MODULE TITLE:

PRINCIPLES OF SUPPLY CHAIN MANAGEMENT

ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

SCHOOL OF COMMERCE

MA- LOGISTICS AND SUPPLY CHAIN MANAGEMENT PROGRAM

JANUARY, 2015

ADDIS ABABA, ETHIOPIA

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 CHAPTER ONE

INTRODUCTION

In this chapter you will learn the following concepts:

1.1 Supply Chain Management: A Historical Perspective

1.2 Basic Concepts of Supply Chain and Supply Chain Management
1.3 Objectives of Supply Chain Management
1.4 Characteristics of Supply Chain Management
1.5 Theories of Supply Chain Management
1.6 Supply Chain Decision Making Areas
1.7 Participants in Supply Chain
1.8 Supply Chain Efficiency and Responsiveness
1.9 Self-Assessment Questions
1.10 Chapter Summary

Chapter Objectives

After reading this chapter, you will be expected to:

describe supply chain and supply chain management

enumerate the participants in the supply chain

distinguish between/among supply chain management theories

provide practical example for the supply chain decision making areas

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1.1 SUPPLY CHAIN MANAGEMENT: A HISTORICAL PERSPECTIVE

Supply Chain Management: A Historical Perspective

Because of ease of world economic integration (globalization) and turbulent environment,

organizations realized the need to look in to new paradigm of operation structure to go beyond
their organizations’ boundary and work with and manage other autonomous organizations in a
cooperative fashion- a Supply Chain Management Approach.

As clearly stated by Gupta & Sahay (2007:6) many organizations and professionals
misunderstood the concept of supply chain. Many people interpret this as another process of an
organization, which deals with logistics and shear IT operation. A supply chain consists of
various stages, which take part in conversion of raw material in to final products and its
delivery to the end customer. It not only includes suppliers and manufactures but also
distributors, transporters, retailers and customers within each organization. It includes all the
important functions i.e. order management, planning, shop-floor operations, inspections,
packaging and dispatch, etc. Moreover, supply chain is an approach to regulate the flow of
materials, information and finances.

The term “supply chain management” arose in the late 1980s and came into widespread use in
the 1990s. Prior to that time, businesses used terms such as “logistics” and “operations
management”.

While reference to supply chain management can be traced to the 1980s, it was in the 1990s
that the term supply chain management captured the attention of senior level management in
numerous organizations.

For some scholars, the concept of supply chain management (SCM), can be traced back to just
before the 1960s of the systems theory (1951). However, increased study of the field began in
the 1980s, with a dramatic increase in the publication rate since 1990 (Wisner et al., 2005;
Oliver and Webber, 1982).

Supply chain management represents the third phase of an evolution that started in the 1960s
with the development of the physical distribution concept and focused up on the outbound side
of the firms’ logistics system. A number of studies during the 1950s and 1960s indicated the
potential of systems concept. The focus was up on total systems cost and analyzing trade-off
scenarios to arrive at the best or lowest physical distribution system cost (that crosses
organizational boundary and incorporates other firms also).

The Origin of Supply Chain Management goes back to the 1950s and 1960s, when US
manufacturers were employing mass production techniques to reduce costs and improve
productivity while relatively little attention was typically paid to creating supplier
partnerships, improving process design and flexibility, or improving product quality, (Wisner

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et al., 2005:10). In the 1960s and 1970s, material requirements planning (MRP) systems and
manufacturing resource planning (MRP II) systems were developed, and the importance of
effective materials management was recognized as manufacturers became aware of the impact
of high levels of inventories on manufacturing and storage costs.

The 1970s were the breakout years for supply chain management. Intense global competition
beginning in the 1980s (and continuing to date) provided incentives to manufacturers to offer
lower-cost, higher quality products along with higher levels of customer service. Many
manufacturers utilized just-in-time (JIT) and Total quality management (TQM) strategies to
improve quality, manufacturing efficiency, and delivery times in fulfilling customers’ order.

Over the past ten years or above, many large firms or conglomerate have found that effectively
managing all of the business units of their own vertically integrated firm -a firm whose
business boundaries extend to include onetime suppliers and/or customers is quite difficult.
Historical evolution of supply chain is presented in the accompanying figure 1.1 as stated by
(Wisner et al., 2005:11)

Figure 1.1 Historic Supply Chain Management Events in the United States

Increased supply chain

Capabilities

Supply chain relationship

formation and extension

JIT, TQM, BPR, supplier &

customer alliances

Inventory management & Cost

Containment

Traditional Mass Manufacturing

1950s 1960s 1970s 1980s 1990s 2000s

Fig. 1.1 Historical Evolution of SCM

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As competition in the U.S. intensified further in the 1990s accompanied by increasing logistics
and inventory costs and the trend toward market globalization, the challenges associated with
improving quality, manufacturing efficiency, customer service, and new product design and
development also increased. To deal with these challenges, manufacturers began purchasing
from a selected number of certified, high- quality suppliers with excellent service reputations
and involved these suppliers in their new product design and development activities as well as
in cost, quality, and service improvement initiatives. This is done so by reducing the supply
base as much as to a single supplier and enter in to a long term agreement as strategic alliance
in doing their business.

As companies began implementing supply chain management initiatives, they began to

understand the necessity of integrating all key business processes among the supply chain
participants enabling the supply chain to act and react as one entity.

1.2 BASIC CONCEPTS OF SUPPLY CHAIN (SC) AND SUPPLY CHAIN

MANAGEMENT (SCM)

1.2.1 Definitions of a Supply Chain

A supply chain is a network that includes vendors of raw materials, plants that transform those
materials into useful products, and distribution centers to get those products to customers.
Known also as the value chain, it is the sequence, which involves producing and delivering of a
product or service (Zailani & Rajagopal, 2005:380).

“A supply chain is the alignment of firms that bring products or services to market.”
Lambert et al., 1998)
“A supply chain consists of all stages involved, directly or indirectly, in fulfilling a
customer request. A supply chain not only includes the manufacturers and suppliers,
but also includes transporters, warehouses, retailers, and customers themselves”
(Chopra and Meindl, 2001).”
A supply chain is a network of facilities and distribution options that performs the functions of
procurement of materials, transformation of these materials into intermediate and finished
products, and the distribution of these finished products to customers” (Ganeshan and
Harrison, 1995).

Within each organization, such as a manufacturer, the supply chain includes all functions
involved in receiving and filling customer requests. These functions include, but they are not
limited to, new product development, marketing, operations, distribution, finance, and
customer service. A supply chain is dynamic and involves the constant flow of information,
product, and funds between different stages.

Customer is an integral part of the supply chain. The primary purpose for the existence of any
supply chain is to satisfy customer needs, in the process generating profits for itself. Supply
chain activities begin with a customer order and end when a satisfied customer has paid for

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his/her purchase. The term supply chain conjures up images of product or supply moving from
suppliers to manufacturers to distributors to retailers to customers along a chain. Thus, most
supply chains are actually networks.

Example 1: Supply Chain of Dell Computer

Customer --------- Manufacturer ------- Customer
Example 2: Supply Chain of Hewlett Packard (HP)
Supplier ----- Manufacturer ------ Retailer ------ Customer

Figure 1.2 A Generic Supply Chain (Wisner et al., 2005:6)

Product & Service flow

Recycling & returns

End- product
manufacturer(
Raw Intermediate Wholesalers,
or focal firm)
component distributors Retailers
material
manufactures

End
Customer

Transportation &
storage activities

Information/planning/activity integration

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1.2.2 Definition of Supply Chain Management

Lummus et al. (2001) conclude that Supply Chain Management (SCM) includes the logistics
flows, the customer order management, the production processes, and the information flows
necessary to monitor all the activities at the supply chain nodes, as quoted in (Sevensson,
2003:305)

The simultaneous integration of customer requirements, internal processes and upstream

supplier performance is commonly referred to as supply chain management (Tan et al., 1999).
As cited in the work of (Zailani & Rajagopal, 2005).

Chandra and Kumar (2000) mention that many firms have moved aggressively to improve
SCM to balance customers’ demands with the need focused mainly on flexible organizational
relationships , total supply chain co-ordination , improved inter-and intra-enterprise
communication , outsourcing of non-core competencies, built-to –order manufacturing
strategy, inventory management , and cost control.

Mentzer (2000) write:

… SCM has been conceptualized with two different components- an integrative

business philosophy and implementation actions- to manage the flow of a distribution
channel from the supplier to the ultimate user…
Scholars have placed emphasis on a reversed focus on the supply chain from the point-of –
final-consumption to the point- of origin (Svensson, 2003)

It has been illustrated that the current SCM-definitions generally comprise and regard the
marketing channel as a single entity, i.e. from the point-of –origin to the point-of –final-
consumption. The interdependence between firms’ business activities and resources in
marketing channels is acknowledged. Sometimes the SCM-definitions do recognize the
importance of the customer, and eventually the ultimate consumer. The current theory
generation of SCM frequently departs towards suppliers, and sometimes towards customers,
but rarely both (Svensson, 2003:313).

Lamming (1996) introduced the theory of SCM as an extension of logistics, though referring to
the extended need of relationship issues to be considered in the theory of SCM as cited in the
work (Halldorsom et al., 2007)

The supply chain encompasses organization and flows of goods and information between
organizations from raw materials to end-users (Handfield and Nichols, 2002). The supply chain
is a meta-organization built up by independent organizations that have established inter-
organizational relationships and integrated business processes across the borderlines of the
individual firms. A supply chain can also be characterized as a borderless organization (e.g.
Picot et al., 200), a value net (Bovet and Martha, 2000), a virtual supply chain (Chandrashekar
and Schary, 1999), an interactive firm (Johansen and Riis, 2005), a multi-organization/single-

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site coordinated operations network (Rudberg and Olhager, 2003), or /and extended enterprise
(Davis and Spekman, 2004; Boardman and Clegg, 2001 as cited in the work of (Halldorson et
al., 2007)

The supply chain is composed of, great number of products, customers, delivery points,
suppliers, costs, etc, in a complex network (Gupta & Sahay, 2007)

The approach of SCM is derived from the fact that there are dependencies between levels in
channels from the point of origin to the point of consumption (Lamber et al., 1998; Hakansoon
and Snehota, 1995; Stern, 1969; Alderson, 1957, 1965; Mc Cammon and Little, 1965; Weld,
1916) as quoted in the work of (Svensson, 2007). SCM might be seen as a business philosophy
that strives to integrate the dependent activities, actors, and resources between the different
levels of the points of origin and consumption in channels. This means that SCM comprises
different kinds of dependencies in, between and across companies in channels from
manufacturers/suppliers to customers/consumers.

In conjunction with the Global Supply Chain forum, Lambert et al. (1998) offers the following
definition of SCM: “Supply Chain Management is the integration of key business processes
from end user through original suppliers that provides products, services, and information that
add value for customers and other stakeholders” as quoted in the work of (Tracey et al.,
2005:179)

The importance of logistics and supply chain management (SCM) has been increasingly
recognized in the manufacturing environment. While a supply chain consists of a number of
partners or components (such as suppliers, manufactures, distributors and customers), its
effective management requires integration of information and material flow through these
partners from source to use.

The supply chain is a network of autonomous or semi-autonomous business entities involved,

through upstream and downstream links, in different business processes and activities that
produce physical goods or services to customers (Samaranayake, 2005)

Recent economic trends have de-emphasized the benefits of vertical integration (e.g.
economies of scale, access to capital, and large physical infrastructure investment) and instead
have focused on the benefits of being specialized (e.g. speed, agility, and rapid growth).

Successful SCM requires an integration of all the components involved into a combination of
business processes within and across organizations. This requires integration of the
organizational elements responsible for each activities and the external suppliers and customers
who are part of the planning and execution process.

For example, The Institute for supply Management describes supply chain management as:
“the design and management of seamless, value-added processes across organizational
boundaries to meet the real needs of the end customer. The development and integration of
people and technological resources are critical to successful supply chain integration”

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The Supply Chain Council’s definition of Supply chain management is:

“Managing supply and demand, sourcing raw materials and parts, manufacturing and
assembly, warehousing and inventory tracking, order entry and order management,
distribution across all channels, and delivery to the customer”
The Council of Logistics Management defines supply chain management as:

“… the systematic, strategic coordination of traditional business functions and the

tactics across the business functions within a particular company and across businesses
within the supply chain for the purpose of improving the long term performance of the
individual companies and the supply chain as a whole.”
Successful supply chain management, then, coordinates and integrates all of business activities
in to a seamless process. It embraces and links all of the partners in the chain. Supply chain
Managements (SCM) framework consists of three major and closely related elements; business
processes, management components and structure of the supply chain (Lambert et al., 1997) as
quoted in (Gupta & Sahay, 2007:22).

