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Operations Management: Analysis and

Improvement Methods Module 3 Supply Chain
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Contents
Lesson 3-1 What is a Supply Chain?
Lesson 3-1.1 What is a Supply Chain? (part 1)
Lesson 3-2 Sourcing Decisions

Lesson 3-2.1 Sourcing Decisions (part 1)
Lesson 3-3 Bullwhip Effect

Lesson 3-3.1 Bullwhip Effect
Lesson 3-1
Introduction - Slide 1
In this lesson, using the example of coffee, we will study
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What are supply chains?

What is involved in managing them?
Transcript
In this lesson, we are going to look at supply chains, and to do this, we're going to use the example of
coffee. So, we're going to look at what a supply chain is, and what is involved in managing such supply
chains. Most of us when we drink coffee, we don't think too hard about where the coffee comes from
other than knowing that it comes from our favorite coffee place, which could be a chain or could be a
very specialized coffee shop that only you and a few friends are aware of. But if you try to think back at
where did this coffee actually come from, we have to sort of go back to the source. Where is it grown?
A Map of Coffee Growing Countries - Slide 2
A Map of Coffee Growing Countries by Robusta, Arabica
Transcript
Now, coffee is a plant that originated in Ethiopia and thrives primarily in the tropical and subtropical
regions. So, therefore, expectedly, most of the coffee production happens in countries in those latitudes.
Brazil for example, is the biggest grower of coffee followed by Vietnam. Then, as you see in the picture,
there are large number of countries which grow coffee in those latitudes. There are two main kinds of
coffee that are grown. One is called Robusta, it's the coffee that's used for probably, making the instant
coffees. It tends to be a little bit more bitter, and is considered slightly a lower quality of coffee. The
more popular and the more common coffee is the coffee Arabica. The Arabica is essentially the one that
you find in gourmet stores, and is generally the coffee that most of us like to consume in the United
States. Now, some countries grow Arabica exclusively. Some countries only grow Robusta, and many
countries grow both. Coffee is very finicky. Coffee depends a lot on the soil, the temperature, the
elevation at which it is grown, and so there are a number of reasons why certain countries are more able
to grow coffee than other countries.
Annual Per Capita Coffee Consumption, 2008 - Slide 3
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A map of annual per capita coffee consumption (2008).
Transcript
Contrast that with where coffee is actually consumed, and what you notice is that, the heaviest
consumption of coffee actually happens in the higher latitudes. These are the countries of Western
Europe, Canada, the US, Russia, even where people tend to drink a lot of coffee. You could argue, of
course, that they drink more coffee, A, because they have winters which are longer, and you need
something to keep you awake, and B, it's colder out there, so a warm cup of coffee is actually something
that you look forward to in the cold temperature. For a variety of reasons, coffee, because of where it
grows, gets grown in one set of countries, and where it's consumed is a different set of countries. So,
now this coffee from where it is grown has to be transported to where it is consumed, and that essentially
means that we have to have a way to supply from the production side to the consumption side, and doing
that a supplier requires what we call the supply chain.
Your Morning Coffee - Slide 4
Your Morning Coffee
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Transcript
Let's take a step back and say, "What does it mean to take coffee, the product that is grown in this
tropical countries, and what is it that we get as the final product?"
The Coffee Process - Slide 5
How Coffee Works
1. Growing
2. Picking
3. Processing
4. Milling
5. Roasting
6. Packing
7. Shipping
8. Grinding
9. Brewing
10. Drinking
Transcript
The national Coffee Association has a list of 10 steps that coffee has to go through. Obviously, the first
step is where coffee is produced, and we talked about where it actually is produced, that at the tropical
countries. Once that coffee is grown, that coffee has to be picked. Coffee is a very, very finicky product,
and so more often than not, because of the elevations at which it is grown, because of the delicate nature
of the plants themselves, coffee is often hand-picked. There is a new development of having automated
picking of coffee using machines which are beater bars that beat the bushes causing the coffee beans to
drop, and they collect coffee beans that way. Once coffee is picked, by the way, I should also mention
that there is a third way that coffee is collected.
The Most Expensive Coffee - Slide 6
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An image of civets (animal)
Transcript
The most expensive coffee in the world actually is a coffee which is picked by animals called civets, and
they eat the bean, and then when they excrete, they excrete the fruit and digest the bulk of the fruit, and
then they excrete the bean, and then that bean is picked out, and that's some of the most expensive coffee
in the world. There are reasons why, that is, because the civet only eats the best beans, and the acids in
the civet's stomach actually make small changes to the bean, which is why the coffee becomes
extremely, intensely flavored.
The Coffee Process - Slide 7
This slide shows the same information as Slide 5 The Coffee Process
Transcript
Nonetheless, after the beans are picked, they have to be processed, which means the pulp has to be
removed, so there are a couple of different processes to do that. There's a wet process, and there's a dry
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process. The dry process is where you dry the beans, and then try to get rid of the pulp part of the fruit.
The wet process is where you ferment the bean, and then try to wash off the fermented pulp, so there's
the processing step. That processing step is then followed by milling step, where there is a parchment
layer on the bean which has to be removed. At that stage, you get what are called green beans. Green
beans are what are usually exported by most producing countries. Those green beans are imported then,
and then either large multinational companies or small boutique firms take those green beans, and then
they go through a process called roasting where the beans are roasted. Roasting is a very intense process,
it needs to be carefully monitored. Lots of variables have to be considered, and the flavor that you get
from your coffee actually comes from the roasting process. Once the beans are roasted, you have a
choice. They can either be packaged right away as beans, or they can be ground, and then packaged. So,
you have roast and ground coffee, and you have roast beans. The roast beans obviously are then to be
grounded by the consumer. So, once packaging is done, we have to go through a process of shipping.
Once shipping is done, we have to go through a process where, either the consumer brews the coffee or
you go to a coffee house or a coffee shop, and a barista brews the coffee. So, that's the brewing process,
which also is critical in developing the taste of coffee. Then there is the final step of actually consuming
the coffee. So, that's the coffee process in 10 steps. Now, as you can think about discovery process, there
are several parts of it that could be done at multiple locations.
Coffee Supply Chain Schematic - Slide 8
In this figure, coffee supply chain schematic for Germany is shown as a flow chart. It shows all the steps
involved in supply chain of coffee starting from where it grows to its consumption. On the left there is
country where coffee is produced and on the right, there is country where coffee is consumed. The chart
starts from left of the diagram with Plantations of coffee which are in producer country. Big plantations
can directly sell the coffee to Importers or Roasters in the Germany while Small Holders can be a part of
Growers Association or they can sell it to Local Traders. Local Traders can then sell it to a Sales Agent
in Germany which then sell it to Importers or directly to Roasters. It is also shown that Small Holders
and their Growers Association can also sell directly to Roasters in Germany. After roasting, coffee is
sent out to in-home consumption or out-of-home consumption. In-home consumption consists of three
sources retail outlets which are supermarkets, specialized shops and web shops. Out of home
consumption consists of two sources outlets which are coffee shops and restaurants.
Transcript
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So, let's look at the coffee supply chain schematic for a country like Germany. So, if you look at the
diagram, on the left, you have the country where the coffee originates, it's the producing country. This
may be large plantations or this may be small holder plantation, this might be small coffee plantations. If
it's a large plantation, they may be large enough that they can ship directly via an importer into Germany.
If it's a small holder, then the small holders may be part of a cooperative or an association which collects
from a bunch of small holders or the small holder may sell to a trader. Either the trader or the Coffee
Association will then sell to a sales agent who may then sell to an importer. Then, that coffee either
which comes directly from the plantation through an importer or through a number of different
intermediaries to the importer. May then go to a company, a large company like say Nestle, who may
then be the roster. So, they're taking the coffee beans and then they roast the coffee. This roosted coffee
is then either sent out for consumptions in home which means it has to go through a number of
supermarkets. So, there might be retail chains or there might be specialized coffee shops or there might
be web sales of this coffee. There's a particular brand of coffee that I like that comes from Brazil which
takes a very torturous route to come to me. Because I have to order it on a website and it only ships to
Brazil, so I have to ship it to a friend in Brazil and then somebody has to pick it and bring it for me
whenever they go to Brazil. So, it gets complicated on how things actually reach the consumer. So,
either it can reach a in-home consumer or it can be for out of home consumption, at a coffee shop or a
restaurant or an office and so on. So, if you think in terms of something as simple as coffee, it goes
through a number of different steps. As it goes through a number of different steps, one has to ask some
questions. For example, when we look at the picture that we have put up, the coffee green beans are
created and those green beans are shipped to Germany where they are roasted. Could the roasting not
have been done in the producing country? Or why did we ship green beans? Why didn't we ship the
coffee cherries or the coffee fruit and then do all the rest of the processing in German? So, even though
there's a set of steps that we have identified and even though in this particular case, we see that there's a
particular way that work has been segmented between the producing country and the consuming country,
we still have to ask the question why was it done one way or the other? So, part of learning about supply
chains is asking these questions.
Interesting Facts - Slide 9
Roasted coffee exports 2013
Value (Billion $) Volume (tons)
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Value (Billion $) Volume (tons)

