Supply Chain Management

Module-4
The role of network design in the supply chain:
Supply chain network design decisions include the assignment of facility role; location of
manufacturing-, storage-, or transportation-related facilities; and the allocation of capacity and
markets to each facility. Supply chain network design decisions are classified as follows:
1. Facility role: What role should each facility play? What processes are performed at each
facility?
2. Facility location: Where should facilities be located?
3. Capacity allocation: How much capacity should be allocated to each facility?
4. Market and supply allocation: What markets should each facility serve? Which supply
sources should feed each facility?
Network design decisions have a significant impact on performance because they determine the
supply chain configuration and set constraints within which the other supply chain drivers can be
used either to decrease supply chain cost or to increase responsiveness.

Factors influencing network design

Strategic factors
A firm’s competitive strategy has a significant impact on network design decisions within the
supply chain. Firms that focus on cost leadership tend to find the lowest cost location for their
manufacturing facilities, even if that means locating far from the markets they serve. Electronic
manufacturing service providers such as Foxconn and Flextronics have been successful in
providing low-cost electronics assembly by locating their factories in low-cost countries such as
China. In contrast, firms that focus on responsiveness tend to locate facilities closer to the market
and may select a high-cost location if this choice allows the firm to react quickly to changing
market needs. Zara, the Spanish apparel manufacturer, has a large fraction of its production
capacity in Portugal and Spain despite the higher cost there. The local capacity allows the company
to respond quickly to changing fashion trends. This responsiveness has allowed Zara to
become one of the largest apparel retailers in the world.

Technological factors
Characteristics of available production technologies have a significant impact on network design
decisions. If production technology displays significant economies of scale, a few high-capacity
locations are most effective. This is the case in the manufacture of computer chips, for which
factories require a large investment and the output is relatively inexpensive to transport. As a
result, most semiconductor companies build a few high-capacity facilities.
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
high fixed cost. To reduce transportation costs, Coca-Cola sets up many bottling plants all over
the world, each serving its local market.

Macroeconomic factors
Macroeconomic factors include taxes, tariffs, exchange rates, and shipping costs that are not
internal to an individual firm. As global trade has increased, macroeconomic factors have had a
significant influence on the success or failure of supply chain networks. Thus, it is imperative
that firms take these factors into account when making network design decisions.
Tariffs and tax incentives Tariffs refer to any duties that must be paid when products
and/or equipment are moved across international, state, or city boundaries. Tariffs have a strong
influence on location decisions within a supply chain. If a country has high tariffs, companies
either do not serve the local market or set up manufacturing plants within the country to save on
duties. High tariffs lead to more production locations within a supply chain network, with each
location having a lower allocated capacity.

Developing countries often create free trade zones in which duties and tariffs are relaxed as
long as production is used primarily for export. This creates a strong incentive for global firms to
set up plants in these countries to be able to exploit their low labor costs.
Exchange-rate and demand risk Fluctuations in exchange rates are common and have
a significant impact on the profits of any supply chain serving global markets. For example, the
dollar fluctuated between a high of 124 yen in 2007 and a low of 81 yen in 2010, then back to
over 100 yen in 2014. A firm that sells its product in the United States with production in Japan
is exposed to the risk of appreciation of the yen. The cost of production is incurred in yen,
whereas revenues are obtained in dollars. Thus, an increase in the value of the yen increases the
production cost in dollars, decreasing the firm’s profits. In the 1980s, many Japanese
manufacturers faced this problem when the yen appreciated, because most of their production
capacity was located in Japan. The appreciation of the yen decreased their revenues (in terms
ofyen) from large overseas markets, and they saw their profits decline. Most Japanese
manufacturers responded by building production facilities all over the world. The dollar fluctuated
between0.63 and 1.15 euros between 2002 and 2008, dropping to 0.63 euro in July 2008. The drop
in the dollar was particularly negative for European automakers such as Daimler, BMW, and
Porsche, which export many vehicles to the United States. It was reported that every one-cent rise
in theeuro cost BMW and Mercedes roughly $75 million each per year.