The area of supply chain management (SCM) has seen a rapid increase in interest among many
organizations. Numerous reasons have been offered for this. First, a SCM focus has provided
firms with competitive advantage given the diminishing returns that are being derived from
intra- enterprise improvement initiatives (Maloni and Benton, 2000). Secondly, a restructuring
of industries as a result of technological discontinuities has led to natural evolution to SCM
(Reddy and Reddy, 2001). Thirdly, SCM has been seen as a practical response to globalization
(Weber et al., 2000), deregulation and dynamic competitive markets (Christopher, 1998).
Finally, dependencies that firms have on others as a result of developments such as lean
operations, outsourcing and JIT have been intensified, leading firms to engage in SCM more
extensively (Burt et al., 2003) as quoted in ( Buregess & Singh, 2006).

Therefore it can be inferred that the emergence of supply chain management philosophy of
competition in the 1990s was the realization of the systems concept developed in the mid 20th
century.

Supply chains encompass the companies and the business activities needed to design, make,
deliver, and use a product or service. Businesses depend on their supply chains to provide them
with what they need to survive and thrive. Every business fits into one or more supply chains
and has a role to play in each of them.

Supply chain management is a new approach of managing materials, functional components,

trading partners who are autonomous and interdependent entities with common goal of
pursuing value creation to their respective customers in the order fulfillment cycle. Its
approach is more of cooperation than competition among chain members, more of trust and
long term relationship arrangement and more of integration of their business processes,
information and financial flows in the order fulfillment cycle to the ultimate customers.

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When the same firm begins to practice supply chain management with other members of a
supply chain, the focus will be on channel integration or extending this strategic alliances to
supplier’s suppliers to customer’s customers.

Figure 1.3 Supply Chain or Supply Chain Network

Example: Wal-Mart is a company shaped by its supply chain and the efficiency of its supply
chain has made it a leader in the markets it serves. Wal-Mart introduced concepts that are now
industry standards. Many of these concepts come directly from the way the company builds
and operates its supply chain around four concepts: These are:
i. The strategy of expanding around distribution centers (DCs)
ii. Using electronic data interchange (EDI) with suppliers
iii. The “big box” store format, and
iv. “Everyday low prices”
Activity 1: Supply Chain Network
Take a given company in your locality and show its supplier network, internal network
and distribution network.
Aim: To have a clear picture of the supply chain

1.2.2 SUPPLY CHAIN MANAGEMENT AS A MANAGEMENT PHILOSOPHY

SCM as a management philosophy takes a system approach to view the supply chain as a
single entity. This means that the partnership concept is extended into a multi-firm effort to
manage the flow of goods from suppliers to the ultimate customer. Each firm in the supply
chain directly or indirectly affects the performance of the other supply chain members, as well
as the overall performance of the supply chain.

SCM as philosophy has the following characteristics:

• A systematic approach to view the supply chain as a whole and managing the total flow
from the supplier to the ultimate customer.

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 • A strategic orientation toward cooperative efforts to synchronize and converge intra-
firm and inter-firm operational and strategic capabilities into a unified whole.
• A customer focus, to create unique and individualized sources of customer value,
leading towards customer satisfaction.
1.2.3 SCM AS A SET OF ACTIVITIES TO IMPLEMENT A MANAGEMENT
PHILOSOPHY

When a company adopts a certain philosophy, a set of management practices must be

established to ensure behavior consistent with the philosophy.

The key activities needed for successful implementation of the SCM philosophy are:

• integrated behavior,
• mutually sharing information,
• mutually sharing risks and rewards,
• cooperation,
• the same goal and the same focus on serving customers,
• integration of processes and
• partners to build and maintain long term relationships.
As stated by (Cox: 1999:173-174), the supply chain concept has both a strategic as well as an
operational importance. To understand this point of view one has to recognize that the supply
chain has two dimensions. The first can be referred to as the operational supply chain; the
second can be referred to as the entrepreneurial supply chain.

The operational supply chain refers to the series of primary and support supply chains that have
to be constructed to provide the inputs and outputs that deliver products and services to the
customers of any company. All companies have operational supply chains, and these supply
chains are normally unique to the company creating them, because they have choices about the
input and output supply chains that they create operationally, when they position themselves
strategically to provide a particular product and service within a specific primary supply chain.

In order to begin the analytical categorization of supply chains it is necessary to understand

three things. First, we need to understand the physical resources that are required within a
supply chain to create and deliver a finished product or service to a customer. Second, we must
understand the exchange relationship between particular supply chain resources and the flow of
revenue in the value chain. Third, we must also understand what it is about the ownership and
control of particular supply chain resources to command more of the flow of value than others.

Therefore, SCM philosophy requires extension of certain behavior to external partners

(suppliers, customers) and in this context the philosophy of SCM turns into a set of activities
that carries out the philosophy. One of the important aspects of an integrated behavior is also
mutual sharing of information among members of the Supply Chain. This is particularly
valuable for the planning and monitoring processes. Open sharing of information such as

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inventory levels, forecasts, sales promotion strategies, marketing strategies, reduces uncertainty
and increases performance.

Activity 2: Strategic dimensions of SC

SC has a strategic significance. Explain this statement by taking your own example.

1.3 OBJECTIVES OF SUPPLY CHAIN MANAGEMENT

The objective of SCM is to maximize the overall value generated, minimize the cost, and
effective and timely distribution of products needed by ultimate customers.

Supply chain profitability in abstract is one of the objectives, which means profit sharing
among partner organizations. Profitability due to low cost to all partners creates value to
customers. Value is created by means of same or higher quality in lesser costs as compared to
competitor’s products.

Supply chain responsiveness is another most sought supply chain objective. Responding to
wide range of customers’ demand, short lead times and wide ranges of products in appropriate
cost creates value to customers (Gupta & Sahay, 2007:13).

SCM provides unique opportunities for creating added value for customers by leveraging the
competencies and knowledge of the entire trading alliance, including:

• lowering costs,
• providing superior customer service,
• adding new value-added services, and
• achieving greater flexibility, and attaining faster innovation.
In brief, the objective of supply chain management is to balance the flow of materials with
customer requirements through out the supply chain, such that costs, quality, and customer
service are at optimal levels.

1.4 CHARACTERISTICS OF SUPPLY CHAIN MANAGEMENT

Langley et al., (2006:22-24), identified five characteristics of supply chain management as

follows:

1. Inventory visibility:- managing the flow and level of inventory is a central focus of supply
chain management and major performance metric to gauge success
2. Pull systems: - Another important characteristic of effective inventory management is to
attempt to pull it through the supply chain in response to demand as opposed to pushing out
inventory in advance of demand, which tends to inflate inventory levels and lead to
obsolete inventory and lower inventory turnover.
3. Cost: - efficiency or lowering cost is an important objective of supply chain management;
this cost is to be considered at the end of supply chain which is called landed cost.

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4. Information: - Managing the flow of information is a key factor for both efficiency and
effectiveness in the supply chain with the key characteristic of sharing information up and
down the supply chain related to the flow and demand requirements. If information is
shared, it can be potentially available on a real-time basis.
5. Customer Service: - Among one of the supply chain characteristics, customer service is a
very important attribute of successful supply chain. In the final analysis, success of today’s
global supply chain is the value that they add for their ultimate customers in terms of the
supply chain’s landed cost/price and the related services that are provided. Customer
service has three recognized levels from supply chain perspective, these are; reliability, on
time delivery and accurately filled orders. As stated clearly, reliability, on time delivery
and accuracy of order fulfillment are the most three dimensions of customer service to be
filled by supply chain members.

1.5 THEORIES OF SUPPLY CHAIN MANAGEMENT

Halldorson et al., (2007:287) tried to consolidate different organizational theories in to Supply

chain management theories as follows:

a. SCM Mitigating Agency Problems- The Principal-Agent Theory (PAT)

Based on the separation of ownership and control of economic activities between the agent and
the principal, various agency problems may arise, such as asymmetric information between the
principal and the agent, conflicting objectives, differences in risk aversion, outcome
uncertainty, behavior based on self-interest, and bounded rationality. The contract between the
principal and the agent governs the relationships between the two parties, and the aim of the
theory is to design a contract that can mitigate potential agency problems. The “most efficient
contract” includes the right mix of behavioral and outcome-based incentives to motivate the
agent to act in the interests of the principal (Eisenhardt, 1998; Logan, 2000).

The alignment of incentives is an important issue in SCM. Misalignment often stems from
hidden actions or hidden information. However, by creating contracts with supply chain
partners that balance rewards and penalties, misalignment can be mitigated (Narayanan and
Raman, 2004; Baiman and Rajan, 2002).

Activity 3: Principal-Agent Relationship

Think of a corporate company managed by CEO/GM/President on behalf of the shareholders.

What practical strategy do you suggest to use so that these managers behave within the owners’
interest rather than engaging in conflict of interest?

b. SCM as Coordination of Transferred Rights of Disposals-Transaction Cost Analysis (TCA)

TCA offers a normative economic approach to determine the firm’s boundaries and can be
used to present efficiency as a motive for entering inter-organizational arrangements
(Williamson, 1997, 1985, 1996). A company may reduce its total transactions costs (ex ante

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and ex post costs of contact, contract, and control) by cooperating with external partners. The
key question is: why do firms exist? In the context of SCM, this question is addressed as:
which activities should be performed within the boundary of each firm, and which activities
should be outsourced? SCM relationships are represented by the hybrid more of governance
between markets and hierarchies. Asset specificity (limited value in an alternative application
of, for example, physical, site, human, and dedicated assets) is the most influential attribute of
the transaction (Rindfleisch and Heid, 1997). Behavioral assumptions of bounded rationality
and the risk of being subject to opportunistic behavior from a partner also influence the
transaction costs. Bounded rationality may result from insufficient information, limits in
management perception or limited capacity for information processing, Mechanisms for
mitigating the risk of opportunism include safeguards and credible commitments such as long-
term contracts, penalty clauses if a partner fails to fulfill the contract, equity sharing, and joint
investments. According to Williamson (1996), trust between the parties is based on “calculated
risk” and not on personal trust between individuals.

TCA has often been used in make-or-buy decisions in supply chains. Examples are outsourcing
of logistics activities (Maltz, 1993; Andersson, 1997; Halldorsson, 2002), buyer-supplier
relationships (Mikkola, 2003b; Bensaou, 1999; Stuart and McCutcheon, 1996), and
restructuring of supply chains (Croom, 2001). In essence, TCA is a useful instrument to decide
whether a transaction should be performed in the marketplace or in-house.

TCA focuses mainly on appropriation concerns, which originate from the behavioral
assumptions of bounded rationality and opportunism ( Knioppen & Christiaans, 2007:166)

c. SCM as Reciprocated Interactions between Institutions -The Network Perspective (NT)

The performance of a firm depends not only on how efficiently it cooperates with its direct
partners, but also on how well these partners cooperate with their own business partners. NT
can be used to provide a basis for the conceptual analysis of reciprocity (Oliver, 1990) in
cooperative relationships. Here, the firm’s continuous interaction with other players becomes
an important factor in the development of new resources (Haakansson and Ford, 2002).
Relationships combine the resources of two organizations to achieve more advantages than
through individual efforts. Such a combination can be viewed as a quasi-organization
(Haakansson and Snehota, 1995; Haakansson 1987). The value of a resource is based on its
combination with other resources, which is why inter-organizational ties may become more
important than possessing resources per se.

Thus, the resource structure determines the structure of the supply chain and becomes its
motivating force. The network theory (NT) contributes profoundly to an understanding of the
dynamics of inter-organizational relations by emphasizing the importance of “personal
chemistry” between the parties, the build-up of trust through positive long-term cooperative
relations and the mutual adaptation of routines and systems through exchange processes.
Through direct communication, the relationships convey a sense of uniqueness, ultimately
resulting in supply chains as customization to meet individual customer requirements. The
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parties gradually build up mutual trust through the social exchange processes. A network does
not seek an optimal equilibrium, but is in a constant state of movement and change. Links
between firms in a network develop through two separate, but closely linked, types of
interaction: exchange processes (information, goods and services, and social processes) and
adaptation processes (personal, technical, legal, logistics, and administrative elements)
Johanson and Mattsson (1987).

d. SCM as Coordination of Relational Assets – The Resource-Based View (RBV)

Only a few articles have applied the resource-based view (RBV) to the field in focus in order to
obtain the sources of competitive advantage through SCM (Lewis, 2000; Pandza et al., 2003;
Rungtusanatham et al., 2003; Carr and Pearson, 2002) or to analyze the structure of chains and
industrial clusters (Miller and Ross, 2003; de Olivera Wilk and Fensterseifer, 2003).

