of product by controlling a combination of the following two
factors:
Production capacity
Inventory
The objective is to maximize profits. Some of the specific approach to managing
capacity and inventory are listed below:
Time flexibility of workforce so as to comfortably utilize the idle or unused space
Use of seasonal workforce so as to meet the sudden shoot in demand and not loose on
the revenue thus generated.
Use of subcontracting so as to acquire an economical way since it works out to be
cheaper.
Use of dual facilities- dedicated and flexible so as to produce at a relatively steady rate
with fluctuations being absorbed by the flexible facility.
Designing product flexibility into the production processes, modification in layout, so
as to meet the sudden demand as well as effectively extract the best possible from all
the resources in an accommodating and flexible manner.
Managing inventory:
Using common components across multiple products, which would facilitate a
relatively constant overall demand.
Build inventory of high demand or predictable demand products, which helps in
synchronization of supply and demand making the utmost and optimum use of seasonal
and off seasonal advantage.

62

Use of Public and Private distribution facilities:

His aspect involves a two-fold consideration
From the transportation point of view
From the warehousing point of view
As can be clearly understood, transportation involves either owning the means of
transport or appointing an agency for transport commonly known as outsourcing of
transportation service. This has to be analyzed considering the long-term benefits, the
cost-benefits, the responsive benefit, and efficiency, comparing the estimated results in
both the cases owned as well as outsourced. Again if the lead time is high, the location
facility if at a greater proximity to the suppliers, and if the cost structure is suitable to
the company the company shall go ahead to establish its own infrastructure to increase
the transportation efficiency. This is mostly the case with companies that practice just in
time method and is affiliated to a reduced inventory system. Similarly, the reason not
many companies owning is its involves huge capital investment, increased
complications, increased labour and the like.
Companies now a day also design their own shapes in the trucks and other means of
transport so as to accommodate maximum in the limited possible space.
A warehouse, may be, privately owned and operated by company making its own
goods. Commonly known as private warehouse. A warehouse may be owned and
operated by another organization, including a government agency, and only used by a
company on certain terms and conditions. Commonly known as public ware house.
Irrespective of whether a warehouse is privately or publicly owned, the following
factors have to be taken into account to work out the cost of storage:
Interest on the cost of buying the site
Interest on the cost of furniture
Cost of repairs and maintenance
Depreciation on building and equipment
Insurance
If productivity (or efficient use) of the warehouse can be increased by 20% there is an
equivalent reduction in costs per unit handled and processed.
There are fixed costs in the shape of the cost of space per square meter or per cubic
meter, which have to be borne, whether or not the warehousing is operating.
Maximum efficiency is obtained by processing a larger number of units through the
warehouse space. The larger the number of processed units, the lower the cost per unit.
There is nothing as a better or the best option but both have their sets of advantages and
disadvantages and a company should critically evaluate all the expenses related and
accordingly decide the better and the most suitable option for itself.
However it is always advised to use a perfect blend of both, private as well as public
warehouses. Also, private warehouses need not be owned, they can be rented or leased
with or without equipment.
Product lines produced at plants, stocked at distribution centers:
Q.17
Product lines- production and Distribution Centres
The tour material in this fig delineates the areas of material handling function and its
tour of duties. Typically, material is handled at the following stages.
63

1. Raw material is transported from the vendor to the warehouse of the production
unit. It is received by trucks, by rail wagon or even by ship. At the warehouse,
the handling of material takes place, and a system is required to be evolved.
Thereafter, the material is stored.
2. At the time the material is required for production process, it is again handled. It
is retrieved and transferred or fed in to the production process.
3. During the production process too, the material is handled in many ways. After
the material has been finally processed and turned in to a finished product, the
finished product is handled and loaded for dispatch by a given mode of transport
to a warehouse or to a dealer.
4. Sometimes, the finished product is packed and directly loaded on to the
transport to vehicle.
5. Sometimes, the material produced at the end of a production process is not the
final finished product but only an intermediate finished product. This
intermediate product is required to be handled and stored to be retrieved again,
whenever required for finishing.
6. Sometimes, the semi-finished product is required to be sent out of the
production unit to another manufacturer. This would require the physical
transport of this intermediate product to the other production unit. In this case,
the product may again be transported back to the production unit for final
processing or storage before dispatch
7. Sometimes, the semi-finished product may be finished in another processing
plant and loaded and dispatched from there.

Finishing
Work at
Another
unit
Vendor

Receipt
Transport

Storage

Productio
n unit

Storage

Customer
Despatch Dealer
Transport Warehouse

Temporary
Storage of
semifinished
Product

8. Assuming that the product has been stored in its final finished form, it has to be
handled before dispatch from the production centre.
9. The goods may be dispatched straight to he customer, in which case the
handling of the product is done by the customer himself as a one-time job. If
dispatches to the customer are regular feature and if specialized handling of
64

goods at the time of delivery is required, suitable arrangements will have to be

made to ensure that handling is good.
10. Sometimes the goods are sent to a retailer or a dealer. In this case, the quantity
of goods dispatched may be larger. If the dispatches are regular and in large
quantities specialized handling may be required. Accordingly, the necessary
arrangements will have to be made.
11. The goods may be dispatched to a field warehouse of the company, or to a
public warehouse, or to the warehouse of a stockiest or distributor. In this case,
they are required to be stored suitably for sometime before they are despatched
to a customer, retailer, or dealer, as the case may be. The alternative requires the
handling of the finished product during its retrieval and despatch to a proper
destination. At the destination the product is handled again.
TOTAL COST ANALYSIS APPROACH
The concept of total cost analysis
Many problems at the operational level in logistics management because all the impacts
of specific decisions, both direct and indirect, are not taken into account throughout the
corporate system. Too often decisions touch in one area can lead to unfortunate results
in the other areas, change in policy on minimum order value, for example, may
influence customer ordering patterns and lead to additional costs. Similarly changes in
production schedules that aim to improve production efficiency may lead to fluctuations
in finished stock availability and thus affect customer service.
A.
The problems associated with identifying with total system impact of
distribution policies are immense. By its very nature logistics cuts across traditional
company organization functions with cost impacts on most of those functions.
B.
Conventional accounting systems do not usually assist in the identification of
these company wide impacts frequently absorbing logistics related costs in other cost
elements.
The cost of processing orders for eg. is an amalgam of specific costs incurred in
different functional areas of the business which generally prove extremely difficult to
bring together.
Figure (1.1) outlines the various cost elements involved in the complete order
processing cycle, each of these elements having a fixed and variable cost component
which will lead to a different total cost per order.