Freight and fuel costs Fluctuations in freight and fuel costs have a significant impact on
the profits of any global supply chain. For example, in 2010 alone, the Baltic Dry Index, which
measures the cost to transport raw materials such as metals, grains, and fossil fuels, peaked at
4,187 in May and hit a low of 1,709 in July. Crude oil prices were as low as about $31 per barrel
in February 2009 and increased to about $90 per barrel by December 2010. It can be difficult to
deal with this extent of price fluctuation even with supply chain flexibility. Such fluctuations are
best dealt with by hedging prices on commodity markets or signing suitable long-term contracts.

Political factors
The political stability of the country under consideration plays a significant role in location
choice. Companies prefer to locate facilities in politically stable countries where the rules of
commerce and ownership are well defined. While political risk is hard to quantify, there are some
indices, such as the Global Political Risk Index (GPRI), that companies can use when investing
in emerging markets. The GPRI is evaluated by a consulting firm (Eurasia Group) and aims to
measure the capacity of a country to withstand shocks or crises along four categories: government,
society, security, and economy.

Infrastructure factors
The availability of good infrastructure is an important prerequisite to locating a facility in a given
area. Poor infrastructure adds to the cost of doing business from a given location. In the 1990s,
global companies located their factories in China near Shanghai, Tianjin, or Guangzhou—even
though these locations did not have the lowest labor or land costs—because these locations had
good infrastructure. Key infrastructure elements to be considered during network design include
availability of sites and labor, proximity to transportation terminals, rail service, proximity to
airports and seaports, highway access, congestion, and local utilities.

Socioeconomic factors
The Government of India has, as a matter of state policy, promoted industrial development of
industrially backward areas in the country concentrating in particular on the northeastern region,
Jammu & Kashmir, Himachal Pradesh, and Uttarakhand. Balanced regional development through
locational dispersal of industries has been one of the principal objectives of the successive
FiveYear Plans and government’s industrial policy.

Customer Response Time and local presence

Firms that target customers who value a short response time must locate close to them. Customers
are unlikely to come to a convenience store if they have to travel a long distance to get there.
It is thus best for a convenience store chain to have many stores distributed in an area so most
people have a convenience store close to them. In contrast, customers shop for larger quantity of
goods at supermarkets and are willing to travel longer distances to get to one. Thus, supermarket
chains tend to have stores that are larger than convenience stores and not as densely distributed.
Most towns have fewer supermarkets than convenience stores.

Logistics and facility Costs

Logistics and facility costs incurred within a supply chain change as the number of facilities,
their location, and capacity allocation change. Companies must consider inventory, transportation,
and facility costs when designing their supply chain networks.
Inventory and facility costs increase as the number of facilities in a supply chain increases.
Transportation costs decrease as the number of facilities increases. If the number of facilities
increases to the point at which inbound economies of scale are lost, then transportation costs
increase.

Uncertainty in Network Design:

Facility design decisions are strategic in nature and a firm will have to live with facility location
and capacity decisions for several years. Most of the data used in the network design
model are likely to change over a period of time. Projections of cost, price and demand over
a longer horizon usually have a lot of uncertainties associated with those numbers. For example,
in international network design, foreign exchange rates affect relative cost structures significantly
and predicting the same is extremely difficult, if not impossible. Firms like Birla
Cement or Asian Paints do not face this problem because they design multi-plant networks
within a country. Though cost of living, inflation and other factors are likely to vary in different
regions even within a country, the extent of variations is likely to be of much lower in
magnitude because migration within a country is much easier compared to migration across
countries. So, in general, design decisions about multi-plant networks within a country are
easier compared to global networks. There are several ways in which firms handle these issues.
Firms try and use scenario building through which they try and generate large numbers of
likely future scenarios and select an option that performs reasonably well across the projected
scenarios. So the focus shifts to selecting a robust solution rather than on picking a solution
that is optimal for one scenario.
Over a period of time, Toyota has introduced greater flexibility in its plants worldwide.
That is, a plant should be able to produce models that are required in the domestic market but must
also be able to produce models for a few export markets. On the whole, the
network will have excess capacity, so based on the exchange rates movement, volume will
be allocated to the respective plants in the network. For example, Toyota might look at its
Indian and Thai plants as the supply source for the South Asian market and keep excess
capacity at both places. If baht is cheaper, it can allocate more volume to the Thailand
facility, and if rupee is cheaper, it can allocate a higher share of the export market to India.
This excess capacity in network provides the luxury of options to the Toyota network. This
is known as real option because it provides a firm flexibility similar to financial options in
financial markets. But unlike financial options, real options are difficult to trade. Firms that
have excessively focused on their global manufacturing facilities have realized that any significant
change in Yuan rate can change the cost structures in a significant way. There is a
lot of pressure on China to devalue Yuan. Currently, LG uses its China facility as an export
base and exports 70 per cent of its production from China. Given the uncertainty on the
Yuan front, LG has decided to build excess capacity in India so that there is another hub
available as an option for export.
The idea of excess capacity in global networks may go against the current logic of a lean
supply chain design. In the lean philosophy, firms are not encouraged to keep this excess capacity,
which has associated costs. Because of the pressures faced by global firms, it is quite tempting to
avoid any excess capacity that may not have short-term payoffs. However, by doing so,
the process firms will lose their flexibility.