The RBV deals with competitive advantages related to the firm’s possession of heterogeneous
resources (financial, physical, human, technological, organization, and reputations) and
capabilities (combination of two or more resources) (Grant, 2991; Penrose, 1959; Prahalad and
Hamel, 1990). These resources and capabilities constitute the core competence of the particular
firm and serve ultimately as its source of competitive advantage. The static stream of research
focuses on attributes that contribute to the heterogeneity of resources and capabilities. Four
barriers may prevent competitors from imitating a firm’s resources and capabilities: durability;
transparency; transferability; and replicability (Prahalad and Hamel, 1990).

These attributes may also apply to inter-organizational arrangements (Jap, 2001). The more
dynamic aspects of the RBV consider a firm’s core competence to be its ability to react quickly
to situational changes and build further competencies (Prahalad and Hamel, 1990) or dynamic
capabilities (Eisenhardt and Martin, 2000). Hence, a firm’s competitiveness is associated with
the configuration of resources and capabilities as the markets evolve. However, inter-
organizational relationships may also facilitate and advance the learning processes of
individual firms. As such, relationships are not only output – oriented but also learning-
oriented. Efficiency may not only be explained in terms of productivity or operational
measures, but also in terms of the opportunity to access another firm’s core competencies
through cooperative arrangements as an alternative to building such competencies in-house
(Haakansson et al., 1999).

The RBV is an implicit assumption in many supply chain decisions. Often, outsourcing
decisions are based on the idea of focusing on core competencies and outsourcing
complementary competencies to external partners. Third party Logistics (TPL) and outsourcing
of standard components and processes to subcontractors are examples. However, outsourcing
of design, NPD, or software development is often a way to gain access to other supply
members’ core competencies through inter-organizational collaboration. (Halldorson, et al.,
2007:288).

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Supply networks are complex sets of relationships between supply-related business partners. A
fundamental issue for all types of networks is their capability of creating value and the ultimate
test of value is how end-customers perceive and evaluate the offerings with competing
networks provide (Svahn & Westerlund, 2007:370)

According to the Resource Based View of the firm (RBV), firms actively exchange resources
in their operation. We can see that intentional nets of actors are a form of collaboration, in
which the main elements or components from management can be recognized. In addition, we
see that it is possible to identify the different – but simultaneously extant – modes of
management, and we propose that in the supply net context they are influencing, controlling
and monitoring, coordination, and integration. (Svahn & Westerlund, 2007:371).

Activity 4: Resource-based view of the firm

What do you understand by the resource based theory of the firm? Not more than 150 words!

1.6 SUPPLY CHAIN DECISION MAKING AREAS

There are five areas where companies can make decisions that will define their supply chain
capabilities. Companies in any supply chain must make decisions individually and collectively
regarding their actions in five areas. These are:

1. Production—what products does the market want? How much of which products
should be produced and when? This activity includes the creation of master production
schedules that take into account plant capacities, workload balancing, quality control,
and equipment maintenance.
2. Inventory—what inventory should be stocked at each stage in a supply chain? How
much inventory should be held as raw materials, semi finished, or finished goods? The
primary purpose of inventory is to act as a buffer against uncertainty in the supply
chain. However, holding inventory can be expensive, so what are the optimal inventory
levels and reorder points?
3. Location—where should facilities for production and inventory storage be located?
Where are the most cost efficient locations for production and for storage of inventory?
Should existing facilities be used or new ones built? Once these decisions are made
they determine the possible paths available for product to flow through for delivery to
the final consumer.
4. Transportation—how should inventory be moved from one supply chain location to
another? Air freight and truck delivery are generally fast and reliable but they are
expensive. Shipping by sea or rail is much less expensive but usually involves longer
transit times and more uncertainty. This uncertainty must be compensated for by
stocking higher levels of inventory. When is it better to use which mode of
transportation?

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 5. Information—how much data should be collected and how much information should be
shared? Timely and accurate information holds the promise of better coordination and
better decision making. With good information, people can make effective decisions
about what to produce and how much, about where to locate inventory and how best to
transport it.
Chopra and Meindl (2007:53-56) defined these areas as performance drivers that can be
managed to produce the capabilities needed for a given supply chain. They further classified
these supply chain performance drivers in to two. These are: Logistical drivers and cross
functional drivers.
i. Logistical Drivers- include facilities, inventory and transportation.
a. Facilities- are the actual physical locations in the supply chain network where
product is stored, assembled or fabricated.
b. Inventory-encompasses all raw materials, work in process and finished goods within
a supply chain. Changing inventory policies can dramatically alter the supply chain’s
efficiency and responsiveness.
c. Transportation-entails moving inventory from point to point in the supply chain.
ii. Cross Functional Drivers-which include information on sourcing and pricing.
a. Information- consists of data and analysis concerning facilities, inventory,
transportation, costs, prices, and customers throughout the supply chain.
b. Sourcing-is the choice of who will perform a particular supply chain activity such as
production, storage, transportation or the management of information.
c. Pricing- determines how much a firm will charge for goods and services that it
makes available in the supply chain.

Effective supply chain management calls first for an understanding of each driver and how it
operates. Each driver has the ability to directly affect the supply chain and enable certain
capabilities.

1.7 PARTICIPANTS IN THE SUPPLY CHAIN

In its simplest form, a supply chain is composed of a company and the suppliers and customers
of that company. This is the basic group of participants that creates a simple supply chain.
Extended supply chains contain three additional types of participants. First, there is the
supplier’s supplier or the ultimate supplier at the beginning of an extended supply chain. Then,
there is the customer’s customer or ultimate customer at the end of an extended supply chain.
Finally, there is a whole category of companies who are service providers to other companies
in the supply chain. These are companies who supply services in logistics, finance, marketing,
and information technology.

In any given supply chain there is some combination of companies who perform different
functions. There are companies that are suppliers, producers, distributors or wholesalers,
retailers, and companies or individuals who are the customers, the final consumers of a

17
product. Supporting these companies there will be other service providing companies that
provide a range of needed services.

1. Suppliers
Different layers of Suppliers in the upstream supply chain provide raw materials to the focal
firms needed for value adding activity (transformation) and delivery to the customer along the
downstream supply chain.
2. Manufacturers

Producers or manufacturers are organizations that make a product. This includes companies
that are producers of finished goods. Producers of finished goods use raw materials and
subassemblies made by other producers to create their products. Producers can create products
that are intangible items such as music, entertainment, software, or designs. A product can also
be a service such as mowing a lawn, cleaning an office, performing surgery, or teaching a skill.
In many instances the producers of tangible, industrial products are moving to areas of the
world where labor is less costly. Producers in the developed world of North America, Europe,
and parts of Asia are increasingly producers of intangible items and services.

3. Distributors

Distributors are companies that take inventory in bulk from producers and deliver a bundle of
related product lines to customers. Distributors are also known as wholesalers. They typically
sell to other businesses and they sell products in larger quantities than an individual consumer
would usually buy. Distributors buffer the producers from fluctuations in product demand by
stocking inventory and doing much of the sales work to find and service customers. For the
customer, distributors fulfill the “Time and Place” function—they deliver products when and
where the customer wants them. A distributor is typically an organization that takes ownership
of significant inventories of products that they buy from producers and sell to consumers. In
addition to product promotion and sales, other functions the distributor performs are inventory
management, warehouse operations, and product transportation as well as customer support
and post-sales service. A distributor can also be an organization that only brokers a product
between the producer and the customer and never takes ownership of that product. This kind of
distributor performs mainly the functions of product promotion and sales. In both cases, as the
needs of customers evolve and the range of available products changes, the distributor is the
agent that continually tracks customer needs and matches them with products available.

4. Retailers

Retailers stock inventory and sell in smaller quantities to the general public. This organization
also closely tracks the preferences and demands of the customers that it sells to. It advertises to
its customers and often uses some combination of price, product selection, service, and
convenience as the primary draw to attract customers for the products it sells. Discount
department stores attract customers using price and wide product selection. Upscale specialty
stores offer a unique line of products and high levels of service.

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 5. Customers

Customers or consumers are any organization that purchases and uses a product. A customer
organization may purchase a product in order to incorporate it into another product that they in
turn sell to other customers. Or, a customer may be the final end user of a product who buys
the product in order to consume it.

6. Service Providers

These are organizations that provide services to producers, distributors, retailers, and
customers. Service providers have developed special expertise and skills that focus on a
particular activity needed by a supply chain. Because of this, they are able to perform these
services more effectively and at a better price than producers, distributors, retailers, or
consumers could do on their own.

Some common service providers in any supply chain are providers of transportation services
and warehousing services. These are trucking companies and public warehouse companies and
they are known as logistics providers. Financial service providers deliver services such as
making loans, doing credit analysis, and collecting on past due invoices. These are banks,
credit rating companies, and collection agencies.

Some service providers deliver market research and advertising, while others provide product
design, engineering services, legal services, and management advice. Still other service
providers offer information technology and data collection services. All these service providers
are integrated to a greater or lesser degree into the ongoing operations of the producers,
distributors, retailers, and consumers in the supply chain.

Supply chains are composed of repeating sets of participants that fall into one or more of these
categories. Over time the needs of the supply chain as a whole remain fairly stable. What
changes is the mix of participants in the supply chain and the roles that each participant plays.
In some supply chains, there are few service providers because the other participants perform
these services on their own. In other supply chains very efficient providers of specialized
services have evolved and the other participants outsource work to these service providers
instead of doing it themselves.

1.8 SUPPLY CHAIN EFFICIENCY AND RESPONSIVENESS

Taken individually, different supply chain requirements often have conflicting needs. For
instance, the requirement of maintaining high levels of customer service calls for maintaining
high levels of inventory, but then the requirement to operate efficiently calls for reducing
inventory levels. It is only when these requirements are seen together as parts of a larger
picture that ways can be found to effectively balance their different demands.
Effective supply chain management requires simultaneous improvements in both customer
service levels and the internal operating efficiencies of the companies in the supply chain.
Customer service at its most basic level means consistently high order fill rates, high on-time

19
delivery rates, and a very low rate of products returned by customers for whatever reason.
Internal efficiency for organizations in a supply chain means that these organizations get an
attractive rate of return on their investments in inventory and other assets and that they find
ways to lower their operating and sales expenses. Supply Chain decision making areas, supply
chain efficiency and responsiveness are summarized as follows.

Fig. 1.4 Supply Chain Decision Making Areas

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 1.9 Self Assessment Questions

1. Define the concept of supply chain

2. Define supply chain management

3. Who are the participants in the supply chain?

4. Describe briefly supply chain decision making areas and capabilities.

5. Identify the deference between value chain and supply chain?

6. There are organizational theories developed and transformed in to supply chain

theories. Discuss these theories relating to practical cases with industry scenario by
example.

7. There are schools of thought with regard to supply chain management on its historical
development. Some argued that it is developed in the 1950s and sixties with the
systems concept where organization is viewed as a sub-system in the supply chain,
whereas, other paradigm showed it emerged from logistics management of the 1980s
and got popularity in the 1990s. What is your position? Discuss.

8. Briefly explain the difference between logistics management and supply chain
management

9. World class organizations in the global and ever increased competition considered
supply chain management as a philosophy to be adopted for sustainable competitive
advantage. This is practiced by maintaining core competencies and outsourcing other
subsidiary activities of the firm. Discuss how this philosophy works on a manufacturing
industry by taking a hypothetical company.

10. Briefly explain why firms adopt supply chain management and what are the drivers for
supply chain management?

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1.10 Chapter Summary

A supply chain is composed of all the companies involved in the design, production, and
delivery of a product to market. Supply chain management is the coordination of production,
inventory, location, and transportation among the participants in a supply chain to achieve the
best mix of responsiveness and efficiency for the market being served.
The goal of supply chain management is to increase sales of goods and services to the final,
end use customer while at the same time reducing both inventory and operating expenses.
Supply Chain Management is “The process for designing, developing, optimizing, and
managing the internal and external components of the supply system, including material
supply, transforming materials, and distributing finished products or services to customers, that
is consistent with overall objectives and strategies.”