Order placement and

communication.
65

Order Entry

Credit Check

Documentation

Order Pricing

Delivery

Invoicing and Collection

Fig. (1.1)
Stages in the order-to-collection cycle
C.
Accounting practice for budgeting and standard-setting has touched to result in a
compartmentalization of company accounts; thus budgets tend to be set on a functional
basis.
The trouble in that policy costs do not usually configure themselves within the
sense water tight boundaries. It is the nature of logistics that, like a stone thrown into a
pond, the effects of specific policies spread beyond their immediate area of impact.
(2) A. A further feature of logistics decisions which contributes to the complexity of
generating appropriate cost information is that they are usually taken against the
benchmark of an existing system.
The purpose of total cost analysis in this context is to identify the change in costs
brought about by these decisions. Cost must therefore be viewed in incremental terms
the change to the system. Thus the addition of an extra warehouse to the distribution
network will bring about cost changes in transport, inventory investment and
communications.
It is the incremental cost difference between the two options which is the relevant
accounting information for decisions making in this case.

66

Fig. (1.2) shows how total logistics costs can be influenced by the additional, or
removal, of a depot from the system.

Total distribution
costs

Trunking costs

Inventory costs

Outlet costs
Costs

Local Delivery
costs

Order Processing
costs

Number of outlets

Fig (1.2)
The total costs of a distribution network
To understand the demand of measuring logistics, it is necessary to review traditional
accounting methods in terms of analysis requirements and to identify costs relevant to
integral logistical systems.

PUBLIC ACCOUNTING PRACTICE

67

Logistical functions are on integral part of the two main financial reports of
business the balance sheet and the profit and the loss statements (P& L). However, the
primary deficiency in determining logistical costing and analysis in the method by
which standardized accounting costs are identified classified and reported.
The first problem results from the fact that accounting practice aggregates costs on a
standard or natural account basis rather than on an activity basis. The process of
classification and assignment helps but does not satisfy the requirements for total cost
analysis. In reality, many expenses associated with logistical performance cut across
organizational units. For eg. efforts to reduce inventory will reduce inventory carrying
cost, but they may also lead to more back orders, which would increase total
transportation cost. The result is deficient data for integrated performance measurement.
In order to design and evaluate logistical operations, it is necessary to identify costs
associated with performing specific activities or tasks, such as the warehouse expenses
for a specific SKU (stock keeping unit). This means that the individual logistical
activities must be identified and that costs be allocated or assigned.
An overlapping deficiency of accounting involves the traditional methods of reporting
transportation expenditures. It remains a standard practice in retail accounting to deduct
freight from gross margin figure. In part, it seems to be based on the belief that
managers can do little about inbound freight. However, the problem extends beyond
where freight is accounted for and reported. In many purchasing situations, freight is
not reported at all as a specific cost. Many products are purchased on a delivered price
basis, which includes transportation cost.
A final deficiency in traditional accounting practice is the failure to specify and assign
inventory cost.
Full costs associated with the maintenance of the inventory such as insurance and taxes,
are not identified and assigned, thereby resulting in an understatement or obscurity in
reporting inventory cost. For eg.- If a brand manager is not held responsible for his
brands inventory carrying cost, he is not motivated to reduce inventory levels.
The financial burden for assets committed to material, WIP and finished goods
inventory is not identified, measured, and separated from other forms of capital expense
incurred by the enterprise.
LOGISTICS ACTIVITY BASED COSTING
Activity based costing seeks to relate all relevant expenses to the value adding activities
performed. For eg.- costs are assigned to a customer or product to reflect all relevant
activity costs independent of when and where they occur.
The fundamental concept of activity-based costing is that expenses need to be assigned
to the activity that consumes a resource rather than to an organization or budget unit.
For eg.- Two products, produced in the same manufacturing facility, may require
different assembly and handling procedures. One product may need an assembly or
packaging operation that requires additional equipment or labor. If total labor and
equipment costs are allocated to the products on the basis of sales units produced, then
both items will be charged for the additional assembly and packaging operations
required by only one of them. This unjustly reduces the profitability of the simplified
product by forcing that product to pay for the operations it does not need. In a
68