Pricing and Revenue Management:

Pricing
The decision to price a product at a particular value is a marketing decision. Prices are fixed
with the ultimate goal of maximizing profits. The law of demand states that as the price of
a good or service increases, the demand for the good or service will decrease and vice versa.
Therefore, for maximizing profits, an optimal pricing decision is needed.

Law of Demand and Optimal Pricing Decision

The law of demand is normally depicted as an inverse relation of demand quantity and price.
To illustrate this concept, let us take the hypothetical case of Super Airlines, which wants to
make a pricing decision for its daily morning flight from Bangalore to Mumbai. Super Airlines
caters to business customers, and based on market surveys, it has estimated the following
relationship between demand for seats on the said flight and price charged by the airline:

Demand = 160 - 20 × Price (where price is in thousand rupees)

The above equation is valid only in the price range of Rs 0–8,000. At Rs 8,000, no customer
will be willing to book a seat and demand will increase by 20 units with decline in unit price (unit
in this case is thousand rupees). At a price close to zero, demand will shoot up to 160. The
profit generated from the flight is as follows:

Profit = Revenue - Fixed cost - Variable cost

= Price × Seats booked - Fixed cost - Variable unit cost × Seats booked

The bulk of the cost of operating a flight between Bangalore to Mumbai is fixed. Once
the Airline has announced the flight and allocated aircrafts (these decisions are made well in
advance), the firm has no choice but to operate the announced flight and hence the fixed cost is
like a sunk cost. Let the fixed cost involved in operating a flight from Bangalore to Mumbai be
Rs 300,000 and we start with the assumption that the marginal cost of filling one more seat is
close to zero. In such a case, optimizing profit is equivalent to optimizing revenue. The revenue
function for this airline will be as follows:
Revenue = 160 Price 20 Price2
As one can see from Figure shown below, the revenue against price curve will be an inverted
U-shaped curve. The revenue will increase initially when the firm increases its price from zero
and will peak at a price of Rs 4,000 and will subsequently decline with further increase in price.
So it will be optimal for the airlines to price the Bangalore–Mumbai flight at Rs 4,000, which
will result in a demand of 80 seats. This will generate a revenue of Rs 320,000 and amount to
a profit of Rs 20,000 per flight.
For a general case of the linear demand curve, the formula is as follows:
D = a – bp
where D is the demand, p is the price and a and b are parameters of the demand curve.
One can easily show that the optimal price denoted as p* is as follows:

In the case of Super Airlines

At a price of Rs 4,000, 80 seats will get booked. So while choosing the aircraft for this
flight, the firm should ideally choose an aircraft whose capacity is just higher than the demand

Multiple-item, Multiple-location Inventory Management:

Selective Inventory Control Techniques
When dealing with a large number of items, the management may not be in a position to
focus attention on all items. For example, a large company like IndianOil will have lakhs of
SKUs to handle; similarly, a grocery chain like Foodworld has to manage thousands of SKUs.
Obviously, not all items are likely to be of equal importance. So it makes sense for a company
to classify items so that managers can pay suitable attention to different categories of items.
There are several classification schemes for categorizing SKUs:
• ABC classification. Items are classified into three categories based on the value of the
consumption. A-category items contribute significantly to the value of inventory and consumption
and are controlled tightly and get more managerial attention. ABC classification is discussed
in greater detail at a later stage.