The business model of vertical integration that came out of the industrial economy has given
way to “virtual integration” of companies in a supply chain. Each company now focuses on its
core competencies and partners with other companies that have complementary capabilities for
the design and delivery of products to market. Companies must focus on improvements in their
core competencies in order to keep up with the fast pace of market and technological change in
today’s economy.
To succeed in the competitive markets that make up today’s economy, companies must learn to
align their supply chains with the demands of the markets they serve. Supply chain
performance is now a distinct competitive advantage for companies who excel in this area.

There are various supply chain management theories developed and can be applied to firms in
the supply chain to achieve better supply chain management.

Participants in the supply chain management are as follows; producers (manufacturers and
suppliers,), service providers, customers, and channel members.

Key Terms

• Supply Chain- various stages, which take part in conversion of raw material in to final
products and its delivery to the end customer

• Supply Chain Management-managing supply and demand, sourcing raw materials and
parts, manufacturing and assembly, warehousing and inventory tracking, order entry
and order management, distribution across all channels, and delivery to the customer

• Supply Chain Participant- a company and the suppliers and customers of that company

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 CHAPTER TWO

ROLE OF PROCUREMENT IN SUPPLY CHAIN MANAGEMENT

In this chapter you will be exposed to the following concepts:-

2.1 Basic concepts of purchasing

2.2 Purchasing functions as a Process
2.3 Sourcing Decisions: The Make-or-Buy
2.4 Important Theories and Their Implications for the Sourcing Decisions
2.5 Role of Supply Base
2.6 Creating and Managing Supplier Relationship
2.7 Supplier Evaluation and Certification
2.8 Supplier Selection
2.9 Supplier Development
2.10 Supplier Integration and Relationship Management
2.11 Self-Assessment Questions
2.12 Chapter Summary

Chapter Objectives

After reading this chapter you will be expected to:

illustrate what purchasing means

demonstrate the steps involved in the purchasing process

compare and contrast between sourcing and outsourcing

explain the significance of supplier evaluation, selection & development

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2.1 BASIC CONCEPTS OF PURCHASING

In the context of Supply Chain Management (SCM), purchasing can be defined as the act of
obtaining merchandise; capital equipment; raw materials; services; or maintenance, repair, and
operating (MRO) supplies in exchange for money or its equivalent (Wisner et al., 2005:32)

In addition to the above definition, traditionally, the main activities of a purchasing manager
were to beat up potential suppliers on price and then buy products from the lowest cost supplier
that could be found. That is still an important activity, but there are other activities that are
becoming equally important. Because of this the purchasing activity is now seen as part of a
broader function called procurement. The procurement function can be broken into five main
activity categories: Purchasing, Consumption Management, Vendor Selection, Contract
Negotiation, and Contract Management (Hugos, 2003:64)

Purchasing is the eyes and ears of the organization in the supplier market place, continuously
seeking better buys and new materials from suppliers. Consequently, purchasing is in a good
position to select suppliers for the supply chain and to conduct certification programs.

As firms increasingly pursue supply chain management strategies in response to competitive

pressures, internally and externally, has increased the importance of purchasing function
(Mentzer, 2001:211). In the coming paragraphs, we will discuss about purchasing and routine
activities related to purchasing. These are:

1. Purchasing

These activities are the routine activities related to issuing purchase orders for needed products.
There are two types of products that a company buys; 1) direct or strategic materials that are
needed to produce the products that the company sells to its customers; and 2) indirect or MRO
(maintenance, repair, and operations) products that a company consumes as part of daily
operations. The mechanics of purchasing both types of products are largely the same.
Purchasing decisions are made, purchase orders are issued, vendors are contacted, and orders
are placed. There are a lot of data communicated in this process between the buyer and the
supplier—items and quantities ordered, prices, delivery dates, delivery addresses, billing
addresses, and payment terms. One of the greatest challenges of the purchasing activity is to
see that data communication happens in a timely manner and without error. Much of this
activity is very predictable and follows well defined routines.

2. Consumption Management

Effective procurement begins with an understanding of how much of what categories of

products are being bought across the entire company as well as by each operating unit. There

24
must be an understanding of how much of what kinds of products are bought from whom and
at what prices.

Expected levels of consumption for different products at the various locations of a company
should be set and then compared against actual consumption on a regular basis. When
consumption is significantly above or below expectations, this should be brought to the
attention of the appropriate parties so possible causes can be investigated and appropriate
actions can be taken. Consumption above expectations is either a problem to be corrected or it
reflects inaccurate expectations that need to be reset. Consumption below expectations may
point to an opportunity that should be exploited or it also may simply reflect inaccurate
expectations to begin with.

3. Vendor Selection

There must be an ongoing process to define the procurement capabilities needed to support the
company’s business plan and its operating model. This definition will provide insight into the
relative importance of vendor capabilities. The value of these capabilities has to be considered
in addition to simply the price of a vendor’s product. The value of product quality, service
levels, just in time delivery, and technical support can only be estimated in light of what is
called for by the business plan and the company’s operating model.

Once there is an understanding of the current purchasing situation and an appreciation of what
a company needs to support its business plan and operating model, a search can be made for
suppliers who have both the products and the service capabilities needed. As a general rule, a
company seeks to narrow down the number of suppliers it does business with. This way it can
leverage its purchasing power with a few suppliers and get better prices in return for
purchasing higher volumes of product.

4. Contract Negotiation

As particular business needs arise, contracts must be negotiated with individual vendors on the
preferred vendor list. This is where the specific items, prices, and service levels are worked
out. The simplest negotiations are for contracts to purchase indirect products where suppliers
are selected on the basis of lowest price. The most complex negotiations are for contracts to
purchase direct materials that must meet exacting quality requirements and where high service
levels and technical support are needed.

Increasingly, though, even negotiations for the purchase of indirect items such as office
supplies and janitorial products are becoming more complicated because they fall within a
company’s overall business plan to gain greater efficiencies in purchasing and inventory
management.

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Suppliers of both direct and indirect products need a common set of capabilities. Gaining
greater purchasing efficiencies requires that suppliers of these products have the capabilities to
set up electronic connections for purposes of receiving orders, sending delivery notifications,
sending invoices, and receiving payments. Better inventory management requires that
inventory levels be reduced, which often means suppliers need to make more frequent and
smaller deliveries and orders must be filled accurately and completely. All these requirements
need to be negotiated in addition to the basic issues of products and prices. The negotiations
must make tradeoffs between the unit price of a product and all the other value added services
that are required. These other services can either be paid for by a higher margin in the unit
price, or by separate payments, or by some combination of the two. Performance targets must
be specified and penalties and other fees defined when performance targets are not met.

5. Contract Management

Once contracts are in place, vendor performance against these contracts must be measured and
managed. Because companies are narrowing down their base of suppliers, the performance of
each supplier that is chosen becomes more important. A particular supplier may be the only
source of a whole category of products that a company needs and if it is not meeting its
contractual obligations, the activities that depend on those products will suffer.

A company needs the ability to track the performance of its suppliers and hold them
accountable to meet the service levels they agreed to in their contract. Just as with consumption
management, people in a company need to routinely collect data about the performance of
suppliers. Any supplier that consistently falls below requirements should be made aware of
their shortcomings and asked to correct them. Often the supplier themselves should be given
responsibility for tracking their own performance. They should be able to proactively take
action to keep their performance up to contracted levels. An example of this is the concept of
vendor managed inventory (VMI).VMI calls for the vendor to monitor the inventory levels of
its product within a customer’s business. The vendor is responsible for watching usage rates
and calculating economic order quantities (EOQs). The vendor proactively ships products to
the customer locations that need them and invoices the customer for those shipments under
terms defined in the contract.

Activity 6: Purchasing and Related activities

In your opinion, which of these activities is more important? Why? Substantiate your argument
with evidence.

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2.2. PURCHASING FUNCTION AS A PROCESS

2.2.1 The Role of Purchasing in an Organization

The Annual survey of manufacturers conducted by the US census bureau showed that
manufactures spent more than 50 percent of each sales dollar on raw materials from 1977 to
2000. Purchase of raw materials actually exceeded value added through manufacturing, which
accounted for slightly less than 50 percent of sales (Wisner et al., 2005).

2.2.2 The Purchasing Process

The purchasing process consists of the following steps.

i. The Material Requisition

The purchasing process starts when the material user initiates a request for a material by
issuing a material requisition (MR) in duplicates. A purchase Requisition (PR), instead of
material requisition used in some firms.

While most requests are transmitted through the generic material requisition, a traveling
requisition is used for materials and standard parts that are requested on a recurring basis.
Planned order releases from the material requirements planning (MRP) and/or a bill of
materials (BOM) can also be used to release requisitions or to place orders directly with the
suppliers.

ii. The Request for Quotation and the Request for Proposal

If the material is not available in the warehouse, the material requisition is channeled to the
purchasing department. If there is no current supplier for the item, the buyer must identify a
pool of qualified suppliers and issues a request for quotation (RFQ). A request for proposal
(RFP) may be issued instead for a complicated and highly technical component part, especially
if the completed specification of the part is unknown. These are not the only ways to select
suppliers. Remember that there are different sources of information about suppliers to consider
in the process.

iii. The Purchase Order

When a suitable supplier is identified or a qualified supplier is on file, the buyer issues a
purchase order (PO) in duplicates to the supplier. Firms should require the suppliers to
acknowledge and return a copy of the purchase order to indicate acceptance of the order.

iv Electronic Procurement Systems (e-procurement)

Electronic Data Interchange (EDI) was developed in 1970s to improve the purchasing process.
The material user initiates the e-procurement process by entering a materials request and other
relevant information such as quality and date needed, in to the materials requisition module,

27
next, the materials requisition is printed out and submitted to a buyer at the purchasing
department/or submitted electronically. The buyer reviews the material requisition for accuracy
and appropriate approval level. Upon satisfactory verification of the requisition, the buyer
transfers the materials requisition data to internet base e-procurement system and assigns
qualified suppliers to bid on the requisition.

The traditional manual purchasing system is tedious and labor intensive task of issuing
materials requisitions and purchase order. However, e-procurement systems have changed the
infrastructure requirement, making it readily affordable to most firms with the following
benefits:- Time Saving, cost saving, accuracy, real-time, mobility, traceability, management,
and benefits to the suppliers(Wisner et al., 2005:40-41).

. Considerations in Placing Purchase Orders

Small value purchases particularly in a manual system should be minimized to ensure that
buyers are not over loaded with unnecessary purchases that may compromise the firm’s
competitive position.

Stockless Buying or System Contracting

Stockless buying or system contracting is an extension of the blanket purchase order. It

requires the supplier to maintain a minimum inventory level to ensure that the required items
are readily available for the buyer.

Petty Cash

Petty cash is a small cash reserve maintained by a clerk or midlevel manager for small
purchases

Accumulating small orders to create a large order

Numerous small orders can be accumulated and mixed in to a large order, especially if the
material request is not urgent.

Activity 7: Purchasing Process

Take few minutes to recall the steps involved in making a purchase in your organization or any
organization in your locality. Is there any difference? If any, why do you think there is a
difference?

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2. 3 SOURCING DECISIONS: THE MAKE – OR- BUY DECISION

Outsourcing popularly refers to buying materials and components that were previously made in
house from suppliers instead of making them in–house. Traditionally, firms preferred the make
option by using backward integration and forward integration.

The conceptual basis for outsourcing is Williamson’s (1975) theory of transaction cost
analysis. Transaction cost analysis combines economic theory with management theory to
determine the best type of relationship a firm should develop in the marketplace. This has laid
the foundations for the purchasing discipline that uses and analysis of the factors which
determine the internal and external boundaries of the firm. The concept of transaction cost
analysis is that the properties of a transaction determine what constitute the efficient
governance structure, market, hierarchy or alliance. The primary factors producing
transactional difficulties include:

 bounded rationality – the rationality of human behavior is limited by the ability of the
actor to process information.
 opportunism – people are prone to behave opportunistically, which means self- interest
seeking with guile.
 small number bargaining – many bargaining situations are infrequent or involve small
quantities where the cost of obtaining full information is prohibitive, i.e. as in an
oligopoly.
 information impactedness- asymmetrical distribution of information among the
exchanging parties that means that one party might have more knowledge than another
(McIvor, 2003: 381).
A concept that is frequently linked with outsourcing is core competence. The ideas of core
competence and its relationship to outsourcing have evolved from the work of Prahalad and
Hamel (1990). They contend that core competencies are not physical assets. Physical assets, no
matter how innovative they may seem in the present, can be very easily replicated or become
obsolete. Instead, Prahalad and Hamel (1990) argue that the real sources of competitive
advantage are to be found in management’s ability to consolidate corporate-wide technologies
and production skills into competencies that empower individual businesses to adapt rapidly to
changing business opportunities.