Switzerland 1.98 47908
Italy 1.33 146356
Germany 1.13 183232
United States 0.77 92677
France 0.6 18264
Belgium 0.42 45503
Canada 0.36 34468
UK 0.3 19016
Poland 0.28 50377
Netherlands 0.25 41198
Slovakia 0.17 31858
Sweden 0.16 22870
(Excludes decaffeinated)
Transcript
Let me show you the interesting fact that many of the countries which were high consumers in Northern
Europe, actually are also exporters of coffee. A country like Germany that we just talked about imports
green beans, but it also exports green beans. If you look at the exports of coffee, you notice that
Germany exports 183,232 tons of coffee. Switzerland, tiny Switzerland exports 47,000 almost 48,000
tons of coffee. In terms of the value of the coffee that is exported, Switzerland happens to be number
one. Close to $2 billion of coffee being exported by Switzerland. Now, why is this? So, what happens in
these countries, for example, we mentioned Germany. Germany imports green beans and German coffee
is well known. So, Germany is able to export the green beans because people who know that the German
companies who import green beans look for quality green beans. So, they know that they can get quality
green beans from those companies in Germany. So, the companies import green beans for local
consumption, but they also export some of the green beans. Because there is a value that has been added
to the bean by the simple association of the name of the company which imported those green beans.
Knowing that they take care of quality, the value of the green bean is higher. Switzerland does
something very different. The primary exporter in Switzerland is Nestle. Nestle makes the little
Nespresso cups. These are extracted coffee and they are then shipped out to the rest of the world. Now,
when you take coffee green beans and created extracted coffee, you add tremendous value because those
tiny coffee cups are fairly expensive. So, a tremendous amount of value gets added which is why
Switzerland even if it is not the largest exporter in terms of volume out of Europe, has the highest value
for the coffee that it exports. This begs the question still as to why a lot of this is not done in the
producing countries? I alluded to the reason when we talked about Germany. Because oftentimes, if
things are produced in an African country, people are not sure that they can get the quality. So, they
prefer to work through an intermediary country like Germany where the company in Germany makes
sure that the quality is good and then they can send it out. There's also partly a historical reason why
supply chains for coffee are the way they are. In that, the producers were often in colonized countries
and the colonial powers were able to then buy these products and then convert them into value-added
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products and that relationship has continued. Because of the credibility associated with the companies in
some of those Western European countries.
Interesting Facts - Slide 10
The flow of coffee beans around the world in 2012
Total exports (not roasted & not decaffeinated): $23.4 billion.
Exported (unit: billion USD) Brazil: $5.7, Vietnam: $3.4, Ethiopia: $1.2, Peru: $1.0, Honduras: $1.4,
Uganda: $0.37, India: $0.61, Indonesia: $1.2, Colombia: $1.9, El Salvador: $0.30, Guatemala: $0.96,
Mexico: $0.66, Nicaragua: $0.52, and Costa Rica: $0.42
Imported (unit: billion USD) Germany: $3.9, Italy: $1.7, US: $5.5, and Switzerland: $0.63
Transcript
So, here's an interesting diagram which shows what happens to coffee that's exported from many of the
exporting countries and where does it go. So, if you look in this particular case, Germany which is a big
importer of coffee, we said also it exports coffee, remember? But Germany which is a big importer of
coffee imports mostly from Brazil and Vietnam. It imports some quantities from other countries and it
then uses that to process. Now, the coffee that comes out of Vietnam is often robusta. So, that is used for
instant coffees. So, these are extracted coffees and then the rest of it which is the arabica, is used for
roasted and roast and ground. There are some times where people blend robusta and arabica to make a
blend of coffee which has more slightly bitter flavors or more robust flavors. But it's interesting to see
where the coffee comes from and how then it gets channeled to other countries.
Different Views - Slide 11
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Sourcing
Logistics
Contracts
Sustainability/social aspects
Risk/finance
Transcript
So as we talked about coffee, just looking at the coffee, we can think of several things that one must
consider. We have to consider about, what is the source of the coffee? Where is it produced? What's the
best place for us to source this? Why should a company in Germany source part of their coffee from
Brazil, part of it from Vietnam, part of it from Africa? How do you decide where to source your
product? Having sourced the product, notice that we are talking about global trade now. How do I move
this product? As I think in terms of moving this product, how do I think of what information I need to
make this possible? How do I know the coffee that I'm getting is the coffee that I bought in Africa? How
do I know that the quality of coffee is good? How do I know what the crop is going to be like in the
producing country so I can plan as an importing company, I can plan for purchasing this coffee? So
there's a lot of different information that I need to be aware of. I need to make contracts with my
suppliers. I need to make sure that when I make this contract, that these contracts are enforceable. And
that if things go wrong, I'm insured against damage. So, as I think about my supply chain, I have to
worry about all these different things. Increasingly, I have to worry about sustainability. Is my practice
of obtaining this particular product sustainable? Am I in the danger of running out of this product? Is
this something that I can consume now and the product will still be available for future generations to
consume, or is this that I'm going to use up all this? So I have to start thinking in terms of sustainability.
And lastly, I need to start thinking in terms of risk. What happens, for example, If my supplier goes
bankrupt? What happens if the ship that I was bringing this particular product in runs into a storm? What
happens if the currency rate changes? What happens if there is political unrest? So as I think in terms of
this whole process by which I bring products from where it is produced to where it is consumed, I have
to have very different views of my supply chain.
Sourcing - Slide 12
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Country of origin
Location
Cost of production
Value addition
Customs, taxes, and restrictions
Transcript
So let's talk about one of them. When I talk about sourcing, I may have to worry about the country of
origin. The country of origin may dictate the quality that I can expect, may dictate the variability in that
quality that I can expect. I have to worry about where the location of this country is because that's going
to affect the cost of transportations. I have to worry about how much does it cost me to produce in that
particular country. We are talking coffee, but remember, everything that we've said can be extended to
any other product. So I might be worried about labor costs. So as I think in terms of sourcing, I have to
worry about the labor costs. Labor cost depend on labor availability. I have to now worry labor
availability. I have to think in terms of sourcing product, that when I source this product, at what level of
completion do I want to source this product? Do I take the coffee cherries, the fruit? Do I take them after
the pulp is removed? Do I take them after the husk is removed, or do I allow it to be roasted and then
take the product? At what point do I do value addition? Because this is a very critical thing that affects
how I decide the sourcing country. So Germany, for example, if you import green coffee beans, you
don't pay any tax on them. But if you import roasted, you pay a 9% tax on it. Taxation becomes an
important issue, so I have to worry about tax regimes in the producing country, in the consuming
country. I have to worry about customs, I have to worry about other kinds of restrictions. I have to worry
about whether there are trade embargoes against a particular country. I have to worry about sanctions on
particular countries and particular companies. So I have to worry about all of these as I think in terms of
sourcing. We've all heard about conflict diamonds. These are diamonds that come from certain regions
of Africa where there is conflict and where militia are causing lots of problems and creating human
rights violations who tried to sell diamonds. And so to avoid buying those diamonds so that those
militias are not enriched, we have a restriction on buying conflict diamonds. So if I was in the diamond
trade, I have to worry about which country are they coming from, how do I guarantee that this product,
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which otherwise is indistinguishable, how do I make sure that it didn't come from one of those
countries? So as a supply chain person, I need to worry about sourcing and those kinds of issues that
don't seem to be sort of obvious when you first think about it. Having sourced a product, having decided
where I will purchase the product,
Logistics - Slide 13
Transportation: Land and sea
Storage: Private / public
Transcript
now I have to think in terms of transportation. Do I move this product by land or do I move it by sea?
Increasingly, we move the product by air shipment. Many expensive products that are small but high
value are airshipped, because it's a lot cheaper to airship than to have a larger amount of expensive
product take weeks to be transported by sea. So I have to worry about the transportation. I have to worry
about intermediate storage of the product. Depending on where I store the product, my tax consequences
could be different. So I have to worry about, do I store it in the country that produced it? Do I pull it out
of the country immediately and then store it? I have to worry about whether I have my own storage,
storage that I own. Or do I go into the public storage area where there are third parties which have
storage facilities and I can keep my product there? So not only do I have to worry about transportation, I
have to worry about the storage of the product at intermediate locations. Now, if I'm doing all of this, I
don't own the shipping company, I don't own the storage company, I obviously may not own the
producer.
Contracts (1 of 2) - Slide 14
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What needs to specified?
Quality, quantity, shipping period