manufacturing sense, identifying and assigning cost factors means that a specific
product will be fully assigned its fair share of all overhead and operating costs.
In the case of logistics, the key event is a customer order and the related activities and
relevant costs that reflect the work required to fulfill the order. Logistical activities
based costing must provide managers the insights needed to determine if a specific
customer, order, product or service is profitable. This requires matching specific
revenue with specific costs.
Effective costing requires identification of he specific expenses to include in an analysis
framework.
A second concern is to specify the relevant cost time frame.
Finally, costs must be allocated or assigned to specific factors that are relevant to
assembly alternative actions.
The guiding criteria for effective logistical activity-based costing are relevancy and
consistency. Relevancy is important in the sense that the cost assignments help
managers to better understand the major factors affecting logistics expenses.
Consistency is important in terms of comparing related activities over time. These
criteria help in the decision making process where logistical activities are concerned.
(5) Cost Identification
To have a representative presentation, all costs associated with the performance of a
logistics function should be included in the activity-based cost classification.
The total costs associated with forecasting and order management,
transportation, inventory, warehousing and packaging must be isolated. Typical logistics
costs can be categorized as:
Direct Costs
Indirect Costs
Overheads
a)
Direct or Operational Costs
Those expenses specifically caused by the performance of logistics work. Such costs are
not difficult to identify.
The direct costs of transportation, warehousing, material handling , and some aspects of
order processing and inventory can be extracted from traditional cost accounts. For eg.the transportation costs for an individual truckload order can be directly attributed to a
specific order. Likewise, only minor difficulty is experienced in isolating the direct
administration cost of logistical operations.
b)
Indirect Expenses
These expenses are more difficult to isolate. Costs associated with indirect factors are
experienced on a more or less fixed basis as a result of allocation of resources to
logistical operations. For eg., the cost of capital invested in real estate, transportation
equipment, and inventory just a few areas within the capital structures of logistics
must be identified to arrive at a comprehension total cost.
The manner by which indirect costs are attributed to logistics activities is determined by
managerial judgments. For eg.- how should the indirect costs, such as equipment,
associated with a warehouse be allocated to the customer order shipped from that
warehouse? One approach is to allocate the overhead costs on the basis of the average
cost per unit.

69

b) i) All capital allocated to the logistical system represents a scarce commodity.

Therefore all expenses paid to support capital investment in logistic operations are
relevant to logistical activity-based costs .The judgments applied in arriving at cost of
capital will greatly influence logistical system design. Thus, procedures and standards
used to calculate indirect logistical costs are critical. They are also essential for potential
outsourcing.
c)
Overheads
A final costing allocation is overhead. An enterprise incurs considerable expenses on
behalf of all organizational units, such as for lighting and heat in various facilities.
Judgement is required to determine how and to what extent various types of overhead
should be allocated to specific activities.
One method is to directly assign total corporate overhead on a uniform basis to all
operational units.
At the other extreme, some firms withhold all overhead allocations to avoid distorting
the ability to measure direct and indirect logistical activity-based costs.
From the viewpoint of effective logistical activity-based costing, it is sound practice not
to allocate any overhead cost that cannot be directly assigned to a logistical activity.
A general rule to follow is that a specific cost should not be assigned to logistical
factors unless it is under the managerial control of the logistical organization. Because
of subjective cost allocation, enterprise in the same industry will report vastly different
logistical expenses. It is important to realize that such cost differentials may have no
direct relationship to the actual efficiency of logistical operations.
Cost Time Frame
A basic concern in logistical activity based costing is to identify the period of time over
which costs are accumulated for measurement.
(1)
Generally accepted accounting principles call for accrual methods to relate
revenues and expenditures to the actual time period during problems can be associated
with establishing logistical activity-based costs.
Expenses associated with raw material procurement through finished product
distribution and almost all other logistical product distribution and almost all other
logistical operating costs are incurred in anticipation of future transactions, making
accrual methods difficult to administer.
(2)
To overcome the time problem, accountants attempt to break costs into two
groups:
a) Costs assigned to a specific product and,
b) Costs associated with the passage of time.
This classification is an attempt made to match appropriate product and time period
costs to specific periods of revenue generation.
(3)
From a logistical perspective, a great many of the expenses associated with
procurement and manufacturing support can be assigned and absorbed into direct
product cost. Thus, because they can be assigned to a specific product, inventories are
valued on the basis of fully allocated cost.
70

Such practices can significantly influence logistical system design, depending

on the characteristics of the business.
(4)
In situations where a considerable period of time elapses between production
and sales, such as in highly seasonal businesses, significant costs of maintaining
inventory and performing logistical operations may not be associated with revenue
generation.
Unless this potential mismatch is clearly understood and accommodated in the
assignment process, logistics can be significantly mismeasured.
(7) Cost Formatting
(1)
The typical way to format activity-based costs is to assign expenses to
the event being managed, for eg.- if the object of analysis is a customer order, then all
costs that result from the associated performance cycle contribute to the total activity
cost. Typical units of analysis in logistical activity-based costing are customer orders,
channels, products and value added services.
In addition to activity-based costing, management may wish to format financial reports
regarding operational measurement and control. Logistical expenses can be presented in
a number of ways for managerial use.
Three common ways are:Functional Grouping,
Allocated Grouping and
FixedVariance Grouping.
Functional Grouping
To format costs by
Functional grouping-requires that all expenditures for direct and indirect logistical
services performed for a specified operating time be formatted and reported by master
and sub-account classification for comparison of one or more operating periods.
No standard format of activity costs or functional groupings is available that fits the
needs of all enterprises.
(i)
Logistical functional cost statements must be designed to facilitate control
within each unique environment.
(ii)
It is important to identify as many cost accounting categories as practical and to
develop a coding system that will facilitate assignment to three cost accounts.
(iii)
Effective total-cost groupings can be maintained over time only if appropriate
coding to reclassify material accounts into functional groups in incorporated in the basic
logistics information system.
Allocated cost formatting or grouping
i) This consists of assigning overall logistical experiences to a measure of physical
performance, for eg.- Total logistical cost can be generated on a per ton, per hundred
weight, per product, per order, or per line-item basis, or on some other physical measure
that is useful for comparative analysis of operating results.
ii) While important for assigning overall expenses to physical performance measures,
this grouping typically has limited use outside logistics management.
Fixed-Variance Grouping