They argue that core competencies are:

… the collective learning in the organization, especially how to co-ordinate diverse

production skills and integrate multiple streams of technologies.
Competencies are the skills, knowledge and technologies that an organization possesses on
which its success depends as cited in the work of (McIvor, 2003:382)

Whether to make or buy materials or components is a strategic decision that can impact an
organization’s competitive position. Wisner et al., (2005: 44-45), stated why organizations
choose outsourcing and making as follows: Cost advantage, insufficient capacity, lack of

29
expertise, and quality are reasons opt for buying or outsourcing to outsiders, whereas, Protect
proprietary technology, no competent supplier, better quality control, use existing idle capacity,
control of lead time transportation and ware housing cost, and lower cost are reasons opt for
making internally by own facilities.

The decision to outsource an activity, sometimes referred to as the make-or buy decision, has
implications for supply chain management because it affects the number of activities under the
direct control of the firm in its internal supply chain. This decision is not trivial because a firm
must first have a clear understanding of its core competencies and retain them. Outsourcing has
direct relevance for supply chain management because of its implications for control and
flexibility (Ritzman et al., 2003).

Outsourcing is a common practice among both private and public organizations and is a major
element in business strategy. Perhaps most organizations now outsource some of the functions
they used to perform themselves (Kremic et al., 2006: 467).

Motivations for Outsourcing

There are three major categories of motivations for outsourcing: Cost, strategy and politics.
The first two commonly drive outsourcing by private industry (Kremic et al 2006:468).

a. Cost driven outsourcing

Much of the literature identified the desire to save costs as an explanation for why outsourcing
occurs. A desire to save indirect costs may also drive outsourcing. Having fewer employees
requires less infrastructure and support systems which may result in a more nimble and
efficient organization.

b) Strategy- driven outsourcing:

More recently the main drivers for outsourcing appear to be shifting from cost to strategic
issues such as core competence and flexibility

c) Politically – driven outsourcing

There are several reasons why a public organization may behave different than a private firm
and therefore may have different outsourcing motivation. Industry performs service to make
money whereas the public organization attempts to ensure general well being; a different goal
and mission. So, while cost and strategy may drive private firms, the desire for the general well
being of citizens may drive outsourcing by public organizations.

Firms are less able to develop major process or business innovations in isolation because of the
dispersion of knowledge and technological resources driven by organizational specialization.
In order to achieve higher effectiveness in their supply activities, an increasing number of
companies elect to focus on their core competencies. This leads to the externalization of their

30
other activities to business partners and makes them dependent on other actors’ resources and
capabilities.

The first sourcing decision for each item is whether to make it or buy it. The decision should
take into account a long-term business strategy, core competencies, the capabilities of optional
supply sources, total ownership cost, and quality implications associated with internal versus
external sourcing. Internal sources should be held accountable to the same supplier certification
criteria established in the supplier service policy (Frazelle, 2002:155).

2. 4 IMPORTANT THEORIES AND THEIR IMPLICATIONS FOR THE SOURCING

FUNCTION

As identified and consolidated in the work of (Shook et al., 2009), there are ten theories and
how they help managers make deal with making strategic sourcing decisions are discussed
below.

1. Institutional Theory- External forces pressure firms to behave in certain ways and not
behave in others and its implication for sourcing decision is to avoid fads and firms
should use a sourcing approach only if the approach matches the firm’s strategy, not just
because the approach is used by others.
2. Resource Dependence Theory -Firms seek to become less dependent on others for
resources, and to make other firms more dependent on them. Its implication for sourcing
decision is make when the resource is important and there are few sources, buy when the
resource is unimportant and there are many sources, ally when the resource is important
and there are several sources and enhance the dependency of suppliers and alliance
partners.
3. Network theory- Managing inter-organizational relationships is central to success. Its
implication for sourcing decision is choosing suppliers that are central to the network.
4. Systems theory -Organizations are best viewed as part of an interwoven and intertwined
system. Its implication for sourcing decision is multiple sources should be sought in
complex and uncertain environments.
5. Resource/knowledge-based views of the firm- Unique assets and capabilities are the
source of enduring competitive advantages. Its implication for sourcing decision is do
not outsource capabilities that create competitive advantage. Buying and alliances may
be vehicles for obtaining capabilities and pick sources with complementary capabilities.
6. Transaction cost economics- Firms should make decisions that minimize costs. Its
implication for sourcing decision is buying when transaction costs are less than
production costs.
7. Agency theory -When one firm delegates responsibility to another, the first firm must
monitor the second or risk opportunistic behavior. Its implication for sourcing decision
is that the costs of monitoring agents are part of the transaction costs and buy when
transaction costs are less than production costs.

31
 8. Strategic choice theory -The decisions managers make about strategic issues are the
primary driver of firm performance. Its implication for sourcing decision is that a firm’s
strategy should drive decisions about whether to make, buy, or ally.
9. Socio-cognitive theory- The interpretations managers make of events and trends are the
primary driver of their decisions. Its implication for sourcing decision is that decisions
about whether to make, buy, or ally are shaped by past practices. Besides, firms with a
strong identity will tend to make rather than buy or ally.
10. Critical theory -Commerce has been a means for the powerful and privileged to exploit
others for their own gain. Its implication for sourcing decision is the make, buy or ally
decision should be guided by how best to improve society. In addition to this, Suppliers
and employees should not be exploited and choose providers that have been historically
exploited and alienated.

2. 5 ROLE OF SUPPLY BASE

The supply base or supplier base refers to the list of suppliers that a firm uses to acquire its
materials, services, suppliers, and equipments (Wisner et al., 2005:46). Supply system (SS) is
used for collection of materials from the vendors and for bundling them into finished products.

Firms engaging in supply chain management emphasize long term strategic supplier alliances
by reducing the variety of purchase items and consolidating volume in to one or fewer
suppliers, resulting in a smaller supply base.

It is argued that the reasons favoring a single Supplier are enumerated as follows: Need
Capacity, spread the risk of supply interruption, create competition, information, and dealing
with special kinds of businesses.

2. 6 CREATING AND MANAGING SUPPLIER RELATIONSHIP

Supplier relationship management is an umbrella term that includes “extended procurement

processes such as sourcing analytics, sourcing execution, procurement execution, payment
settlement and closing the feedback loop- supplier score carding and performance monitoring”,
as quoted in (Wisner et al., 2005).

Supplier partnerships are the ultimate expression of supplier integration— implying sharing in
profits and losses stemming from changes in the material, information, or cash flows between
two organizations (Frazelle, 2002:160).

Supplier Relationship Management (SRM) Software automates the exchange of information

among several layers of relationships that are complex and too time consuming to manage
manually and results in improved procurement efficiency, lower business costs, real time
visibility, faster communication between buyer and seller, and enhanced supply chain
collaboration (Wisner et al., 2005).

32
Supply relationships may present a key way for business to influence the sustainability of their
products and services (Simpson & power, 2005:67). Supplier development for performance
improvement requires the firm’s involvement to commit financial, capital and personnel
resources to the development task and to share timely and sensitive information. Building
strong supplier partnerships requires a lot of hard work and commitment by both buyers and
sellers. The nature of relations maintained with suppliers can affect the quality, timeliness, and
price of a firm’s products and services. These are:

i. Competitive orientation: The competitive orientation to supplier relations views

negotiations between buyer and seller as a zero-sum game: Whatever one side loses the
other side gains. Short-term advantages are prized over long-term commitments.
ii. Cooperative orientation: With the cooperative orientation to supplier relations, the
buyer and seller are partners, each helping the other as much as possible. A Cooperative
orientation means long-term commitment, joint work on quality, and support by the
buyer of the supplier’s managerial, technological, and capacity development (Ritzman
et al., 2003).

In the context of the more traditional “vertical” context, a vender is represented simply by a
seller or provider of a product or service such that there is little or no integration or
collaboration with the buyer or purchaser, in essence, the relationship with a vendor is
“transactional,” and parties to a vendor relationship are said to be at “arm’s length” (i.e. at a
significant distance). Leaning more toward the strategic alliance end of the scale, a partnership
represents customized business relationships that produces results for all parties that are more
acceptable than would be achieved individually (Langley et al., 2006:419).

Alternatively the relationship suggested by a strategic alliance is one in which two or more
business organizations cooperate and willingly modify their business objectives and practices
to help achieve long term goals and objectives.

Transaction Relational

Figure 2.1 Supplier relationships (Langley et al., 2006)

2. 7. SUPPLIER EVALUATION AND CERTIFICATION

Only the best suppliers are targeted as partners. One of the goals of evaluating suppliers is to
determine if the supplier is performing according to the buyer’s requirements.

An extension of supplier evaluation is supplier certification, defined by Institute for Supply

Management as “an organization’s process for evaluating the quality systems of key suppliers
in an effort to eliminate incoming inspections”.

33
Suppliers are integral part of the supply chain of an organization, and management of suppliers
requires specialized negotiating skills, as they are not a part of the organization. Suppliers have
to be selected carefully, as they can have a very positive or a very adverse impact on the
overall performance of the organization (Ramanathan, 2007:258).

The selection of appropriate suppliers is a very important problem for any organization, and
requires consideration of a multitude of factors, some of which can be quantitative, while some
can be qualitative (Ramanathan, 2007:261).

According to Abraham and Daniel (2005), the selection of suppliers with proper allocation
helps the manufacturing firm for proper management of suppliers. There are a number of
factors that have to be considered for suppliers selections. These are: number of vendor per raw
materials, vendor location, Capacity allocation, local regulation and tax implementation, local
market implication, and local labor and material costs

2. 8. SUPPLIER SELECTION

The process of selecting a group of component suppliers for important materials, which can
potentially impact the firm’s competitive advantage, is a complex one and should be based on
multiple criteria.

The overall supplier selection problem of multiple sourcing is not only to select the right
suppliers, but also to allocate optimal order quantity among the selected suppliers, based on a
number of key criteria such as costs, quality, and delivery reliability, etc (Cho,2008). To make
supplier selection decisions and to review the performance of current suppliers, management
must review the market segments it wants to serve and relate their needs to the supply chain.

Factors that firms should consider while selecting suppliers include: Product and process
technologies, willingness to share technologies and information, quality, cost, reliability, order
system and cycle time, capacity, communication capability, location, and service. Three
criteria most often considered by firms selecting new suppliers are price, quality, and delivery.

A fourth criterion is becoming very important in the selection of suppliers-environmental

impact. Many firms are engaging in green purchasing, which involves identifying, assessing,
and managing the flow of environmental waste and finding ways to reduce it and minimize its
impact on the environment.

2. 9. SUPPLIER DEVELOPMENT

A growing trend among firms that practice supply chain management is supplier development
where firms assist existing or new suppliers to improve their processing capabilities, quality,
delivery, and cost performance by providing the needed technical and financial assistance.

34
Developing suppliers in this manner allows firms to focus more on core competencies, while
outsourcing non core activities to suppliers.

Supplier development is defined as “any activity that a buyer undertakes to improve a

supplier’s performance and /or capabilities to meet the buyer’s short and /or long time supply
needs. A seven step approach to supplier development are discussed as follows- Identify
critical products and services , identify critical suppliers, form a cross – functional team, meet
with top management of supplier, identify key projects, define details of agreement , and
monitor status and modify strategies.

An important concern of supply chain management is the actions that parties of a relationship
undertake together in order to improve relationship coordination (Claro et al., 2006: 216).

The supply side of many firms is dominated by a few suppliers that provide a representative
share of its purchased product lines. There are also suppliers that provide items that are critical
to the success of the buyer’s offerings. Failure in even one of these relationships with suppliers
can be critical to a firm’s operation. Collaboration refers to situations in which parties in a
business relationship work together to achieve mutual goals (Anderson and Narus, 1990;
Morgan and Hunt, 1994) and each party’s organizational boundaries become penetrated by the
integration of activities as the supplier becomes involved in activities that traditionally are
considered the buyer’s responsibility and vice-versa (Yilmaz and Hunt, 2001) as quoted in the
work of (Claro et al., 2006: 217).