• FSN classification. Items are classified based on volume of usage: fast moving (F), slow
moving (S) and non-moving (N). Fast-moving items are usually stocked in a decentralized
fashion while slow-moving items are stocked centrally. Non-moving items are candidates for
disposal and the firm will like to make sure that non-moving items do not take up a significant
share of inventory investment. This classification is quite popular in the retail industry.

• VED classification. Items are based on criticality: vital (V), essential (E) and desirable (D).
This classification is quite popular in maintenance management. Based on the VED classification,
one can fix different service levels for different items. Of course, a firm prefers to work
with a very high service level for V category of spare items. For example, Reliance industry
maintains a 99.995 per cent service level for V category of spares. While deciding the inventory
level for a D category product, one will fix relatively lower levels of service requirements.
Cummins India is a classic example of a firm that has applied ideas of selective inventory
control techniques in managing its spares inventory.
ABC Classification

One of the most popular methods of classification of items is the ABC classification. It is a
common practice to use three ratings: A (very important), B (moderate importance) and C
(little importance). SKUs in A categories can be given higher priority in terms of allocation of
management time. To carry out the ABC analysis, all the items are rank-ordered based on the
sales in value terms. Cumulative percentages of the total sales (in rupee) and the total number
of items are computed and these percentages are plotted. We illustrate the concept with an
example of ABC analysis carried out by a mattress manufacturing firm for its sales office at
Delhi. In this particular case, since all the items had more or less the same price, ABC analysis
was done on quantity, but typically it should be done on rupee value.
The company has 126 SKUs, but the top three SKUs accounted for
about 60 per cent of the sales volume. The format of the ABC analysis is illustrated in Table 4
The same data have been plotted in Figure As can be seen, 75 per cent of the items
constitute less than 5 per cent of value, so the firm has to find a method for the Delhi sales
manager to prioritize his time. That is, he should have very simple systems for these 75 per cent
of items and spend most of his time and attention on A-category items.
ABC categorization has been used with success in following areas:
• Allocation of managerial time. An A-category item should receive the bulk of managerial
attention and C category items should receive very little.
• Improvement efforts. The improvement effort should be directed at A-category items
only. For example, supplier relationships, lead time reduction, reduction in uncertainty
in lead time, etc.
Setting up of service levels. According to one philosophy, the A category should receive
99 per cent service level, the B category should receive 95 per cent and the C category
should receive 90 per cent service level so that the overall weighted service level for the
company will be around 97 per cent. Some firms do exactly the opposite. They provide
99 per cent of service level to C-category items, 95 per cent to B-category items and 90
per cent to A-category items. It is not that the firm actually allows 10 per cent of stockouts in A-
category items, but during the replenishment cycle, the firm monitors closely
all the A-category items in terms of actual demand as well as the status of supply. If
the manager anticipates the possibility of a stockout situation, even before the actual
stockout takes place he or she start working on contingency plans so that he or she can
avoid the stockout situation. So although actual safety stock is kept at a low level, the
effective service level is very high. Obviously, this kind of close monitoring cannot be
handled for all items but can be carried out for a few A-category items. We suggest that
the firm work with this approach of low safety stock but have contingency plans in
place for A-category items.
Stocking decision in the distribution system. A-category items are kept at all regional distribution
points, but C-category items are kept at a central warehouse only. B-category
items are kept only at a few regional hubs but not at all regional stock points.
ABC analysis can be done on sales data as well as on inventory data, on supplier data and
on purchase orders data. One will find a similar relationship. Although the exact distributions
among the three categories vary according to industry, based on our field experience, we find
that the range within which distribution is likely to vary could be as follows:
Some firms use a similar concept, called the 80–20 rule, that is, 80 per cent of the sales is
taken care of by 20 per cent of the items. In this system, items are classified in just two categories.
So far we have focused on constraints related to managerial time. The company may have
certain other constraints such as financial constraints. It is not uncommon for financial controllers
to provide an upper limit on the amount of inventory that the company should keep.
Sometimes organizations may have space constraint too, which may force the firm to look at
all the items together and vary service levels for different category of items to meet the constraints
on finance or space.