Delivery commitments
Shipping methods
Payment conditions
Parties involved
Transcript
So now, as I deal with each one of them, I need to worry about contracts with these different
intermediaries, these different companies that I'm dealing with. What should my contract specify? Well,
some obvious things I might want to specify is I might want to specify the quality of the product. I might
want to specify how much of the product, and I might want to specify the time at which I want the
product. But then I may have more specific requirements. I might want delivery to occur in specific time
vendors. I might want to make delivery commitments which tell me that the product that I received will
have certain quality. So that has to be specified. I may have to specify the shipping method. Either I have
to take care of the shipping myself or I have to tell my supplier this is how we are going to ship.
Companies, large companies like Walmart are very particular about how products are shipped. To their
warehouses by their suppliers. Why, because poorly package product, product that comes in without
advance notice to Walmart, messes up Walmart's process in the warehouse. So, as a supply chain person,
I have to worry about how shipping is going to be done, how packaging is going to be done. Obviously
that all has to be specified in the contract to make sure that my suppliers are the counter party in my
contract knows exactly what is expected of them. I would have to specify the payment conditions, when
are they going to get paid? Is it going to be 30 days after the product is received? Is it going to be 60
days after the product is received? So I have to have the payment conditions, do I pay lump sum? Do I
pay something in advance? All those issues have to negotiated. I may have to involve 3rd parties such as
banks, insurers, etc. To make sure that this contract goes as promised. So that if there is any problem that
arises, there are these third parties that will take some of this risk away from me or are they actually
making the payments.
Contracts (2 of 2) - Slide 15
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Standard Contracts: European Coffee Federation (ECF) / Green Coffee Association (GCA)
Incoterms: International Commercial Terms
Transcript
So I have to worry about all these issues as I think in terms of contracts. Now, beyond the things I need
to specify in the contract, one of the things I find is that I do this on a routine basis. I don't go out and
buy coffee only once. I buy coffee regularly, I buy it from many different suppliers and so if I have to
have a contract, and if each company wants to buy such a contract have to negotiate terms separately
every time it becomes very difficult. So, it has become common to have what are called standard
contracts. So, in the case of coffee there is an ECF or an European Coffee Federation contract. For North
America, primarily for the US, there's the Green Coffee Association standard contract. The green here is
not as in sustainable, the green here is because there's green beans. So you're talking about the green
coffee. So these two are fairly standard contracts and so instead of having to specify everything for each
contract separately, we use a standard contract. We still have to negotiate price, we still have to specify
certain things about delivery period, etc. But every possible term of the contract does not have to be
specified because this is a standard contract. It's a pro forma contract. Similar to the standard contract,
there's a contract that extends more generally, it's called the Incoterms or International Commercial
Terms. And this contract is used for all different kinds of products, and it specifies whether the supplier
is going to be responsible for part of the shipment or who's going to specify how the product is going to
be shipped and so on. And so this is called incoterms and so now not do I have contract, I have a very
specific forms of this contract that I can use to make my transaction with my courter part parties
somewhat easier. And this becomes part of understanding what supply chains are. Increasingly now, I
have to worry about other issues.
Social Aspects - Slide 16
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Sustainability
Fair trade
Labor practices
Organic
Transcript
We are now worried about sustainability. With coffee, we worry about the fact that maybe rain forests
are being cut down to help coffee plantations. And that may not be good for our environment. So one of
the things we may be concerned about is our coffee being grown in a sustainable fashion? And, so there
companies and associations that assure us that the coffee that comes to us has been produced in a
sustainable fashion. We worry about fair trade. Are the people who are growing our coffee, are they
getting sufficient compensation for their efforts, or is the intermediary siphoning off most of the value of
that particular product? So we worry about fair trade. Part of the worrying about fair trade are the labor
practices that are used. So we don't want to have slave labor for example, picking our coffee. We don't
want to have child labor for example. So we have to worry about these kinds of issues when we think in
terms of supply chains. And lately we are now worried about whether our coffee is organically grown.
So there's this whole movement about having organic coffee. And so how does one make sure that the
coffee we're getting is indeed organic? So that's another social aspect of a supply chain that we have to
concerned with.
Risk - Slide 17
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Physical or security
Quality
Price
Macroeconomic
Performance
Transcript
We talked about risk, what kinds of risk are these? Well, obviously, there's the risk to the product, there's
a physical risk to the product, or the product getting damaged. If I'm bringing coffee beans in, if the
coffee beans are damaged or if mold grows on the coffee beans, that's a problem for me. So I have to
worry about the physical condition of the product. I have to worry about the security of the product.
What prevents someone from stealing my product as it's being transported? So there are these risks?
We've all heard of piracy. And we've all heard of companies having to pay ransoms for ships that pirates
have captured. So there's a risk now that is a security risk that I have to be concerned in my supply
chain. I have to worry about quality. So when somebody buys coffee from let's say Brazil. So a company
in Germany buys coffee from Brazil, they want to make sure that the coffee that they are getting is the
right quality. So even now, with all the different systems that we have put in place, the company will ask
for a sample to be sent. They take the sample, the roast it, they make coffee out of it, and then they taste
the coffee to figure out if the coffee was any good. Now, once they have tasted the coffee, they say yes,
this is the coffee that I'm willing to buy. When the coffee is shipped and received by the company. They
check it again to make sure that what the received was exactly the same as what they were promised. So
there is still this process that has to be followed to make sure that the quality is right. Now what happens
if the quality that we receive is not the same? Who takes responsibility for this eventuality? Does the
company that bought the coffee have to pay for this now, or does the company that supplied? Who pays
for the transportation where the transportation company just had nothing else to do with it that would
ship, and so a cost was incurred. Who pays for that cost? So I have worry about quality risk. I clearly
have to worry about price, fluctuations in price, because if I buy a product now, do I buy it now, do I buy
it later? So I have to worry about price. Fluctuations when I worry about supply chains. I also have to
worry about macroeconomic issues. The fact that currency Values change between countries is a risk.
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All coffee, because of the fact that the US consumes, is the largest consumer of coffee, all coffee
transactions are done in US dollars. I find a company in Europe, I will put Euros. So if the value of the
US dollar changes, it changes what it actually costs me to buy the product. So I have to worry about
macroeconomic issues. And then finally, I have to worry about performance issues, the performance of
the counterparters that are involved in my supply chain. My suppliers, my transporters, my warehouse
operators, what if they don't do what they are supposed to do? So I have performances that I have to
worry about.
Finance - Slide 18
Letters of credit
Banking intermediaries
Risk and insurance
Hedging and futures
Transcript
Now, if that wasn't bad enough, I also have to worry about how do I finance on my operations? And so I
have to worry about obtaining letters of credit. I have to figure out who the banking intermediaries are,
who are going to provide these letters of credit. I need to have working capital to be able to buy things,
who do I borrow things from? I have to worry about risk, and I have to buy insurance to protect me
against that risk. And so I have to worry about dealing with insurance companies. And because coffee is
a commodity, I would worry of about hedging against suppliers uncertainities, demand uncertainties.
Pricing uncertainties, fluctuations in exchange rates, problems with changes in tax structures in different
countries, so I have to worry about that. And there's a whole futures market that I have to worry about,
where I have to trade for coffee futures. And all of that affects my supply chain, because oftentimes
when I trade for coffee futures, I end up having to buy and transport coffee from a location that I did not
originally intend to buy it from. And so there's a lots of different issues that I have to worry about as I
think about my supply chain.
What is Supply Chain Management? - Slide 19
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Active management of intra-firm activities
Maximize customer value
Achieve sustainable competitive advantage
Transcript
So now that we have looked at the coffee supply chain, it's good to sort of step back. We looked at one
particular product and a product which even though the taste is very complex, coffee, as you may know,
is considered the second most complex taste product consumed by man. The most complex is barbecue
meat, so it's a complex tasting product. For the overall supply chain is not as complex as they supply
chain for many other different products. So what do we mean by a supply chain? Essentially a supply
chain is a set of firms and intermediaries who are bringing things from raw material to the final product.
And accordingly when you talk about supply chain management, what we're looking at is the active
management of the activities that happened between these forms. So all the intra-firm activities that
occur, we are worried about how they will occur. We worry about how things are going to be moved
physically from one form to the other. We worry about how information to facilitate that movement is
going to occur. We worry about how cash is going to flow between the forms. We worry about how we
are going to make sure that the forms that are talking to each other in the supply chain are working with
each other in the supply chain. How they are going to be held accountable for whatever it is that they are
supposed to be doing? Now we do all of this in the hope of maximizing customer value. We would like
to add as much value as possible to the product without increasing or adding too much cost to be able to
achieve this value. And the final goal as a supply chain or as a company in the supply chain, is that in
this valuation process, that we do it in a sustainable form. So that we have a competitive advantage or
our competitors in the market. And the way we get this competitive advantage is to create the most value
at the lowest cost.
Layers of the Supply Chain - Slide 20
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Logistics—physical movement of goods
Information—shared and private information
Financial—cash flow through the supply chain
Governance—nature of contracts binding the supply chain
Transcript
Another way to think about supply chains is to think about it in layers. This is similar to looking at the
different views of the supply chain. The only difference is that we are now going to separate out the
physical aspects of the supply chain from the information aspects, etc. At the basis level that we can
look at the supply chain is the logistical layer of the supply chain. This involves the physical movement
of goods between companies. And so often times, the study of logistics is confused with the study of
supply chains. But logistics is just one part of the supply chain. We also have to worry about the
information network that has to be created so that the supply chain can work efficiently. What
information should be shared within the different parties or the different companies involved in the
supply chain? Which of this information should be shared? What information should not be shared?
What should be kept private? We have to figure out those issues when we think in terms of the supply
chain. What are the consequences of not sharing some of this information in the supply chain? And we'll
talk about one such consequence later on. We then can look at the financial layer of the supply chain, we
can look at the cash flow through the supply chain. For some people, the supply chain, the main concern
is the cash flow, cash to cash cycle. When do I invest cash in it? When do I get my returns back? And
that might be the only thing that I might be interested looking at my supply chain. But that's not the only
part of the supply chain as we've looked at so far. And finally, we are to look at the governance of the
supply chain. And what do we mean by the governance? We want to look at what kinds of contracts are
being signed between companies, so that the supply chain holds together. So that we can have a
sustainable supply chain. When do we need contracts? When are those contracts not adequate? And if
these contracts are not adequate, when do we stop buying things from someone and start making them
ourselves? So we have to think in terms of this governance layer. So we can think of this in those four
layers, the logistics layer, the information layer, the financial layer and then the governance. And then
obviously, there's interplay between these layers because nothing in logistics works without information.
As you try to do financial layer and look at cash flows, we still need information sharing to do that.
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Governance requires us to have knowledge of the financial structure of the supply chain. It also needs us
to have knowledge about how information is going to be shared, so the parties can do their work. And
finally, the governance manages the logistics as well. So all this layers, even though we are looking at
them or talking about them as four different layers, they are interconnected. And the central connection
across the different functions that allow supply chains to work well. This is what makes supply chains
more interesting and complex and difficult to manage. This is why we need to study supply chains. So
what we have seen so far, is that we have multiple forms involved in this process. They our locator
globally, they are not collocated so that it's easier to communicate. And we have to worry about all kinds
of details to make sure that we can have a functioning supply chain for any given product.
Lesson 3-2 Sourcing Decisions