In relationships with suppliers, the buyer appears concerned about trust and transaction specific
investment. The buyer’s joint effort response appears to be shaped by the calculative-,
affective- and believe- based trust. When trust is high, relationships tend to be more
collaborative in nature. Furthermore, relatively high degree of joint effort responses are likely
to be undertaken to protect the specific assets and also to integrate further the resources and
activities. The joint efforts can minimize the systemic transaction costs related to high
transaction specific investments (Claro et al, 2006:221).

Supply base management is one of the most strategic areas of responsibility in the purchasing
and supply function in organization (Ogden, 2006:29).

Research has supported the argument that an organization is only as good as its supply base
(Rajagopal and Bernard 1993; Reed and Walsh, 2003)” as cited in the work of (Ogden,
2006:29).

Developing partnerships is one of the most important steps in building and maintaining
customer-supplier relationships. Supply chain initiatives that seek to incorporate all suppliers
as strategic partners, should first examine which suppliers hold especially strategic
significance.

35
Activity 8:

Take few minutes and write a short note that shows the difference between supplier evaluation,
certification, selection and development.

2. 10. SUPPLIER INTEGRATION AND RELATIONSHIP MANAGEMENT

The supplier base is really an extension of the enterprise. As such, supplier relationships (face-
to-face, telecommunications, or the Internet) need to be developed as aggressively and
strategically as customer relationships. The reliability, predictability, and value added in links
with suppliers serve as the foundation for the ability to serve customers reliably, predictably,
and with increasing value. Wal-Mart’s supplier relationships (though criticized as heavy-
handed in many circles) are the foundation of their business success. Dell Computer’s on-site
supplier community serves as the foundation for its successes in logistics. These relationships
have been developed through a formal supplier relationship management (SRM) program.
SRM programs include annual conferences where logistics trends in all organizations are
shared, upcoming business initiatives that will impact the supplier community are presented,
and agreements are reached for future logistics standards and capabilities.

Supplier integration and excellence in SRM are difficult to measure, but they are easily
recognized by the presence or absence of the following practices: supplier partnerships;
Vendor managed inventory (VMI); Forecast sharing; and supply chain collaboration,
optimization, scheduling, and simulation.

1. Supplier Partnerships

Supplier partnerships are the ultimate expression of supplier integration—implying sharing in

profits and losses stemming from changes in the material, information, or cash flows between
two organizations. Supplier partnerships require ongoing, regular, and ad-hoc meetings focused
on streamlining and standardizing products, information, and cash flows between the two
parties. Supplier partner meetings should also be a forum for sharing business plans and
demand projections. Supplier partners may represent between 5 percent and 20 percent of the
supply base, and 50 percent to 80 percent of the inbound product volume.

They are typically the most loyal and logistically sophisticated subset of suppliers. Suppliers
can and should be classified as partners, strategic allies, or commodity providers based on the
degree of partnering and information sharing.

2. Vendor Managed Inventory (VMI)

Some supplier relationships have evolved to the point of permitting the supplier (or vendor) to
manage customer inventory levels. VMI programs require the supplier to maintain inventory

36
visibility, place replenishment orders (with themselves) on behalf of the customer, and achieve
agreed-upon customer service levels. As a result, VMI programs require a high degree of trust
between the parties and extensive logistics capabilities on both sides.

3. Demand Information Sharing

An absolute necessity in supplier integration is true demand information sharing. Demand

information could be point-of-consumption data, future demand period forecasts, existing
orders, and/or future growth plans. Without this sharing, the supplier is left guessing as to the
amount and timing of future demand. Since most reputable suppliers err on the side of
providing enough inventory for the worst case, excess inventory is built up at every point
where guessing occurs. Demand information sharing eliminates the guesswork in supply chain
and inventory planning. Any time this information is not shared, the supplier must create a
forecast of our forecast, significantly proliferating the forecast error and leading to excessive
inventory or shortages in the chain.

4. Supplier Visibility

Just as suppliers need visibility into our inventory levels to execute vendor managed inventory
programs, we need visibility into our supply partner’s inventory, production schedule, and
production capacity to permit supply chain scheduling and optimization. Demand information
sharing and supplier visibility are two essential elements that build trust between supply
partners and form the foundation of supplier integration. Our human nature only trusts what we
can see. For some reason, we don’t trust what we can’t see. As a result, any blind spots in the
supply chain become seedbeds for excess inventory buildups to cover worst-case scenarios. A
variety of Web-based tools are available in the marketplace today that permits total supply
chain visibility.

5. Supply Chain Collaboration, Scheduling, Optimization, and Simulation

Just like a factory’s optimal production schedule minimizes the total production and inventory
carrying costs, given labor and material availability, manufacturing and storage capacities, and
demand requirements, an optimal supply chain schedule minimizes the total cost to
consumption. This includes inventory carrying, transportation, warehousing, and lost sales,
given the supply chain’s production, transportation, warehousing capacity, and inventory
requirements at every node in the logistics network. In some supply chains, a fourth party is
used to produce the optimal schedule, and each major player (supplier, customer, and carrier)
shares true demand and capacity information with this fourth party who is responsible for
producing an optimal supply chain design and operating schedule. This schedule includes retail
receiving hours, warehouse shipping and receiving schedules, transportation schedules, and
production schedules. One fallacy in supply chain scheduling is that all scheduling should be
pull-based. Study after study has revealed that a mix of pull- and push-based scheduling
techniques characterize supply chain optimization.

37
2.11 Self Assessment Questions
1. Why does the contemporary view of procurement as a strategic activity differ from the
more traditional view of "purchasing"?
2. How can strategic procurement contribute to the quality of products produced by a
manufacturing organization?
3. Explain the rationale underlying volume consolidation. What are the risks associated
with using a single supplier for an item?
4. How does lowest Total Cost of Ownership differ from lowest purchase price in the
supply chain?
5. What is the underlying rationale that explains why firms should reduce their supply
bases?
6. Explain how different theories related to outsourcing affect make or buy decisions/
7. Discuss the supplier evaluation metrics
8. How does a firm's procurement strategy impact its decisions regarding the appropriate
Supply Chain Strategy?
9. Discuss the difference between purchasing management, Procurement Management,
Supply Management, and Supply Chain Management
10. Discuss briefly the purchasing process in the order fulfillment cycle?

2.12 Chapter Summary

Managing materials flow in the supply chain requires an interface between logistics,
procurement, and manufacturing strategies. Purchasing can be defined as the act of obtaining
merchandise, capital equipment, raw materials, services, or maintenance, repair, and operating
(MRO) supplies in exchange for money or its equivalent.
Procurement in an organization is charged with responsibility for obtaining the inputs required
to support manufacturing and operation. The focus is multidimensional, attempting to maintain
continuous supply, minimize lead times from suppliers and inventory of materials and
components, and develop suppliers capable of helping the organization achieve these goals.
Ultimately, modern procurement professionals focus on the Total Cost of Ownership of
acquired resources, not just the purchase price of those inputs. This requires that they consider
carefully the trade-offs among purchase price, supplier services and logistical capability,
quality of materials, and how the materials affect costs over the life cycle of the product into
which they are incorporated.
Procurement strategies today involve consolidation of the volumes purchased into a smaller,
more reliable, number of suppliers. They include efforts to integrate supplier and buyer
operations to achieve better and lower-cost logistics performance. Supplier integration in new
product design represents another strategy to reduce total ownership costs.
A make or buy decision- outsourcing issues is justified based on cost benefit analysis case is
supported by different outsourcing theories in the supply chain.

38
Supply base reduction, supplier development programs, strategic alliance with suppliers,
vendor managed inventory, supplier relationship management are purchasing function’s
paradigm strategic shift from a traditional buying activities on routine basis.

Key Terms:
• Procurement - obtaining by various means (e.g., loan, transfer, hire purchase) of
supplies and services with or without consideration.”
• Purchasing is the process by which a company (or other organization) contracts with
third parties to obtain goods and services required to fulfill its business objectives in the
most timely and cost-effective manner
• Outsourcing-contracting out services and activities traditionally provided in house.
• Supply Management-procurement activities, inventory management, receiving
activities, stores and warehousing, in-plant materials handling, production planning
scheduling and control, traffic and transportation, surplus and salvage.

Case: A Major Purchase without Purchasing Function

A construction company engaged in the construction of road sector in Addis Ababa, Ethiopia
faced the following purchasing puzzle during its operation.

The company was established recently with an initial capital of over ten million dollar as a
general contractor privately registered as per the requirements of commercial code of Ethiopia
and ministry of Works and Urban Development for General Contractor Grade one. There are
General Contractor Grade one qualification requirements in terms of machinery, professional,
technical, material and financial requirements set by the government body. As the company
was established and suddenly grew from Rental Company to a big general construction
company of grade one level, it faced structural problem especially procurement or supply
function. First of all , the company doesn’t have purchasing function in its organizational
structure. Buying activities are carried out on daily need basis by non professional purchasers
where they face frequent returns, delays, and engaged in tiresome and highly costly
transactions as they do not have time to compare prices in the market. The blunder made at the
top level management is when capital purchase is made for construction machineries like
dozer, excavator, roller; loader, etc are purely based on least price bases from second market
(salvage products0 where their maintenance cost became a regular workshop activity.

As a newly established company, the firm faced this challenge and yet has to run and complete
four projects that worth over $50,000,000.

Question: Suppose you are assigned as a supply chain management consultant to advice the
firm, how do you solve it?

39
 CHAPTER THREE

ROLE OF LOGISTICS IN SUPPLY CHAIN MANAGEMENT

In this chapter you will learn the following concepts:-

3.1 Definition, evolution, and role of logistics in business

3.2 Logistics activities
3.3 Logistics optimization
3.4 Logistics master planning
3.5 Financial measures of Logistics Performance
3.6 Productivity Measures of Logistics Performance
3.7 Quality Measures of Logistics Performance
3.8 Cycle Time Measures of Logistics Performance
3.9 Logistics Relationship and third party Logistics
3.10 The Role of Warehousing in Supply Chain Management
3.11 Self-Assessment Questions
3.12 Chapter Summary

Chapter Objectives

After reading this chapter, you will be able to:

understand what logistics activities constitute

prepare logistics master planning

conduct logistics performance measurement

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3.1 THE DEFINITION, EVOLUTION, AND ROLE OF LOGISTICS IN BUSINESS

Logistics is the flow of material, information, and money between consumers and suppliers. In
the 1950s and ‘60s, the military was the only organization using the term logistics. There was
no true concept of logistics in private industry at that time. Instead, departmental silos
including material handling, warehousing, machining, accounting, marketing, and so on, were
the norm. The five phases of logistics development—workplace logistics, facility logistics,
corporate logistics, supply chain logistics, and global logistics are discussed below.

1. Workplace Logistics

Workplace logistics is the flow of material at a single workstation. The objective of workplace
logistics is to streamline the movements of an individual working at a machine or along an
assembly line. The principles and theory of workplace logistics were developed by the
founders of industrial engineering working in WWII and post-WWII factory operations. A
popular name today for workplace logistics is ergonomics.

2. Facility Logistics

Facility logistics is the flow of material between workstations within the four walls of a facility
(that is, inter-workstation and intra-facility). The facility could be a factory, terminal,
warehouse, or distribution center. Facility logistics has been more commonly referred to as
material handling. The roots of facility logistics and material handling are in the mass
production and assembly lines that distinguished the 1950s and 1960s. In those times and even
into the late 1970s, many organizations maintained material-handling departments. Today, the
term material handling has fallen out of favor because of its association with non-value added
activities. In the 1960s, material handling, warehousing, and traffic were grouped together to
become known as physical distribution; procurement, marketing, and customer service were
grouped together to become known as business logistics. (Even today in many academic
institutions, logistics is still divided along these lines; where logistics is taught in the business
school, it is taught as business logistics and in the engineering schools as physical distribution).