71

i) This is the most useful for identifying the logistics cost implications of current or
alternate operating practices.
ii) This method of formatting consists of assigning costs as either fixed or variable to
appropriate the magnitude of change in operating expenditure that will result from
different volumes of logistical throughput.
iii)Costs that do not directly vary with volume are classified as fixed. In the short run,
these expenses fixed even if volume were reduced to zero.
iv) Costs influenced by volume are classified as variable for eg.- the cost of a delivery
truck is fixed: if the truck costs $40,000 to purchase , the firm is charged $40,000
whether the truck is used for 1 or 1,000 deliveries.
However, gasoline to operate the truck is variable total gasoline costs depend on how
frequently the truck is driven.
The use of fixed and variable cost formatting offers a convenient way to handle
expenses in logistical system design models.
TOTAL COST PRESENTATION
For purposes of implementing and presenting logistical total-cost analysis, it is common
practice to focus on INVENTORY and TRANSPORTATION as the two main network
design factors.
a)
Both inventory and transportation expenses can be defined in a format
sufficiently broad to include activity and functional cost relationships for related
logistical components.
For eg.- communication costs that are associated with order processing and with
expenditures required for warehouse storage and material handling can be classified
under the inventory umbrella.
2)
In terms of inventory, total cost includes all expenses related to inventory
carrying cost and customer ordering.
A
Inventory carrying cost includes taxes ,storage, capital, insurance and
obsolescence.
B
The cost of ordering includes the full expense of inventory control,
order preparation, communications, update activities and managerial supervision.
3)
The total cost of transportation includes for-hire transport expenses and
accessorial charges plus costs related to the hazards incurred with the various modes,
legal forms of transport, and associated administrative expenses. If private
transportation is used, accounts direct, indirect, and overhead costs.
4)
A brief summary of the total cost of logistical activities is presented in Fig. 2
(Table). Classification of costs in terms of inventory or transportation highlights the
basic trade offs that determine the cost justification for logistical network design.
5)
The basic logic for focusing on transportation and inventory as key factors that
they logistical operations.
A
Transportation deals with the geographic (spatial) dimensions of
logistical operations by positioning product where the customer wants to purchase it.
B
Inventory involves the rate at which capital assets are used (temporal)
to meet customer requirements by having product available WHEN the customer wants
to purchase.
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6)
A second justification for focusing on transportation and inventory is that these
two factors include 80 to 90 percent of overall logistics expenses for the typical firm.
7)
The columns on the right side of Fig. 2 (Table) reflect potential activities that
may be used to segment costs for managerial review.
For eg.- an ordering cost can be assigned to a specific order, or it may be
grouped by customer.
If the objective is to determine the expenses associated with any specific level of
de-aggregated activity, it is essential to assign specific costs to the actual targets or
events.
For eg.- if the de-aggregated activity is the ordering cost for one specific
product, the actual expenses for that product alone must be identified.
As noted earlier, the extension of total costs to an activity based format may not meet
public accounting precision. The purpose of activity based costing is to give managers a
better perspective of the total cost, associated with performance of a specific activity.
Total Costs Classified by Inventory and Transportation
ACTIVITY-Based Assignments
Customer Order Product Value-added Service
INVENTORY- related costs
Inventory carrying cost (ICC):
Tax
Storage
Capital
Insurance
Obsolescence
Ordering:
Communication
Processing, including material
handling and packaging
Update activities, including
receiving and date-processing
INVENTORY CONTROL
Management
TRANSPORTATION- related costs
Direct:
Rates
Accessorial charges
Indirct, liability not protected by carrier
Managerial:

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Location Analysis Data Requirements: The primary analysis data requirements are
definitions of markets, products, network, customer demand, transportation rates, and
variable and fixed costs.
Market definition:
Location analysis requires that demand be classified or assigned to a geographic area.
The combination of geographic areas constitutes a logistics service area. Such an area
may be a country or a global region. The demand for each customer is assigned to one
of the market areas. The selection of the market definition method is an extremely
important element of the system design procedure.
A number of market definition structures have been developed. The most useful for
logistics modeling are: County, Standard metropolitan statistical area (SMSA) and ZIP
or postal codes
The major issues for selecting a market definition concern the number of areas required
to provide accurate results. While more market detail increases accuracy, it also
increases analysis efforts. Research indicates that approximately 200 markets offer an
effective trade-off between accuracy and analysis effort.
Product definition: Although individual product flows can be considered when
performing a location analysis, it is usually not necessary to use such detail. Individual
items especially those with similar distribution characteristics, production sites, and
channel arrangements are grouped or simplify the analysis.
Network definition The network definition specifies the channel members, institutions
and possible locations to be included in the analysis. Specific issues concern the
combinations of suppliers, production, locations, distribution centers or channel
member alternatives. While using a more comprehensive definition reduces the chance
of suboptimising logistics system performance, total channel location analysis increases
complexity. Location analysts must evaluate the trade offs between increasing analysis
complexity and improved potential for total supply chain optimization.
Market demand: Market demand defines the shipment volume in each geographic area
defined as a market specifically location analysis is based on the relative product
volume shipped to each market area. While the volume may pertain to the number of
units or cases shipped to each market, most location analyses are based on weight since
transportation cost is strongly influenced by the amount of weight being moved. Market
demand utilized in the analysis may also be based on historical shipments or anticipated
volume if substantial changes are expected.
Transportation rates: Inbound and outbound transportation rates are a major data
requirement for location analysis. Rates must be provided for shipments between
existing and potential distribution channel members and markets. in addition , rates
must be developed for each shipment size and each transportation link between
distribution centers and markets. it is common for location analysis to require in excess
of a million individual rates. Because of the large number rates are commonly
developed using regressions or are retrieved from diskettes provided by most carriers.
Variable and fixed costs: The final location analysis data requirements are the variable
and fixed costs associated with operating distribution facilities. Variable costs include
expenses related to labour, energy. Utilities and materials. in general, variable expenses
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are a function of throughput. Fixed cost includes expenses related to facilities,