In this lesson, you will learn about strategic considerations associated with sourcing decisions.
Transcript
In this lesson, you will learn about sourcing and strategic considerations associated with sourcing.
Why do Supply Chains Exist? (1 of 2) - Slide 22
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Why not have one single firm that controls the whole process from raw material to final product?
The vertically integrated firm
Transcript
So the question is why do supply chains exist at all? Why not have one single firm that controls the
entire process from raw material to the final part? This is what is famously called the vertically
integrated firm. And so the question that one has to ask is since there is profit to be made in every step of
the process, why is it not best for a single entity to control all the steps of production?
Why do Supply Chains Exists? (2 of 2) - Slide 23
Lack of expertise/competence
Lower costs
Resource constraints
Transcript
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Now obviously, for any product if you ask this people will have fairly obvious reasons why you may not
want to do this. For one, you may not have the expertise to do some of the tasks. So for example, if I'm
making cell phones, I might be great at electronics, but I may not know how to make glass. And so it
makes sense for me to go and get glass from someone else who knows how to make glass. So I may not
have expertise, or I might be able to do it, but I am not very good at it. I don't have the competence. And
so for me to do something might be too expensive. And so that may be another reason why I don't do it.
So it's possible that someone else is able to do it at a lower cost. Now why might they be able to do it at
a lower cost? Well, they're in a different area where labor costs are lower. Or they make tons of it so they
have economy of scale, and that's why they can make it at a lower cost. It could be that I don't have
enough capacity. Maybe I'm multi-talented. Maybe I have competence. Maybe I have expertise in
everything. But I just don't have enough time or capacity to do this, and so I have to get it from
somebody else. So it's fairly obvious that there could be lots and lots of fairly simple and logical reasons
why we may want to get things from other people.
Outsourcing Risks - Slide 24
Dependence on suppliers
Loss of flexibility
Loss of core activities
Intellectual Property (IP) loss
Supplier financial risk
Transcript
But there's a problem. The minute I decide to rely on somebody else, I set myself up with certain risks.
So for example, I rely on the glass manufacturer to provide the glass that goes on my cell phone. Now
what if my glass manufacturer is late in providing me the glass? Now my product is late because I don't
get deliveries on time. What if the glass manufacturer goes bankrupt. So by sourcing product from
someone else, now I've exposed myself to a risk. I lose some amount of flexibility when I outsource. I
now have to try and match my schedule against the schedule of my supplier. So the mere fact that I'm
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outsourcing now restricts me in certain ways. Now it's possible that the main problem with creating a
cell phone is that you need to have to right kind of glass. So by going to a supplier for glass, it might
now be easier for the supplier to realize, hey, I am making the main component. Why don't I just make
the product? So in a sense, making of glass might be the core activity, for a cellphone it's very important
thing. But it is not a core activity. But it could be and so loss of that core activity to a supplier would
mean that I lose my entire business. Sometimes, I have to rely on a supplier because of capacity
constraints. And when I do that I have to share information with them. Having this information allows
that supplier now to be able to make the product. This is what's called intellectual property. It's hard to
pass on information to someone and then expect that they will not try to use it for their own benefit. So
this loss of intellectual property is a big concern when I decide to outsource to suppliers. And then,
finally there are the typical risk, the financial risk that's involved because the supplier now is an external
party on whom I'm relying. And the supplier is not financially sound then I expose myself to a financial
risk as well. So there are a number of different risks that I find myself exposed to now, now that I've
decided to get something from a third party. In fact, this is one of the main concerns why many
companies are worried about outsourcing parts of their operation to other companies. So the question
obviously one has to ask is when does it make sense to outsource and when does it make sense to do
things yourself?
Transaction Cost Economics - Slide 25
An economic theory that seeks to explain how a firm should be organized based on the attributes of the
transactions it undertakes
Oliver E. Williamson (Nobel Prize winner 2009)
Transcript
And for the longest period of time it wasn't very clear why we organize ourselves in this particular
fashion. Where we have suppliers and then we have buyers, which are two separate entities. And they
trade with each other instead of just being one vertically integrated firm. And Oliver Williamson in the
late 70s and early 80s came up with this theory called transaction cost economics. This is an economic
theory that tries to explain how a firm should be organized based on the transactions that it has to
undertake. When does it make sense to do certain things in house and be vertically integrated, when does
it make sense to actually outsource? And if you do outsource, what kinds of precautions do you have to
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take? This theory has been so powerful that it earned Professor Williamson a Nobel Prize in 2009. So
transaction cost economics looks at three attributes of every transaction.
Transaction Characteristics - Slide 26
Frequency of Transaction
Asset Specificity: Specialized investments made by one or both parties to enable the transaction
Uncertainty: The inability of one of both parties to predict the environment or each others behavior
Transcript
It looks at the frequency of the transaction. How often is this transaction made? It looks at what it calls
asset specificity. So to do any particular transaction, you need certain skills, certain technologies, certain
equipment, certain personnel. How specialized are these things that make these transaction possible?
Both parties to a transaction bring something to the table in terms of these assets. How specific are these
assets to this specific transaction? So for example, if I go to a woodsmith somebody who makes wood
products. And I asked them to make a round bar of wood. Lots of people require round bars of woods, so
the woodsmith has equipment that they use to make round bars. But lots of people require it. So my
specific transaction of buying this thing from the woodsmith does not require the specific asset. On the
other hand, if I want to order from this woodsmith, the same round wood bar with an extremely high
level of polish on it. And that requires the woodsmith now to have very specialized equipment that
nobody else requires for their round bars. Now there's a very specific asset that the woodsmith has to
buy. And now this transaction requires a very specific asset. And so given that now I have a very specific
asset that's required, my transaction is very different than when I was looking at buying just a simple
word bar with no special finishing. So the specificity of the asset becomes very important. But this
wouldn't matter as much were it not for the third characteristic of the transaction which is the uncertainty
that's involved. And what do we mean by uncertainty? Now, when we think of uncertainty, there are
obviously environmental uncertainties that might exist. For example, it could be that the work that my
woodsmith gets, the quality of that work could be uncertain. Sometimes it's good quality, but sometimes
it's bad quality. It's possible that the woodsmith gets busy certain times, and so the woodsmith is late in
delivering the product to me. So there are uncertainties involved with that, but there are also other
uncertainties. For example, the woodsmith when he has to buy this particular product which puts this
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high finish on the rod that I'm buying. The woodsmith now has to wonder I'm going to invest in this
particular equipment it's going to cost me a lot, it's only specific to this one particular customer. What is
to say that this customer won't turn around and stop ordering from me and I'm left with this equipment?
So the woodsmith has no way of knowing or predicting the behavior of the buyer. Ultimately, it could be
that this piece that I'm buying from the woodsmith is a very important part to a larger project that I'm
doing. And now I have to worry whether the woodsmith is going to hold me ransom. The woodsmith
knows that the woodsmith is the only one with this particular asset and there is no one else with this
particular asset. And so they're the only ones who can provide me with this thing. And so what is to
prevent them from holding me ransom when they try to deliver the product and say no, you gotta pay
more for my product. So there's an uncertainty that's created. And the fact that this uncertainty may or
may not be resolved changes how we think about our transaction. Now of the three things that we looked
at, the three attributes, the one that is considered the most important is asset specificity. And the reason
for it is that it creates this unique imbalance in the transaction. And so we talk a little bit more about that.