3. Corporate Logistics

As management structures advanced and information systems accordingly, the ability to

assimilate and synthesize departments (material handling, warehousing, and so on) into
functions (physical distribution and business logistics) in the 1970s permitted the first
application of true logistics within a corporation. Corporate logistics became a process with the
common objective to develop and maintain a profitable customer service policy while
maintaining and reducing total logistics costs. Corporate logistics is the flow of material and
information between the facilities and processes of a corporation (inter-workstation, inter-
facility, and intra-corporate). For a manufacturer, logistics activities occur between its factories

41
and warehouses; for a wholesaler, between its distribution centers; and for a retailer, between
its distribution centers and retail stores. Corporate logistics is sometimes associated with the
phrase physical distribution that was popular in the 1970s. In fact, the Council of Logistics
Management (CLM) was called the National Council of Physical Distribution Management
(NCPDM) until 1982.

4. Supply Chain Logistics

Supply chain logistics is the flow of material, information, and money between corporations
(inter-workstation, inter-facility, inter-corporate, and intra-chain). There is a lot of confusion
surrounding the terms logistics and supply chain management. The supply chain is the network
of facilities (warehouses, factories, terminals, ports, stores, and homes), vehicles (trucks, trains,
planes, and ocean vessels), and logistics information systems (LIS) connected by an
enterprise’s supplier’s suppliers and its customer’s customers. Logistics is what happens in the
supply chain. Logistics activities (customer response, inventory management, supply,
transportation, and warehousing) connect and activate the objects in the supply chain. To
borrow a sports analogy, logistics is the game played in the supply chain arena.

It is unfortunate that the phrase supply chain management has been so readily and commonly
adopted as a reference to excellence in logistics. First, it is not supply (or demand) that should
dictate the flow of material, information, and money in a logistics network. Actually, there are
some links in the chain and some circumstances in which supply dictate flow and some in
which demand should dictate flow. Second, if you drew lines connecting all the trading
partners in a typical supply chain, what you would see would not look anything like a chain.
You would see something that looks more like a complex web of links. A chain stretched full
is a line. The danger in the choice of the term chain is that the term oversimplifies the
complexities in logistics management and leads to inflated expectations for what can be
achieved by supply chain management systems. Finally, the term management suggests that a
single party in the chain can truly manage and dictate the operations of the supply chain.
Instead, the best any party can do is to collaboratively plan the operations of the chain.

5. Global Logistics

Global logistics is the flow of material, information, and money between countries. Global
logistics connects our suppliers’ suppliers with our customers’ customers internationally.
Global logistics flows have increased dramatically during the last several years due to
globalization in the world economy, expanding use of trading blocs, and global access to Web
sites for buying and selling merchandise. Global logistics is much more complex than domestic
logistics, due to the multiplicity of handoffs, players, languages, documents, currencies, time
zones, and cultures that are inherent to international business.

42
 6. Next-Generation Logistics

There are many theories as to the next phase of logistics development. Many logisticians
believe that collaborative logistics, logistics models built with continuous and real-time
optimization and communication between all supply chain partners will be the next phase of
evolution. Other camps in the logistics community believe the next phase of evolution will be
virtual logistics or fourth-party logistics, where all logistics activities and management will be
outsourced to third-party logistics providers who are in turn managed by a master or fourth-
party logistics providers acting kind of like a general contractor.

Activity 9

Compare and contrast between the various types of logistics

3. 2 LOGISTICS ACTIVITIES

In the definition, logistics is comprised of five interdependent activities: customer response,

inventory planning and management, supply, transportation, and warehousing. Each activity
and its objective is described briefly below:

1. Customer Response

Customer response links logistics externally to the customer base and internally to sales and
marketing. Customer response is optimized when the customer service policy (CSP) yielding
the lowest cost of lost sales, inventory carrying, and distribution is identified and executed. The
logistics of customer response includes the activities of:

• developing and maintaining customer service policy

• monitoring customer satisfaction

• order Entry (OE)

• order Processing (OP), and

• invoicing and collections

2. Inventory Planning and Management

The objective of inventory planning and management (IP&M) is to determine and maintain the
lowest inventory levels possible that will meet the customer service policy requirements
stipulated in the customer service policy.

The logistics of inventory planning and management includes:

43
 • forecasting

• order quantity engineering

• service level optimization

• replenishment planning

• inventory deployment

3. Supply

Supply is the process of building inventory (through manufacturing and/or procurement) to the
targets established in inventory planning. The objective of supply management is to minimize
the total acquisition cost (TAC) while meeting the availability, response time, and quality
requirements stipulated in the customer service policy and the inventory master plan. The
logistics of supply include:

• developing and maintaining Supplier Service Policy (SSP)

• sourcing

• supplier integration

• purchase order processing

• buying and payment

4. Transportation

Transportation physically links the sources of supply chosen in sourcing with the customers we
have decided to serve chosen as a part of the customer service policy. We reserve
transportation for the fourth spot in the logistics activity list because the deliver-to points and
response time requirements determined in the customer service policy and the pick-up points
determined in the supply plan must be in place before a transportation scheme can be
developed.

The objective of transportation is to link all pick-up and delivery -to points within the response
time requirements of the customer service policy and the limitations of the transportation
infrastructure at the lowest possible cost.

The logistics of transportation includes:

• network design and optimization

• shipment management

• fleet and container management

44
 • carrier management

• freight management

5. Warehousing

Warehousing is the last of the five logistics activities because good planning in the other four
activities may eliminate the need for warehousing or may suggest the warehousing activity be
outsourced. In addition, a good warehouse plan incorporates the needs of all the other logistics
activities. Good or bad, the warehouse ultimately portrays the efficiency or inefficiency of the
entire supply chain.

The objective of warehousing is to minimize the cost of labor, space, and equipment in the
warehouse while meeting the cycle time and shipping accuracy requirements of the customer
service policy and the storage capacity requirements of the inventory play. The logistics of
warehousing includes:

• receiving

• put away

• storage

• order picking

• shipping

3.3 LOGISTICS OPTIMIZATION

What is often lacking is the analytical resources required to model and solve logistics
problems. Because logistics problems tend to be complex and cross-functional, optimization
techniques are and should be used to develop and quantify an ideal solution. Executed
properly, the optimization process tends to depoliticize a project and focuses a project team’s
attention on the solution that maximizes total corporate performance. Hence, optimization is a
key ingredient in our logistics master planning methodology. There are many optimization
techniques, including customer service policy optimization, computing optimal purchase order
quantities, determining optimal product sources, choosing optimal locations for distribution
centers, and optimizing the placement of products in a warehouse. In each case, the
fundamental principle is the same—there is a quantifiable objective function that should be
minimized/maximized, and a set of quantifiable constraints that make it difficult to
minimize/maximize the objective function. For example, to determine the optimal customer
service policy, the objective is to minimize the total logistics costs (TLC), including inventory
carrying costs, response time costs (warehousing and transportation), and lost sales costs. The
constraints are the availability of inventory and the response time requirements that make up
the core of the customer service policy. Mathematically, we can write the following:

45
Minimize:

Total logistics costs = Inventory carrying costs + Response time costs+ Lost sales cost

Constraints:

1. Inventory availability >Customer service inventory target

2. Response time < Customer service response time target

A major advance in logistics optimization is the graphical representation of supply chains and
related tradeoffs. With inventory availability expressed as the unit fill rate, the greater the fill
rate, the lower the lost sales cost, but the higher the inventory levels and associated inventory
carrying cost required. In response time, we can reduce lost sales cost by responding faster;
however, we will incur a higher response cost either for more expensive transportation modes
or for more warehousing space located in close proximity to our customer base.

Activity 10

Take few minutes to look at your organization/ an organization in your area and formulate
logistics related problem (objective) to be optimized accompanied by the constraints.

3.4 LOGISTICS MASTER PLANNING

Logistics master planning (LMP) - is a planning process that develops short- and long-term
metrics, process definitions, information system requirements, and organizational requirements
for logistics as a whole and for customer response, inventory management, supply,
transportation, and warehousing individually. No matter the level of detail, we always move
through the phases in the same order: investigate, innovate, and implement.

3.5 FINANCIAL MEASURES OF LOGISTICS PERFORMANCE

Logistics is playing an increasingly important role in value creation, revenue enhancement,

capital consumption, and expense control. As a result, logistics financial performance is
playing a bigger role in corporate financial performance. Measuring and improving logistics
financial performance is increasingly important in measuring and improving corporate
financial performance. In addition, since logistics is often in competition with other business
processes for capital projects, the better the overall financial reporting we do in logistics, the
better chance we have to justify our logistics projects.

The most important principle to remember in developing and implementing logistics financial
performance measures is that nearly every generally accepted corporate financial measure has
a corresponding logistics financial measure. Some key corporate financial measures and their
corresponding logistics financial measures are described below.

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 1. Logistics Expenses (LE)

Logistics expenses are dominated by labor expenses but also include telecommunications,
inbound and outbound freight, fuel, fees to third parties, and leased or rented space.

Logistics Profit (LP = R - LE)

Logistics profit is computed simply as revenue minus logistics expenses. The computation of
logistics profit per item, per category, or per location is helpful in determining the business
viability of an item, category, or location

2. Logistics Asset Value (LAV)

The logistics asset value is the sum total of the value of assets deployed in logistics including
inventory, logistics facilities, transportation fleets, material handling systems, logistics
information systems, and so on. The valuation is typically based on book value, replacement
value, and/or the capitalization of logistics assets.

3. Return on Logistics Assets (ROLA = P/LAV)

The return on logistics assets is computed simply as the ratio of corporate profit (P) to LAV.
The ratio can demonstrate the difference between the return on logistics assets versus the return
on overall corporate assets or the assets deployed in the other areas of the business.

4. Logistics Capital Charges (LCC = LAV *ACR)

Logistics capital charges are computed as the product of the investment in logistics assets and
the asset carrying rate (ACR). The ACR is used to annualize the holding cost of fixed assets.

5. Total Logistics Cost (TLC = LE + LCC)

Total logistics costs (TLC) is defined to include expense and capital costs in the five logistics
processes: customer response, inventory planning and management, supply, transportation, and
warehousing. The total logistics costs are made up of the following: total response cost (TRC),
total inventory costs (TIC), total supply costs (TSC), total transportation costs (TTC), and total
warehousing costs (TWC).

TLC = TRC + TIC + TSC + TTC + TWC

Total supply chain cost is different from logistics cost which is aggregated for supply chain
members of all costs incurred to make, move the product across supply chain and sell to the
ultimate customer.

Total Supply chain profit is the difference between what supply chain members incurred to
deliver the product to the market and what the market is willing to pay for the product at the
time of delivery to the ultimate customer.

47
Customer response (CR) costs (or total response costs [TRC]) include the cost of labor,
telecommunications, and space required for the personnel and systems used in order processing
and order status communication.

The TIC includes the inventory carrying cost and the cost of personnel, office space, and
systems employed in managing inventory. Inventory carrying cost is computed as the product
of the average inventory value (AIV) and the inventory carrying rate (ICR).

ICC = AIV * ICR

The ICR is an annual percentage applied to the AIV to estimate inventory carrying charges.
The rate includes the opportunity cost of capital (every dollar invested in inventory could
theoretically be earning the opportunity interest rate), insurance, taxes, loss, and obsolescence.
With this definition, the ICR typically ranges between 10 and 30 percent per year. In addition,
storage and warehousing costs may also be included if they are not already being considered as
a part of total logistics cost. If warehouse operating costs are included, the ICR typically ranges
between 15 and 40 percent. In most cases, corporations underestimate their inventory
investment and associated carrying charges. Often, corporations do not even have a standard
inventory carrying rate.

The AIV for an item should be estimated as the product of the average inventory level (AIL) in
units and the unit inventory value (UIV). The UIV is the investment in or cost of creating each
unit of inventory at its current status (raw material, work in process, or finished goods). The
UIV is typically the selling price less the margin. The AIV is computed as follows:

AIVi = AILi - UIVi

Total supply costs (TSC) include the cost of labor, space, systems, and telecommunications
used in planning, approving, executing, and tracking purchase orders.

Total transportation costs (TTC) include inbound and outbound transportation costs. If the
company operates a private fleet, the costs of fueling, maintaining, acquiring, and staffing the
fleet must be included. If carriers are used, the freight bills can be used to compute freight
transportation costs.

Total warehousing costs (TWC) include the cost of labor, space, material-handling systems,
and information-handling systems. The cost of labor is simply the product of the annual
working hours (AWH, hours/year) and the warehouse wage rate (WWR, dollars/hour with
fringes). The cost of space is the product of the total floor space (TFS, in square feet) and the
space occupancy rate (SOR, dollars/SF year). The cost of material handling systems is the
product of the material handling systems investment

(MHSI, dollars) and the systems capitalization rate (SCR, percent per year). Similarly, the cost
of information-handling systems is the product of the information-handling systems investment
(IHSI, dollars) and the SCR.