equipment and supervisory management. Within a relevant distribution facility
operating range, fixed costs remain relatively constant. While variable and fixed cost
difference by geography is typically not substantial there are minor locational
considerations that should be included to ensure analysis accuracy. the major
differences result from locational peculiarities in wage rates, energy cost, land values
and taxes.
Conclusion: substantial logistics planning emphasis is placed on location analysis. in
the past distribution networks were relatively stable, so it was unnecessary for firms to
compete system analyses regularly. However the dynamics of alternative distribution
channel options, changing logistics cost structures and availability of third party
services require that logistics networks be evaluated and refined more frequently today.
It is common for firms to perform evaluations annually or monthly.
Total cost-analysis:
The basic integrative concept in logistical network design is total cost. An example
illustrated a total cost justification for using high cost airfreight. The basic thesis was
that in situations where the speed and dependability of air delivery would permit other
costs (such as warehousing and inventory) to be reduced or eliminated, high cost
premium transportation would be justified by achievement of lower total cost. Total cost
could be reduced by careful integration of logistical activities.
The basic concept of total cost is simple and complements the notion of designing
logistics as an integrated performance system. The main problem in operationalizing
total cost is that traditional accounting practice for classifying and reporting critical
expenses does not typically provide adequate logistics metrics.
Public accounting practice:
The two main financial reports of business enterprises are the balance sheet and the
profit and loss statements (P&L). The purpose of the balance sheet is to summarize
assets and liabilities and to indicate the net worth of ownership. The P&L statement
reflects the revenue costs associated with the specific operations over a specific period
of time. As the name profit and loss implies, its purpose is to determine the financial
success of operations.
These two are mainly suited for investors, taxation and auditing purposes and not for
logistical purposes

The first problem results from the fact that accounting practices aggregates cost
on a standard or natural account basis rather on activity basis. The practice of
grouping expenses into natural accounts such as salaries, rent, utilities and
depreciation fails to identify or assign the operations responsibility .In reality
many expenses, associated with logistical performance cut across organizational
units. For example efforts to reduce inventory will reduce inventory-carrying
costs, but they may lead to back-orders, which would increase the total
transportation cost.
The practice of classifying the costs on a natural basis also creates a problem in
activity-based cost analysis. In order to design and evaluate logistical operations
it is necessary to identify costs associated with performing specific activities or
tasks, such as the warehousing expenses for a specific SKU. This means that the
individual logistics must be allocated or assigned.
75

Transportation expenses- Freight is not accounted for. Many products are

purchased on a delivery price basis, which includes transportation cost.
Failure to assign inventory costs
Finances committed to Raw materials, WIP, Finished goods not carefully
separated from other capital expenses.

Activity-Based Costing:
Activity-based costing seeks to relate all relevant expenses to the value adding activities
performed. For example, costs are assigned to a customer or product to reflect all
relevant activity cost independent of when and where they occur. The fundamental
concept of activity-based costing is that expenses need to be assigned to the activity that
consumes a resource rather than to an organizational or budget unit. For example, 2
products produced in the same manufacturing facility, may require different assembling
and handling procedures. One product may need an assembly or packaging operations
that requires additional equipment or labor. If total equipment and labor costs are
allocated to the products on the basis of sales or units produced than both items will be
charged for the additional assembly and packaging operations required by only one of
them.
In case of logistics, the key event is a customer order and related activities and relevant
costs that reflect the work required to fulfill the order In other words, logistical activitybased costing must provide managers the insights needed to determine if a specific
customer, product, order, or service is profitable. This requires matching specific
revenue with specific costs. The guiding criteria for effective logistical activity-based
costing are relevancy and consistency. Relevancy is important in the sense that the costs
assignment helps managers to better understand the major factors affecting logistics
expenses. Consistency is important in terms of comparing related activities over time.
In the final analysis, a logistical costing system has to make sense only to the managers
who are using it as a guide to decision making.
(I) Cost Identification:
All costs associated with the performance of logistics function should be in the activitybased classification. The total cost associated with fore casting and order management,
transportation, inventory, warehousing, packaging must be isolated. Typical logistics
costs can be categorized under two headings direct and indirect costs, cost of capital
and overheads.

a) Direct Costs:
These costs are those expenses specifically caused by the performance of logistics
work. Such costs are difficult to identify. For example, the transportation costs for an
individual truckload order can be directly attributed to a specific order. Likewise only
minor difficulty is experienced in isolating the direct administration cost of logistical
operations.

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b) Indirect Costs:
These are more difficult to isolate. For example, the cost of capital invested in real
estate, transportation equipment, and inventory- just a few of the areas within the capital
structure of logistics- must be identified to arrive at a comprehensive total cost. The
manner by which total costs are attributed to logistics activities are determined by
managerial judgments. One approach is to allocate the overhead cost on the basis of the
average cost per unit.
All expense paid to support capital investment in logistical operations are relevant to
activity-based costs. The judgment applied in arriving at cost of capital will greatly
influence logistical system design. Thus procedures and standards used to calculate
indirect logistical costs are critical. They are also essential for potential outsourcing.
c) Cost of Capital :
Capital investment Expenses for logistical activities are relevant to logistical activitybased costs. Cost of such capital also needs to be included in your logistical cost.

d) Overhead
An enterprise incurs considerable expenses on behalf of all organizational units, such as
for light and heat in various facilities. Judgement is required to determine how and to
what extent various types of overhead should be allocated to specific activities. One
method is to directly assign total corporate overhead on a uniform basis to all
operational units. At the other extreme, some firms withhold all overhead allocations to
avoid distorting the ability to measure direct and indirect logistical activity- based costs.
(II) Cost Time Frame
A basic concern in logistical activity-based costing is to identify the period of time over
which costs are accumulated for measurement. Accounting principles call for accrual
methods to relate revenues and expenditure to the actual time period during which
services are performed. Expenses associated to raw material procurement through
finished product distribution and almost all other logistical operating costs are incurred
in anticipation of future transactions, making accrual methods difficult to administer.
To overcome the time problem, accountants attempt to break costs into 2 groups- costs
assigned to a specific product and costs associated with the passage of time. Using this
classification an attempt is made to match the appropriate product and time period costs
to specific periods of revenue generation. From a logistical perspective, a great many of
the expenses associated with procurement and manufacturing support can be assigned
and absorbed into direct product cost.
In situations where a considerable period of time elapses between
production and sales, such as in highly seasonal businesses, significant costs of
maintaining inventory and performing logistical operations may not be associated with
revenue generation.
(III) Cost Formatting