But when we think about this transaction now with its three different attributes, we have to start thinking
in terms of well, why does this matter? Well, it matters because now, whenever we make a transaction,
there's a cost associated with making this transaction. So when I buy the piece of wood from the
woodsmith, the cost of the wood is just one of the cost associated with buying this particular product.
There are other costs now associated with this transaction. I want to find a woodsmith who has the
capability to produce that fine finish on this roll that I'm going to be buying.
Transaction Costs - Slide 27
Apart from the cost of items or services, transactions involve other costs:
Identifying suppliers
Informational cost of finding prices, quality, durability
Transportation costs
Legal costs
Insurance costs
Transcript
So there's a cost associated with identifying the right suppliers. I may have costs associate with finding
what is the right price I ought to be paying for this particular product? I may have to specify what the
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right quality I need to check whether that quality is actually provided. I may have to worry about the
durability of the product that is being given to me. There are other costs that are the transportation costs
associated with moving that product from the woodsmith to my factory or my facility. There are legal
costs because soon as I decide to do this, I have to sign the contract, to sign the contract I need to get
some legal representation. So there's a cost associated with creating a contract to take care of the fact
that the woodsmith may not be able to provide me the things in time that may cause severe damage to
my business. I may need to ensure against the eventuality that this uncertainty doesn't actually
materialize and so now I have insurance costs. So the simple transaction that we were looking at has a
lot of different costs that are now associated with it. To do our business so that we can add value without
significantly adding cost, we have to look at what is the best way to organize ourselves so that these
transaction costs are minimized. And that's what we talk about in transaction costs economics.
Transaction Cost Economics (1 of 3) - Slide 28
A graph of transaction cost. The y-axis is by asset specificity from low to high. The x-axis is by
uncertainty from low to high.
Transcript
So let's look at the decision we have to make of whether we should actually go to a wordsmith and buy
this thing from the wordsmith or buy the equipment and put it in the house and then make this particular
product ourself. And to do this, we'll look at two of those attributes; the frequency attribute we'll talk
about briefly but the more important ones are the asset specificity and uncertainty. So, on this graph that
we have right now, let's put the x-axis as being the amount of uncertainty and the y-axis as being the
asset specificity. So, we can have low uncertainty on the x-axis and high uncertainty. So, on the left we
have low uncertainty, on the right we have high uncertainty. And on the y-axis with assets specificity,
similarly at the bottom we have low uncertainty and at the top we have high uncertainty. Now, if you
take the case where asset specificity is low and uncertainty is low. In this case, there is no real reason
why there's any benefit for us making this part up in-house. Giving it to a supplier who might be able to
do it at lower cost may be perfectly a reasonable thing to do because the cost of doing this transaction is
relatively low. The supplier already has the ability to make this. They don't need to buy a very
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specialized equipment to make this product and I don't have to worry about them feeling me very much
so that the actual cost of making this transaction is very small, it's almost frictionless and now if the
supplier is able to provide this product to me at a lower cost, there is no reason for me to make it. And
so, the obvious choice is to buy. Let's go to the other extreme, and let's say asset specificity is very high
and the uncertainty is very high as well. So what do we mean by this? So, let's say that I am going to
have this product manufactured in a third country. The supplier in that country would have to be given
quite detailed information about my product to actually make this particular product. So, I'm bringing
some intellectual property to this part of this product to this transaction. This intellectual property is
specific to my product. So there is high asset specificity, the intellectual property here is the asset that I
am concerned with. Now, let's say that this third country that I'm looking at, this supplier country, has
very poorly developed legal system. So that even if I sign a contract with the supplier that says that they
cannot use my information for anything else other than for making my product, I have no way of
enforcing the contract because I don't know whether the courts will uphold my contract or whether they
won't. So now, I have very high uncertainty. In this case, I'm bringing very specific assets to the
transaction and I have a high amount of uncertainty. Clearly, asking this supplier in this country to make
it for me would be a very risky proposition and the chances are that I might lose my intellectual
property. In this case, even if it is possible that the supplier is able to supply this thing to me cheaply, I
might prefer to make it in the house. In fact, I should prefer to make it in the house because there's a
very good chance that I might lose everything in this transaction because of the higher asset specificity
and the high amount of uncertainty that's part of this transaction. So at the two extremes, the answer is
relatively clear. From a strategic point of view, if asset specificity is low and uncertainty is low, I ought
to buy. If asset specificity is high and uncertainty is high, I have to make.
Transaction cost economics is explained through a simple two-dimensional graph. On the x-axis there is
uncertainty and, on the y-axis, there is asset specificity. A two headed block angled 45 degree on x-axis
is shown in the middle of the graph. Next to the top arrowhead, which represents high uncertainty and
high asset specificity, it is appropriate to “Make”; and at the lower arrowhead, which represents low
uncertainty and low asset specificity, it is appropriate to “Buy”. The block arrow connecting the two
ends has Supply Partnerships is written on the arrow. It shows that if uncertainty and asset specificity are
lower, company will prefer to buy and if uncertainty and asset specificity are higher then company will
prefer to make and in between buy and make, there will be supply partnerships.
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Transcript
In between, there's a continuum where what does it mean to be low and high in any case? These are sort
of arbitrary things that we are talking about of something being low and something being high. Most
companies are able to figure out what kind of risk are they exposing themselves in each of these
situations. And so, what happens is that for the pop things in between, we have to come up with different
kinds of supply partnerships. We have to look at what might be the best way to deal with this? What
kind of contract might have to be signed if I want to actually get a supplier to provide me with this
product? Okay. So we've kind of looked at the diagonal but let's look at the other colors. What happens,
for example, if I have high asset specificity, but uncertainty is low. So for example, I bring intellectual
property to the transaction and have a supplier make it. But the supplier is at the country with strongly
developed legal system. So that now if I sign a contract with the supplier, I can actually enforce that
contract. So that if the supplier decides to break the contract and use my asset for something else, use my
intellectual property for something else, I can actually take them to court and make them pay. Now
clearly, there's a cost associated with this transaction, but it may be possible that I can still do this
because the supplier is able to provide me things at a much lower cost and so I need protection from the
supplier using my intellectual property but the uncertainty is low because I know any protection that I
get which involve the cost is enforceable. Now lastly, what happens if I have, I go to the last column and
I say what happens if my asset specificity is low and my uncertainty is high? Now, in this case, a lot
depends.
This slide shows the same information as Slide 29 Transaction Cost Economics (2 of 3).
When asset specificity is high but uncertainty is low, supply partnership needs protection, strong
contracts.
When asset specificity is low but uncertainty is high, supply partnership becomes "depends"
Transcript
It depends on how many suppliers that are in the market. It depends on how important this product is for
me. It might depend on is this a new technology that I'm going to be developing that can be used in the
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future and might become important to me in the future. Is it something that I'm experimenting with?
Because notice that the fact that its low asset specificity means that neither party to the transaction is
bringing anything that needs to be protected against the uncertainty. And so at that point, there are a
variety of different choices that we may make. It's not clear whether we should buy or make and it might
depend on the circumstances. Let's try and take this transaction cost economics theory and see how it
applies to our make or buy decision.
The Make or Buy Decision - Slide 31
The Make or Buy Decision Table - Slide 31

Make Outsource
Business/environment is
Allows product or service
unattractive
differentiation
Non-critical end product
Strategy Synergies across business
Stable/dependable supply market
Hostile supply market
Suppliers are capable and
Need to push technology envelope
innovative
Few suppliers Holdup risk is manageable

Market risks Low switching costs
Risks
Need for quick response Short lead times
Intellectual Property No IP risks
Internal cost advantage Supplier has lower cost

Economic
Recent process investment Major investment required
Factors
Significant skills/expertise Weak in-house skills
Transcript
So when we decide whether we want to make or buy a product, we have to look at it from three
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perspectives. There's a strategic perspective that we have to take, which basically looks at the overall or
the overarching importance of this decision to our enterprise. We have to look at the risks that might be
involved and then finally, we have to look at economic considerations when we decide whether we're
going to do this or not. Now, if I have a process or a product or service that I'm looking at either
outsourcing or doing in house, if this particular product or service allows me to differentiate my product
or service in the market, then outsourcing it may not be the best idea. So for example, if I have come up
with a recipe to make a secret barbecue sauce, which is the best in the world, now for me to make it, I
don't make a lot of barbecue sauce. But for me to make it, it's expensive. I have to buy all the ingredients
at retail prices to do this. It might be cheaper for me to outsource it to someone who can get the
ingredients at a wholesale price and do it cheaper. But the minute I do it, my secret sauce is no longer
secret. And so I might want to keep the making of this particular barbecue sauce in house. If I find that
what I'm looking to outsource provides me a way to differentiate my product or service, then keep it in-
house. Perhaps that may not be a reason. Perhaps this is not a secret sauce. Okay. Okay. But what I find
is that being able to do this, I have many businesses that I grew this across. Even though this is not a key
differentiator of my products or services, I needed across many of my businesses. So in that particular
case, I look at it and I have enough volume across many of my businesses that I might still want to keep
doing it. What about the case where I can get things from a supplier? For the supplier is my competitor.
So in a sense, my suppliers are hostile to me, I'm at risk. Because I've now created a situation where my
supplier could turn around on me anytime. So, in that case I might want to make. Finally, it might be that
I need to improve my technology. It might be that I make cell phones when I don't make glass but the
class that's made by my supplier is not very good and I need to make better quality glass. I need to have
a glass that I can throw against the wall and nothing happens to it. But my supplier is not willing to do it.
So, I need to push the technology envelope on making this glass. So, I need to make in-house so that I
can push the technology in them. On the other hand, when I'm outsourcing, I look out and I notice that
the making of this product or adding the service is not a particularly attractive business or the production
environment in which I have to make this is not particularly attractive. For example, I might have to take
products and print them chemically and that creates fumes and I might not think that that's an
environment that I want to create in my factory and so I might decide to outsource. So, it's not a business
I want to be in, it's not something that's important to me, I want to outsource it. It's possible that the end
product that we are looking at may not be critical to my business. If I'm making an electronic gadget, the
power cord that goes from the electronic gadget to the walls to power of this gadget, that cord is not an
important enough product I can let somebody else make it. If I think of power cords, there are a lot of
suppliers who make these power cord. They're very good at it and they make it in volume and so the
supply market for this power cord is dependent. So, in that case, for strategic reasons, I don't want to be
involved in making power cords. It's also possible that my suppliers are quite innovative. So, if I'm
looking at this piece of glass, if my glass suppliers are constantly coming up with better and better glass,
there's no need for me to get involved because this is not core to my business. So, at a high level I want
to think strategically and say does this make sense for my business to make our buy? Then I need to
consider what are the risks. So for example, if there are very few suppliers in the market, what happens
if one of the suppliers decides to stop supplying us? We may then find that outsourcing a component
from that supplier is risky. What happens if suddenly technology changes and the rest of the market is
able to make it cheaper? Now, I'll have invested in equipment and that might be a problem. I then need
to look at whether there's a need for quick response. Oftentimes the market that I am in may need me to
react quickly and so in that case I might decide that I should make it in-house. Lastly, there's risk to my
intellectual property. So, asking somebody else to make a product if that risks intellectual property, I
may not be willing to take the risk because loss of that intellectual property could mean my entire
business suffers. Contrast that with what happens when you outsource.So, the risk that a supplier would
hold-up deliveries for whatever reason if that risk is manageable. Why? Because there may be multiple
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suppliers and the supplier is worried that you could easily go to a different supplier, in which in that case
I'm okay to outsource. If it's easy for me to switch suppliers, if the switching costs are not particularly
expensive, I might decide to outsource. And the lead time for the product are small. So, if I'm buying a
product that's a commodity product that's easily available then I can go to the market and buy it
immediately, then again I might outsource. Finally, counter to the way we talked about intellectual
property, if there is no intellectual property risk involved then obviously it makes sense to outsource.
Lastly, after we've sought of negotiated our way through the strategic part of this decision and after
we've considered the important risks that we may be taking, we come to sought of economic analysis.
Oftentimes when people learn about make or buy decisions they only think about the economic analysis.
Now, the typical economic analysis says, "Can I make things cheaper in-house or is it cheaper to make it
elsewhere?" Now obviously if it's cheaper for me to make it then I will make it, if it is cheaper to
outsource it then I might allow the supplier to make it. What costs ought to be considered when making
this analysis is tricky sometimes. Because apart from the direct material cost and the indirect costs et
cetera, there are opportunity costs. Do I want to spend time worrying about the making of bolts in my
very high tech factory even if it's cheaper for me to make it or do I allow somebody else to make it even
if it's marginally more expensive because the opportunity cost is higher. I could be using the time and
effort that we are putting into manufacturing of bolts into making a more high value product. So, it's not
just looking at the cost of making that particular item, it's the benefit of doing something else.Now, there
may be other reasons why I might make it. It might be more expensive for me to make the bolt in-house
but I've already invested in a large screw machine, machines that make screws and this is an extra thing
that I can make on it which helps me pay for this prior investment. In that case, I should try and make it
to make use of the capacity that I have on hand. Conversely, if it's going to require me to make a major
investment even if it's going to be cheaper, I might look at it and I might decide that it probably doesn't
make sense to make a major investment in this and let someone else do it. Finally, I have to look at the
competence of my organization. If I have significant skills and significant expertise in making
something, then obviously I ought to be making it. Usually, when I have that skill and expertise, usually
make costs are lower, usually I have other equipment et cetera, that is required to make this particular
product available. Or if I have poor in-house skills. So for example, I know that I could chemically
create some sheet metal parts in-house. I know if I did it it would be cheaper but I don't have anyone
who's experienced in doing this in my organization. Now obviously I need to recruit someone, bring
them in and I might still be able to make it work. Or I might decide that I don't have the in-house skills
for this, I might as well go to someone else who does this on a regular basis and who has a lot of
expertise in it and let them do it rather than me do it. Even though if I did it I might end up saving or
being economically illiterate background because there are a lot of hidden costs associated with
managing a new enterprise or a new effort within your own organization. So, the make or buy decision
then sought of follows these three-tiered approach where we think of things strategically, we evaluate
the risks, and then we look at the costs associated with it. In the 1990's early 2000's, there was a big
move for companies to move production out of their own facilities and outsource it and often offshore it
to low labor cost countries. What many of these companies found is that even though they were able to
get things relatively cheaply, a large number of them found that they wanted to bring back or cancel
those offshoring engagements and bring back the production either in-house or going onshore location.
Because the cost advantages often they're obvious upfront but there are a lot of hidden costs of actually
doing the transaction, of having to monitor the process, of having to ensure quality, of having to worry
about reputational risk than a by-product was shipped by the supplier. Lastly, the fact that you could
actually have an IP lost or intellectual property might be lost was a big concern for many of these
companies and some of them did actually lose intellectual property. So, there was a trend to sought of
move back and many of those initial outsourcing contracts or offshoring contracts were cancelled. Now
remember outsourcing does not necessarily mean offshoring. Outsourcing means allowing someone else
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to provide you with the product or service. Offshoring is where that someone else, the counterparty is
located in a different country. Usually in a low cost country typically in Asia or Africa. So, people may
still outsource, but they may choose to instead of doing it offshore they may do it onshore which means
if you're in the United States you outsource to a supplier that's within the United State If you're out in
Europe you outsource to somebody who is within Europe and so on.
Lesson 3-3 Bullwhip Effect