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The typical way to format activity-based costs is to assign expenses to the event being
managed. For example, the object of analysis is a customer order, than all costs that
result from the associated performance cycle contribute to the total activity cost. Typical
units of analysis in logical activity- based costing are customer orders, channels,
products and value added services. The cost analysis will vary depending on which
analysis unit is selected for observation Logistical expenses can be presented in a
number of ways for managerial use. Three common ways are
Functional grouping,
Allocated grouping, and
Fixed variance grouping.

A) Functional Grouping:
To format costs by functional grouping requires that all expenditures for direct and
indirect logistical services performed for a specified operating time be formatted and
reported by master and sub account classifications. Thus ,a total cost statement can be
constructed for comparison of one or more operating periods .It is important to identify
as many cost accounting categories as practical and to develop a coding system that will
facilitate assignments to these cost accounts.

B) Allocated Costs Grouping:

This consists of assigning overall logistical expenditures to a measure of physical
performance. For example, total logistical cost can be generated on a per ton, per
product, per order, or on some other physical measure that is useful for comparative
analysis of operating results.

C) Fixed Variance Grouping:

This is the most useful for identifying the logistics cost implications of current or
alternative operating practices. This method of formatting consists of assigning costs as
either fixed or variable to approximate the magnitude of change in operating
expenditure that will result from different volumes of logistical throughput. Costs that
do not directly vary with volume are classified as fixed. In the short run, these expenses
would remain if volume were reduced to zero. Costs influenced by volume are
classified as variable. For example, the cost of a delivery truck is fixed, however
gasoline to operate the truck is variable.

Total Cost Presentation:

It is the common practice to focus on inventory and transportation as the two main
network design factors, which are sufficiently broad to include activity and functional
cost relationships.
In terms of inventory, total cost includes all expenses related to inventory carrying cost
and customer ordering. Inventory carrying cost includes all taxes, storage; capital,
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insurance and obsolescence .The cost of ordering includes the full expense of inventory
control, order preparation, communications, update activities and managerial
supervision.
The total cost of transportation includes for hire transport expenses and accessories
charges plus costs related to the hazards incurred with the various modes, legal forms of
transport, and associated administrative expenses.
The basic logic for focusing on transportation and inventory, as key factors are that they
represent the spatial and temporal dimensions of logistical operations. Transportation
deals with the geographical (spatial) dimensions of logistical operations by positioning
the product where the customer wants to purchase. Inventory involves the rate at which
capital assets are used (temporal) to meet customer requirements by having product
available when the customer wants to purchase.

Logistical Measurement
The combination of slower economic growth and increased competition has forced
firms in every industry to concentrate on efficient and effective deployment of logistical
resources. On result of these efforts has been the emergence of a new corporate position
devoted to logistical controllership. The logistics controller is concerned with
continuous measurement of a firms performance. In order to carry out the measurement
process controllership focuses on the assessment of resource deployment and goal
attainment.
Dimensions of Performance Measurement
Substantial effort has been expended to improve the quality of information that logistics
managers have at their disposal to measure, compare and guide logistical performance.
In most firms old reporting formats need to be redesigned to take advantage of new
computer based control systems. In place of traditional status and trend reports, todays
managers require flexible and on demand ad hock report.
Objectives
The three objectives for developing and implementing performance measurement
systems include monitoring, controlling and directing logistics operations.
Monitoring measures track historical logistics system performance for reporting to
management and customers. Typical monitoring measures include service level and
logistic cost components.
Controlling measures track ongoing performance and are used to refine a logistics
process in order to bring it into compliance when it exceeds control standards. An
example of a control application is transportation damage tracking. If a system is in
place to periodically report product damage, logistics management can identify the
cause and adjust the packaging of loading process as needed.
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Directing measures are designed to motivate personnel. Typical examples include pay
for performance practices used to encourage warehouse of transportation personnel to
achieve higher levels of productivity. Specifically consider warehouse material handlers
of delivery drivers who are paid for eight hours of work based on standard production
rates. If the material handlers can complete the assigned tasks in less than the allotted
time, they are allowed personal or unassigned time. On the other hand if they require
more than the allotted time, the disincentive is that they are not compensated for the
additional time. In some cases employees are actually given a bonus when the task is
completed in less than the allotted time. When such directed measures are used it is
important that both positive and negative performance be measured.
For example the completion of an assigned task such as order selection in less than the
standard time must be traded off against increased errors or damage.
Typical Logistics Activity Based Measures
1.
2.
3.
4.
5.
6.
7.
8.

Order Entry time per order

Delivery time per order
Order selection time per order
Inquiry time per order
Order entry time per customer
Order selection time per customer\delivery time per customer]
Order selection time per product
Delivery time per product

Perspective
The appropriate management perspective must be evaluated and determined. The
continuum of possibilities ranges from all activity based measures to entirely process
based measures.
Activity based measures focus on individual tasks required to process and ship orders.
Examples include customer orders entered, cases received from suppliers, cases shipped
to customers. These measures record the level of activity and in some instances the
level of productivity.
While activity based measures focus on the efficiency and effectiveness of primary
work efforts they do not usually measure the performance of the overall process of
satisfying customers. For example order takers who are judged on the number of calls
per hour may be rated high with respect to activity based measurement may do poorly
in the overall satisfaction process because they fail to take the time to listen carefully to
customers. For this reason it is important that some performance measures taken an
overall process perspective.