Lesson 3-3.1 Bullwhip Effect
In this lesson, we will learn how demand variability propagates through the supply chain and how the
"Bullwhip effect" can be minimized.
Transcript
In this lesson, we are going to learn a very important concept that comes up in supply chains. We're
going to study about demand variability, and how it propagates through the supply chain, how small
changes in demand that occur at the retailer end can cause massive changes further down the supply
chain when it comes down to may be raw material suppliers or component suppliers.
Magnification of Demand Variability - Slide 33
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Magnification of demand variability is shown through a three-dimensional diagram. X-axis is the time
dimension, y-axis is the replenishment amount and 3rd axis is the geographical dimension. There are 4
levels of geographical dimension, at level 1 we have a retailer in London which is being supplied by a
depot in Watford at level 2, which is being supplied by an assembler in Dublin at level 3 which is being
supplied by a sub-assembly in Poland at level 4. It shows that when a small change in demand occurs at
level 1 retailer in London. This change then magnifies and shows up at level 2 depot in Watford with a
lag of few weeks. A few weeks later, this change, again magnified, shows up at assembler on level 3 in
Dublin. After a few more weeks this change, again magnified, shows up at sub assembly in Poland. This
graph shows how a small change at level 1 gets magnified by the time it reaches level 4.
Transcript
Let's look at an example, in which case we have a retailer in London who's being supplied by a depot in
Watford, that depot in Watford is being supplied from an assembly plant in Dublin and that assembly
plant gets sub-assemblies from Poland. Each of these levels of suppliers have lead times between them.
So from the time that the retailer orders, retailer gets supplies from the depot, there may be a matter of
weeks from the time the deep orders to get it from the assembler might be a few more weeks and from
the time the assembly plant orders it from the sub-assembly plant in Poland that might be another few
weeks. So, accordingly what happens is that when a small change in demand occurs at the retailer, a few
weeks later because of batching of orders and the retailers, that change in demand shows up perhaps 3-4
weeks later at the depot in Watford. Because it is a batched order and you may have similar batched
orders coming from a number of other retailers, the change that the depot sees, tends to be magnified
from the change that the retailer actually saw. A few weeks later once again because of batching and
lead times, the assembler or the assembly plant in Dublin, actually sees this change. Finally, even more
weeks later there is a problem that is seen in Poland where there's a sudden increase in demand. Because
of this, it is often times difficult to understand why there was a certain change in production at the
Poland plant when there was no problem occurring at the retail. The problem at the retailer occurred
several weeks ago and so the fact that this supply chain causes a delay in the actual change being noticed
in Poland is because of both the lead times and the batching quantities at each of those different levels.
So, we have two things that are going on, we have a magnification of the demand variability that's
occurring because of all the batching that's occurring and there's a displacement in time or a delay that
with which that particular magnified demand is observed as we go further upstream into the supply
chain. Now, clearly lead times are a problem here, batch quantities are a problem here. If it could have
instantaneous supplies, and if you could supply one-offs so that we will not batching, a lot of these
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problems will be resolved because we'll see immediately the factory in Poland would see immediately
that there is a problem that's occurring at the retail level. Similarly, because it would have been one for
one replacement, there would not have been that much magnification that would occur, you would see
the same change occurring demand at the current.
Contributing Factors (1 of 2) - Slide 34
Demand variability
Panic ordering
Strategic ordering
Batch quantities
Quantity discounts
Trade promotions
Leadtimes
Transcript
So, there are number of contributing factors then that are occurring over here. The first one is the fact
that whenever when has demand variability, that demand variability tends to get magnified. Why does it
get magnified? Because if there is a certain high demand at the retailer, the retailer may run out of
inventory and that stock-out may cause the retailer to panic order. When the panic order, they order
much more than they require and then that causes a spike in demand, which really doesn't exist because
there aren't that many more customers ordering, it is that the fact that the retailer is uncertain whether
they have enough amount to take care of future demands. It may also be that we may have supply
uncertainties. So, for example, if the supplier has machine breakdown, or there's a fire at a supplier, then
the buyers look at the fact that there's a problem and they can either panic order or even if I don't panic
order, I keep it in mind that this is a possibility and so I strategically order. So, I know that there is a
shortage that's coming, so I inflate my order knowing that I may not get my full order. So, if I needed
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100 parts and I know that I'm not going to get my full 100 parts because of a shortage from the supplier,
I order a 1,000 parts so that if I am given a fraction of my order, a fraction of the 1,000 is actually a 100
and I get the 100 that I need. So, I am being strategic about my ordering. Batch quantity is obviously
how an effect as we looked at before because batch quantity is essentially tend to magnify this effect of
the demand variability. There are external factors that we have looked at, the demand variability which
then causes the panic ordering et cetera. But sometimes, we cause these problems ourselves. So, for
example to incentivize customers to buy more, I might give a quantity discount. Now the minute I give a
quantity discount, the customer tends to buy in larger quantities. When they buy in larger quantities, they
are now ordering in larger batches, larger batches tends to distort the demand signal that's coming from
the customer and so quantity discounts can have a problem with. One of the things that companies often
do is provide what are called trade promotions. So, if I'm the manufacturer of a serial product, so a
breakfast cereal product, I might tell the retailer that I'm going to give your trade promotion. I'll give you
a 10 percent discount if you increase your volume or the volume of sales. Now the retailer may look at
this and say, "Oh, that's wonderful. The fact that you're giving me a 10 percent discount, I'll buy a lot
more from you that not only satisfies my demand currently for whatever promotion I'm going to put in,
but I might buy for future use as well." So, I'm essentially cannibalizing my demand from future periods
and putting them in the current period and that tends to distort the signal that's coming for the actual
demand for this particular product. Lastly, as we've talked about before, lead times are big contributing
factor, so that the longer the lead time, the more time it takes for the signal to reach from the consumer
demand to these upstream stages of the supply chain. So, lead times become a problem for us as well.
Contributing Factors (2 of 2) - Slide 35
Shortages
Quality recalls
Engineering changes
New Product Introductions (NPI)
Delivery problems
Transcript
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Now there are other contributing factors that can happen, for example, there might be shortages, we
talked about the fact that we may have shortages that may arise not from anything that we are doing
wrong, not from an accident occurring or a fire occurring in our particular facility, but because of poor
planning. It could be that maybe we didn't order enough raw materials from our suppliers so that now
our product is in short supply and that is now triggering panic ordering from our customers. We might
have quality recalls. So, the product that we sent out was bad quality, because it was bad quality, our
customers are not able to use it. They realize that we're not able to provide a quality product, they want
to buffer against that problem, they had safety stock that had spurious demand in our system. You might
have engineering changes. Our product has to be modified somewhat for whatever reason, for a safety
reasons, for the fact that maybe during assembly it might be better to have a small change in design so
that assembly becomes easier. That causes problems because now we may have supplied a part using the
previous specifications and now with an engineering change, we have to replace all those parts with new
parts and that creates a demand search which is a temporary demand search. New products are
notoriously bad in this regard, because we often do not have a very good sense of the demand for such
new products. New products also often involve a lot of engineering changes as the product is stabilized.
Your products tend to have quality problems, shortage's chronic for new products off and so new
products become a big problem for us. Finally, we may have delivery problems. Delivery problems may
have nothing to do with either us or with our customer, they may have to do with the logistics provider.
Kentucky Fried Chicken recently had a big problem where many of their stores did not have chicken.
Imagine Kentucky Fried Chicken without chicken, and the reason this happened is they changed
logistics providers and the new logistics provider had a bunch of trouble getting started. So, that they
were not able to get the chicken supplies to their transportation network, to the stores on time and that
led to many cases having to actually shut down in England. So, delivery problems may be a contributing
factor for a bullwhip effect because they cause a distortion in the demand sales. So, how do we deal with
this? How do we combat? So, remember the Bullwhip is our effect where a small perturbation at one end
results in large changes upstream in the supply chain. What we said is that because of lead times and
because of batch quantities, the actual demand signal, the actual demand that the retailer is experiencing
gets distorted as it passes to the end of the supply chain.
Combating Bullwhip (1 of 3) - Slide 36
Information Sharing
Point-of-Sales (POS) information
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Improved forecasting and analytics