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Process based measures consider the customer satisfaction delivered by the entire
supply chain. They examine total performance cycle time or total service quality, both
of which measure the collective effectiveness of all activities required to satisfy
customers. Todays firms are paying more attention on process measures while trying
not to sub optimize individual activities. The Perfect Order is an increasingly common
process measure.

Internal Performance Measurement

Internal performance measures focus on comparing activities and processes to previous
operations and/or goals. For example, customer service might be compared to last
periods actual performance as well as to this periods goal. Research suggests that
logistics performance measures can generally be classified into these categories:
1. Cost.
2. Customer service.
3. Productivity.
4. Asset management.
5. Quality.
COST: The most direct reflection of logistics performance is the actual cost incurred to
accomplish specific operating objectives. Logistics cost performance is typically
measured in terms of rupees, as a percentage of sales, or as a cost per unit of volume.
CUSTOMER SERVICE: These measures examine a firms relative ability to satisfy
customers.
PRODUCTIVITY MEASURES: It is unclear whether it is the most important or even
necessarily a critical measure of performance for all systems.
Productivity is a relationship (usually a ratio or an index) between output (goods/or
services) produced and quantities of inputs (resources) utilized by the system to produce
that output. Thus it is a very simple concept. If a system has clearly measurable outputs
and identifiable, measurable inputs that can be matched to the appropriate outputs,
productivity measurement is routine. However, it can be difficult and frustrating if (1)
outputs are hard to measure and input utilization is difficult to match up for a given
period of time, (2) input and output mix or type constantly changes, or (3) data are
difficult to obtain or unavailable.
There are 3 types of productivity measures: 1. Static: - if all the output and input in a given system are included in the
productivity equation, it would be a total factor static productivity ratio. It is
considered static because it is based on only one measurement.
2. Dynamic: - It is completed across time. If outputs and inputs in a system
compare static productivity ratios from one period to another, the result is a
dynamic productivity index, for example:

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Outputs 1994/inputs 1994

Outputs 1990/inputs 1994
3. Surrogate: - This represents factors that are not typically included in the concepts of
productivity but are highly correlated with it (customer satisfaction, profits,
effectiveness, quality, efficiency, etc.). Most managers operationalize productivity in
this manner.
ASSET MEASUREMENT: Focuses on the utilization of capital investments in
facilities and equipment as well as working capital application to inventory to achieve
logistics goals. Logistics facilities, equipment, and inventory can represent a substantial
segment of a firms assets. In the case of wholesalers, the amount exceeds 90 %. It
measures focus on how fast liquid assets such as inventory turnover as well as how
well fixed assets generates return on investments.
QUALITY: Quality measures, which are the most process-oriented evaluations, are
designed to determine the effectiveness of a series of activities rather than an individual
activity. However quality is usually difficult to measure because of its broad scope.
A contemporary measurement concept that is increasing in interest is the perfect
order. Delivery of the perfect order is the ultimate measure of quality in logistics
operations, that is, the perfect order concerns the effectiveness of the overall integrated
logistical firm performance rather than individual functions. It measures whether an
order processes smoothly through every step order entry, credit clearance, inventory
availability, accurate picking, on-time delivery, correct invoicing and payment without
deducting- of the order management process without fault, be it expediting, exception
processing, or manual intervention.
The perfect order represents ideal performance. From an operational perspective a
multi-industry consortium defines the perfect order as one that meets all the following
standards
1. Complete delivery of all items requested
2. Delivery to customers request date with one-day tolerance
3. Complete and accurate documentation supporting the order, including packing
slips, bills of lading and invoices and
4. Perfect condition that is faultlessly installed, correct configuration, customerready with no damage.
However there are many roadblocks to achieving such a level of success. Today the best
logistics organizations report achieving a 55 to 60 perfected perfect order performance,
while most organizations report less than 20 per percent.
External Performance Measurement
While internal measures are important for detailed organizational monitoring, external
performance measures are also necessary to monitor, understand and maintain a focused
customer perspective and to gain innovative insights from other industries. The topics
of customer perception measurement and best practice benchmarking, which address
these requirements, are discussed and illustrated below.
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Customer Perception Measurement

To succeed in any activities of business one has to always cater to and satisfy the needs
of the customer. To do so, it is essential for one to know how the customer thinks in
order to meet his needs in a more satisfying manner. Therefore, an important component
of leading edge logistical performance is the regular measurement of customer
perceptions. Such measures can be obtained through surveys or by systematic order
follow up. These surveys can be company - or industry sponsored.
Such surveys ask questions regarding the firms and the competitors performance in
general or for a specific order in particular. Most of the surveys incorporates
measurement of customer perceptions regarding availability, performance-cycle time,
information availability, problem resolution and product support. The survey may be
developed and administered by the firm itself or by consultants, delivery agents or
industry organizations.
Conclusion
Internal performance measures focus on the activities required to serve customers.
Measurement of these activities, as well as comparison with goals and standards, is
necessary to improve performance and motivate and reward employees. Cost
measurement is the minimum component of any performance measurement system.
More sophisticated firms incorporate customer service, asset management and
productivity measurement. While such measures generally monitor internal process
efficiency, they do not examine external process effectiveness very well, particularly
from the customers viewpoint. The quality measures applied today by the most
sophisticated logistics organizations offer such an external perspective. While the
individual internal measures discussed above offer a broad performance evaluation,
they do not provide an integrated point of view. For example many customers desire
high performance regarding both service and quality.
Best Practice Benchmarking:
Benchmarking
companies are
those of both
Benchmarking
operations.

is a critical aspect of comprehensive performance measurement. Many

adopting benchmarking as a technique to compare their operations to
competitors and leading firms in related and non-related industries.
is also used in important strategic areas as a tool to calibrate logistics