Vendor Managed Inventory (VMI)
Supplier and customer communications
Transcript
A simple thing that we could do is, why not let all levels of the supply chain, all the suppliers get to see
the actual demand. Now, this is not always possible and this is not always wise, but oftentimes, allowing
some amount of information to flow back indicating to our suppliers what is actually going on with the
real demand can help mitigate this problem. So that they don't react to the fact that they are seeing this
pulse coming through the system and they think that that's an increase in demand and therefore ramp up
production. Remember, if they ramp up production and there really wasn't demand and they will have
too much inventory which means later on the have to make a lot less, which causes this big swing in
production, highs and lows in production. One way to provide misinformation is to provide Point-of-
Sales information. So, you see, retailers do this very often where they provide Point-of-Sales
information to manufacturers. Another way to deal with this is to improve forecasting models, improve
the analytics that one does. Companies that come up with other clever ways. There's a concept called
Vendor Managed Inventory. Where a company actually manages the inventory of its components at the
buyer, and the reason they do that, is then they can observe the actual pattern of usage of the buyer so
that they know that any batching effects are merely that, that they are being caused because of batching
and that the demand doesn't change appreciably. Vendor Managed Inventories are one way to combat the
Bullwhip effect. Lastly, improved supplier and customer communications. It might be a simple enough
thing where if we realize that, as a customer, that the demand that we are seeing from our customer, so if
I'm a retailer and I'm seeing demand from my customers, and if I realize that there might have been a
small blip or an increase in demand for some reason and that this is not likely to continue, it might be a
good idea for me to pass that information to my suppliers and to my suppliers suppliers etc. So, having
that kind of communication also helps reduce the Bullwhip effect.
Manufacturing Decisions
Batch size reduction

Just-In-Time (JIT)
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Inventory pooling
Delayed differentiation or postponement
Leadtime reduction
Transcript
There are things we can do in terms of how we do manufacturing. Remember we said that the order,
quantities or batch sizes were one of the big reasons why we have the Bullwhip. Because they tend to
magnify whatever small changes are occurring. So, one of the things that one could do is to lower the
batch sizes or reduce the order or quantities. Now, remember to be able to do this we have to be clever
about this because we need to make sure that we don't automatically create incentives by offering
quantity discounts or creating promotions which create larger batches. But batch size reductions of is a
very important thing that is done in Lean manufacturing. In Lean manufacturing the idea is to make as
small batches as possible and if at all possible make a batch size of one. This is the basis of Just-in-Time
manufacturing. Where the idea is, don't make and store product which is called Just-In-Case
manufacturing. So, if you make and store product, then if changes occur, then you cannot able to react to
those changes because the products already been made, and so Just-In-Time manufacturing is a way to
avoid this. Another way to deal with this is to look at what's called inventory pooling. So, if I have a
number of retailers and they have their own pool of inventory, I could look at that as being a common
pool so that a small increase in demand at one which may be merged by a reduction of demand in the
other, so that the overall demand is still flat, I can deal with those situations because the pool of
inventory that I'm drawing from is the same. So, what happens in this particular case is that, even if
retailer A observes a higher demand and wants to order more, retailer B who is observing a slightly
lower demand at this point in time and is ordering less, I can look at both of them and say, "Oh! The net
demand for my product hasn't increased. There's no reason for me to increase production of my
particular product." So, inventory pooling is a way to deal with that. There are other tactics that are used.
There is a tactic called postponement or delayed differentiation. Where I make products and then modify
them at the last minute in accordance to the needs of the supplier. A classic example of this, is to make
white T-Shirts and keep a stock of white T-Shirts. Now, if the customer comes and wants a blue t-shirt at
the last minute, I dip the white shirt in blue dye and give it to them. The advantage of this is that I don't
have to keep every possible color of T-Shirt. I just keep a stack of white T-Shirts, and at the last minute, I
differentiate the product. This has the advantage of lowering inventories in the system which in turn
helps me with the Bullwhip. Then lastly, I want to do leadtime reduction. Leadtime reduction is part of
Just-in-Time manufacturing. It comes in along with the batch size reduction. But leadtimes often are
affected by transportation times. If I'm ordering from supplier and the supplier happens to be oversees, it
takes me a long time to bring the product. Some companies may even fly their product so that they can
reduce the leadtime, and if the product is valuable enough, reducing the leadtime by using air shipments
versus sea shipments may be one way that you can reduce leadtimes that are created by transportation.
So, there are a number of decisions that we can make that allow us to change our manufacturing systems
in such a way that we can combat the Bullwhip.
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Marketing Decisions
Pricing discipline
Rolling sales incentives
Trade promotions or quantity discounts
Transcript
Lastly, as we have been talking so far, there are marketing decisions that we can manipulate. For
example, pricing that does not change because of promotions. I do not want to have sales all the time
because what happens when I have a sale is that people wait for a sale and buy in bulk during that time
and during the rest of the time the sales are low. If I kept the same price all the time, then my demand
will be correctly reflected based on what customers need and customers aren't strategically buying the
product. So, pricing disciplines is important. This means trying not to have coupons. This means trying
not to have special sales, not to have creative promotions. Now, certain businesses, those kinds of things
are part of the fabric of those businesses. So, companies expect to do this because consumers expect to
have coupons. Companies expect to have sales because consumers want to have sales, and sometimes
they are unwarranted, but if at all possible, we should try to minimize it, try to minimize this size of the
discounts that are being given, so that the demand comes to you as and when the customer requires it.
One of the ways that sales personnel are compensated is by having sales incentives. The same thing is
true with how retailers or sometimes compensated. If you are a car dealership, There's a sales incentive
for selling a certain number of cars every quarter. What happens because of this, is that by the end of the
quarter, the retailer makes a Herculean effort to try and meet that sales target. The problem with that is
now you have uneven demand that is being created. So, you're creating variability in demand, that
variability in demand theb sort of ripples through their supply chain. So, one way to avoid that is to have
a rolling sales incentive, where you think in terms of looking at a rolling three-month horizon to see how
many sales are achieved, so that there aren't any hard cut-off dates at the end of each quarter where
there's a big push to try and create more sales or create more demand. Lastly, and we've talked a lot
about this, trade promotions and quantity discounts can be a problem and should be avoided wherever
it's possible. So, if you do this several actions, if you share information, if we change our manufacturing
systems so that they are more Just-In-Time, and if we maintain pricing discipline and make our
marketing decisions so that we don't distort the demand signals, then we are able to combat the Bullwhip
effect more effective.
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Operations Management: Analysis and Improvement Methods Mo... file:///Users/sujinyou/Downloads/BADM 567 Operations Manage...

Operations Management: Analysis and

Lesson 3-2 Sourcing Decisions

Lesson 3-3 Bullwhip Effect

In this lesson, using the example of coffee, we will study

What are supply chains?

A Map of Coffee Growing Countries - Slide 2

A Map of Coffee Growing Countries by Robusta, Arabica

Annual Per Capita Coffee Consumption, 2008 - Slide 3

A map of annual per capita coffee consumption (2008).

Your Morning Coffee - Slide 4

Your Morning Coffee

The Coffee Process - Slide 5

How Coffee Works

The Most Expensive Coffee - Slide 6

An image of civets (animal)

The Coffee Process - Slide 7

Coffee Supply Chain Schematic - Slide 8

Interesting Facts - Slide 9

Roasted coffee exports 2013

Value (Billion $) Volume (tons)

Value (Billion $) Volume (tons)

Interesting Facts - Slide 10

The flow of coffee beans around the world in 2012

Total exports (not roasted & not decaffeinated): $23.4 billion.

Lesson 3-1.2 What is a Supply Chain? (part 2)

Different Views - Slide 11

Customs, taxes, and restrictions

Transportation: Land and sea

Storage: Private / public

What needs to specified?

Quality, quantity, shipping period

Incoterms: International Commercial Terms

Social Aspects - Slide 16

Risk and insurance

Hedging and futures

What is Supply Chain Management? - Slide 19

Active management of intra-firm activities

Maximize customer value

Achieve sustainable competitive advantage

Layers of the Supply Chain - Slide 20

Logistics—physical movement of goods

Information—shared and private information

Financial—cash flow through the supply chain

Governance—nature of contracts binding the supply chain

Lesson 3-2 Sourcing Decisions

Why do Supply Chains Exist? (1 of 2) - Slide 22

The vertically integrated firm

Why do Supply Chains Exists? (2 of 2) - Slide 23

Outsourcing Risks - Slide 24

Loss of core activities

Intellectual Property (IP) loss

Supplier financial risk

Transaction Cost Economics - Slide 25

Oliver E. Williamson (Nobel Prize winner 2009)

Transaction Characteristics - Slide 26

Transaction Costs - Slide 27

Lesson 3-2.2 Sourcing Decisions (part 2)

Transaction Cost Economics (1 of 3) - Slide 28

Transaction Cost Economics (2 of 3) - Slide 29

Transaction Cost Economics (3 of 3) - Slide 30

The Make or Buy Decision - Slide 31

The Make or Buy Decision Table - Slide 31