Most of the firms use the following types of Benchmarking tools:

1. Published Logistics Data: This method uses existing data that are published in
various periodicals and university researchers. This method of data is easily
obtainable and is cheaper to obtain. But the information got in this means is
normally too general and may not be tailor-made for the firms exact problems.
Since this information is available in public, it does not offer a real competitive
advantage.
2. Benchmark against noncompetitive firms: In this method a noncompetitive
firm in the related industry is benchmarked. This is done by studying and
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reviewing the other firms measures, practices and processes to develop insights
that will improve performance. The firm that is chosen to benchmark might be
in the same industry but will be operating in a different market.
3. Alliance of Organisations: In this method, an alliance is formed between two
organizations that systematically share benchmark data on a regular basis. These
kinds of alliances require more effort to maintain but usually provide
substantially better information than the preceding two methods.
Strategic Factors
The key strategic factor to consider during the make-versus-buy decision is
performance capability. The decision to outsource involves evaluating which supplier is
the most capable of performing the service at a best practice level. This requires an
evaluation of potential outsource services in terms of their contribution to a firms core
and noncore activities. Typically a firm will not want to run the risk of diluting core
competencies by having external firms perform isolated, highly sensitive activities.
Once a firm has isolated those activities that are core supportive the balance of
required activities or the noncore requirements become outsource candidates.
The most difficult step for most firms is to identify which activities are critical core
capabilities. The outsourcing decision should not be limited to asset investment.
Instead, it must center on capabilities provided or achieved through the asset
investment. If the capabilities achieved by performing activities internally do not
extend an enterprises core competencies, then such activities should be outsourced.
The desirability of outsourcing is based in part on the benefits of specialization. If
required service can be improved or an enterprise can reduce its overall investment or
operating requirements, then outsourcing is an attractive alternative.
Make-versus-buy decisions involve trade-off analysis among economic and strategic
factors. A large portion of such analysis examines cost to service elements.
Outsourcing is easily justified if visible costs decrease and service improves, as long as
other economic and strategic requirements are satisfied. Specialization can result in
economies of scale enabling simultaneous achievement of reduced cost and improved
service.
Economic Factors
Oliver Williamson examined economic factors in terms of transaction costs. These
costs are those expenses associated with performing a specific activity. The
fundamental Williamson proposition was that free market allocation would result in a
balance of internal sourcing and outsourcing that would minimize the transaction cost.
Outsourcing creates a situation where external firms can behave opportunistically at the
expense of their customer. Service provider withholding poor performance information
to ensure its operational success. Such information withholding could result in a major
problem for the service providers customers.
If only a few companies exist with capability to perform the required logistics service,
One that approximates monopoly power replaces the ideal free or competitive market.
This situation is further complicated if the requested logistics service require transaction
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specific assets such as dedicated trucks, buildings or wok forces. In the event of
cancellation, such customized assets may not be easily transferred to other customers.
Transaction cost analysis suggests that logistics activities be performed internally if the
transaction costs are lower than expenses associated with outsourcing. Internal costs
are usually lower when (1) only a few potential third-party suppliers are available for
outsourcing, (2) transaction- specific assets are required, or (3) various suppliers of such
services are in a position to take advantage of the transaction setting.
The trade-offs depend on which party is best positioned to achieve i.e. best
economies of scale. For example, when considering outsourcing or owning a
warehouse, volume is a critical factor. Suppose the product requiring storage follows an
erratic demand pattern. On average, 25000 units need to be stored to meet monthly
requirements. However, peak storage demand requires 50,000 units, while the lowest
point of seasonality requires only 5,000. If a privately owned warehouse is used, it must
have the capacity to hold 50,000 units. When demand justifies only 5,000 units storage,
the warehouse would be operating at approximately 10 percent of capacity (5000/50000
= 10percent capacity). Under such utilization, fixed, overhead, labour and managerial
expenses would be spread over so few units that the cost per unit would be very high.
On the other hand, outsourcing to a public warehouse could result in standard
per unit cost that is independent of month-to-month storage requirements.
When outsourcing is outsourced, customer typically negotiates a rate that
requires it to pay only for space used. Therefore, the price is the same per unit whether
the firm stores 5,000 or 50,000 units. If the price per square foot is $1.50 and a unit
takes up 2 square fees, the total charge per unit is $3.00, regardless of the total no of
units stored. The level of rate typically charged would reflect average utilization as
contrasted to either a minimum or maximum.
Alternative opportunity cost of capital is one such expense involved in
outsourcing. A private trucking fleet requires substantial equipment investment. To
fully evaluate outsourcing, an enterprise should consider alternative uses of the capital
that would be invested in a private fleet of trucks. For example, the same amount of
money could be used to increase manufacturing capacity, improve logistics facilities, or
expand other aspects of the business. The enterprise must determine which types of
investment offer the best long-term advantage.
Another consideration is cost associated with obsolescence. Firms investment in
technologies, which can become obsolete before the enterprise can fully amortize the
cost. In such case, technology may not have paid for itself in productivity and
efficiency before it must be replaced. Outsourcing logistics activities means that third
party service provider is responsible for technology investments, and this reduces the
risk of obsolescence. Because of high volume usage, service providers will amortize
cost of technology investment before they become obsolete. Furthermore the service
provider is forced to update technology, to maintain attractiveness to their customer
base.
Final important consideration in outsourcing is related to labour. When moving from
internal to external performance of logistic, the labour requirements and management
responsibilities of the customer will be reduced or shifted to service supplier. This shift
affects cost like early retirement, layoffs, reassignment morale, productivity unionization
and retaining. And while moving to logistical service in-house from a third party
provider, hiring, training, internal labour shifts and implementation time are the key
considerations that may serve to limit flexibility
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