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1. Logistics Cost-Sales Ratio (LCSR =TLC/R)

The logistics cost-sales ratio is the ratio of TLC to corporate revenue. TLC as a percentage of
sales is a popular measure of logistics cost performance.

Some other helpful unit costs are the logistics cost per order (LCPO), the logistics cost per line
(LCPL), and the logistics cost per item (LCPI). The ratios are computed simply as the ratio of
TLC to the orders shipped per year (OPY), the lines shipped per year (LPY), and the number of
items (or SKUs) stocked (NIS). The equations for each of these costs are shown here:

LCPO = TLC / OPY

LCPL =TLC / LPY

LCPI = TLC / NIS

2. Logistics Value Added (LVA = P - LCC)

Logistics value added is computed in similar fashion to the economic value added (EVA) of a
corporation, subtracting logistics capital charges from after tax profitability. Since EVA is the
most reliable predictor of future shareholder value (LVA is an excellent measure of the
contribution of logistics to future shareholder value. In addition, by incorporating the impact on
revenue, expenses, and capital charges, LVA is a good indicator of the overall value of
logistics initiatives.

3.6 PRODUCTIVITY MEASURES OF LOGISTICS PERFORMANCE

A danger in focusing too much attention on logistics costs is that certain cost elements cannot
be controlled by logistics managers and engineers. For example, logistics managers have
limited control over some of the major cost factors, including wage rates, fuel costs, occupancy
cost, inventory carrying rates, and systems capitalization rates. Instead, logistics managers have
direct control over the amount of inventory in the system, the amount of working hours
expended, the amount of occupied space, and the number of transportation miles traveled.
Essentially, logistics managers and analysts have influence over the amount of logistics
resources consumed in providing target customer service levels.

Performance indicators will include measures of logistics resource utilization and productivity.
Those measures are the focus of this section, which describes utilization and productivity
measures for the logistics workforce, transportation capacity, logistics facilities, and inventory.
The productivity of a specified resource(s) is generically measured as the ratio of the output of
the resource(s) to the consumption of the resource(s):

Productivity rate = Output resource /Consumption resource

49
The utilization of a specified resource(s) is generically measured as the ratio of the output of
the resource(s) to the capacity of the resource. Utilization resource = Output resource /Capacity
resource

1. Logistics Workforce Productivity Indicators

The logistics workforce includes the operators, supervisors, planners, analysts, and managers
employed in customer response, inventory planning and management, supply, transportation,
and warehousing.

The principal mission of the logistics workforce is order fulfillment. Hence, the output of the
logistics workforce is typically measured in orders. The consumption unit for the logistics
workforce is typically measured as the number of full-time equivalents (FTEs) and/or working
hours. As a result, logistics workforce productivity (LWFP) is computed as the ratio of the total
orders shipped (TOS) to the number of full-time equivalents working in logistics (LWF):

LWFP =TOS / LWF LWFP = TOS/FTEs

Two popular variants on this indicator are the logistics hours per order (LHPO) and the sales
per logistics employee (SPLE). The LHPO is computed as the ratio of the number of hours
worked in logistics to the total orders shipped. This is the inverse of LWFP with the
consumption of the logistics workforce measured in hours as opposed to FTEs. The indicator is
an effective benchmark for determining the labor requirements and labor cost per order
(LCPO). LHPO and LCPO are calculated as follows:

LHPO = (LWF * FHPY) / TOS

LCPO =LHPO * LWR

The deployment of electronic commerce technologies and paperless logistics should

dramatically reduce the LHPO, and this measure can be used in the justification of those
technologies. The sales per logistics employee (SPLE) are computed as the total sales revenue
divided by the number of FTEs in the logistics workforce:

SPLE =TSR / LWF

2. Customer Response (CR) Productivity Indicators

The primary productivity indicator for CR is the number of customer orders processed per
person-hour. Through customer service automation methods, including Internet ordering, EDI,
automated contact management, call center automation, and/or touchtone ordering, the
productivity and quality of CR can be improved.

3. Inventory Management Productivity

The most popular indicators for inventory management productivity are inventory turnover and
the productivity of the inventory planners. The productivity of the inventory planners is
50
computed simply as the number of SKUs planned per planner. Inventory turnover
computations are more varied and sophisticated.

Since the output of inventory is sales and the consumption is investment, by far the most
popular measure of inventory productivity is inventory turnover (IT). IT may be computed as
the ratio of total sales revenue at cost (TSR) to the average inventory value (AIV) or the total
unit sales (TUS) to the average inventory level (AIL):

IT = TSR / AIV

IT = TUS / AIL

IT may be computed for a facility, a country, a supplier, or globally.

4. Supply Productivity

Supply productivity measures are focused on the buying and procurement organization. Three
common measures of supply productivity are:

• The number of purchase orders per person-hour

• The number of SKUs managed per full-time-equivalent

• The dollar value managed per full-time-equivalent in procurement

5. Transportation Productivity

The principal output of transportation is delivered dollars, orders, weight, and/or cubic volume.
The principal resources consumed in transportation are operating (vehicle and/or driver) hours,
container capacity, and fuel. (These resources are of principal concern if the corporation
operates a private fleet.)

The useful productivity ratios resulting from these inputs and outputs relate in ratio the
delivered dollars, orders, pounds, or cubic volume to the available operating hours, cubic
capacity, weight capacity, or fuel.

6. Warehouse Operations Productivity

The principal missions of a logistics facility (warehouses, distribution centers, logistics centers,
and/or terminals) are throughput and storage. The principal resource consumed in achieving the
throughput mission is the labor and systems deployed in material handling. The overall labor
productivity for a distribution center is computed as the ratio of the number of units processed
per year to the number of person-hours consumed per year. For material-handling systems, we
measure consumption as the annualized investment cost in material-handling systems. The
annualized material handling systems investment (MHSI) is estimated by multiplying the
estimated replacement cost of MHSI by the systems capitalization rate (SCR). The principal
material-handling output is the number of units and/or weight moved. The material handling

51
unit cost (MHUC) is computed as a ratio of the annualized investment in material handling
systems to the total units moved (TUM) measured in pallets, cases, containers, and/or pieces):

MHUC = (MHSI *SCR) / TUM

MHUC = Annualized MHSI/TUM or (Estimated Replacement MHSI) * SCR

TUM

The reason we have storage space is to house inventory, and the principal consumed resource
is floor space. Hence, space productivity, often referred to as storage density (SD), is computed
as the ratio of the AIV or AIL- to- total floor space (TFS). Ideally, the AIL is expressed in a
common material handling unit of measure such as pallets or cases.

SD = AIV / TFS

SD = AIL / TFS

3.7 QUALITY MEASURES OF LOGISTICS PERFORMANCE

How do you measure logistics quality? Unfortunately, no industry standard exists for doing so.
In fact, so many different measures are available that many managers have given up trying.
The most effective indicator of logistics accuracy or quality is the perfect order percentage
(POP), which ties together the indices for logistics quality in each of the logistics activities.
The perfect order percentage and its components are defined in the following section.

Perfect Order Percentage (POP)

According to the American Heritage Dictionary, accurate means deviating only slightly or
within acceptable limits from a standard (accuracy is the quality or state of being accurate.)
Logistics encompasses customer service, inventory planning, manufacturing and procurement,
transportation, and warehousing. Defining the right measurement focus, defining the right
standard, and defining the acceptable limits of deviation from the standard for an integrated set
of activities as broad as logistics are complex tasks. Let’s consider each issue in turn. First, the
right measurements focus; the link and common deliverable of customer service, inventory
planning, manufacturing and procurement, transportation, and warehousing is an order.
Logistics exists to fill orders. Second, the standard. The standard has to be perfection;
otherwise, the pursuit of the standard will not yield the order of magnitude improvements
needed in all areas of logistics.

The perfect order is logistically perfect, meaning it is:

• Perfectly entered (the entry is exactly what the customer wants) by the means
(telephone or direct entry) the customer desired in a single entry

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 • Perfectly fillable with the exact quantity of each item available for delivery within the
customer-specified delivery window
• Perfectly picked with the correct quantities of the correct items
• Perfectly packaged with the customer-designated packaging and labeling
• Perfectly shipped without damage
• Perfectly delivered in the customer-designated time window and to the customer-
designated location
• Perfectly communicated with order status reports available 24 hours a day
• Perfectly billed with on-time payment
• Perfectly documented with customer-specified documentation means, including paper,
fax, EDI, and/or Internet

Suppose each of these nine logistics activities were performed correctly (assuming
performance- independence) 90 percent of the time. Then, more than 60 percent of the orders
would be imperfect. If each of these activities were performed correctly 95 percent of the time,
40 percent of the orders would be imperfect. If each of the activities were performed correctly
99 percent of the time, 10 percent of the orders would be imperfect. If each of these activities
were performed correctly 99.95 percent of the time, then 0.5 percent of the orders would be
imperfect.

To get an idea of your own perfect order percentage, take the product of your performance in
each area you define as making up perfect order performance.

1. Customer Response (CR) Quality Measures

The principal indicators of quality in customer response (CR) are:

Order entry accuracy (OEA) =Orders entered exactly as specified by the customer

Total orders entered

Order status communication accuracy =Orders for which order status is communicated correctly

Total orders with status communication requests

Invoice accuracy =Invoices with perfect match of items, quantities, prices, and totals

Total invoices

2. Inventory Management Quality Measures

The two most important indicators of inventory management quality are inventory availability
(typically referred to as fill rate) and a related measure, forecast accuracy.

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 a. Fill Rate Inventory availability performance is typically expressed as the demand fill
rate. Fill rate can be expressed as the line, order, and/or unit fill rate. In each case,
the fill rate measures the ratio of satisfied to total demand. The line fill rate (LFR) is
the ratio of the number of order lines completely satisfied (LS) to the total order
lines requested (LR): LFR = LS / LR

The order fill rate (OFR) is the ratio of the number of orders completely satisfied (OS) without
substitution or backorder to the number of orders requested (OR):

OFR =OS / OR

The unit fill rate (UFR) is the ratio of the total units shipped (TUS) to the total units requested
(TUR):

UFR=TUS/TUR

In each case, the fill rate can be measured as the first-time-fill-rate (FTFR), which assesses the
fill rate upon initial demand, or the secondary fill rate (SFR) achieved via substitutions and
backorders. Unless stated otherwise, all references to the fill rate here will be to first-time fill
rate. If you only know one of the fill rate measures, the other two can be estimated as follows.

The LFPR can be estimated by raising the UFR to the average units per line (upl) power. The
OFR can be estimated by raising the LFR to the average lines per order (lpo) power. Formally,
it is as follows:

LFR =UFRupl

OFR = LFRlpo

b. Forecast Accuracy- The most popular measures of forecast accuracy are the
algebraic deviation and percentage, the absolute deviation mean and percentage, and
the standard deviation of forecast errors.

The measures related to the algebraic are as follows:

Algebraic deviation = Forecast demand - Actual demand

Algebraic deviation percentage = Algebraic deviation/actual demand

Absolute deviation = Forecast demand - Actual demand

Absolute deviation percentage = Absolute deviation/actual demand

Mean absolute deviation (MAD) =Sum of absolute deviations over N periods/N

Mean absolute deviation percentage =Sum of absolute deviation percentages over N periods/N

The standard deviation of forecast errors is often estimated as 1.25 *MAD.

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 3. Supply Quality Indicators Just like the perfect order percentage, the supply quality
indicator is the best indicator for our logistics quality, its counterpart, the perfect
purchase order percentage (PPOP) is the best indicator of overall supply quality. The
PPOP is computed just like the POP.
4. Transportation Quality Indicators The most important transportation quality indicators
for our own or for our carrier’s fleet are the on-time arrival percentage (OTAP),
damage percentage (DP), claims-free shipment percentage (CFSP), and miles between
accidents (MBA).

On-time arrival percentage =Orders arriving within agreed time window

Total orders

Damage percentage =Orders arriving without in-transit damage

Total orders

Claims-free shipment percentage =Shipments without claims

Total shipments

Miles between accidents =Total miles driven

Number of accidents

These indicators can be summarized similar to the perfect order percentage to develop a perfect
delivery percentage, the percent of deliveries arriving on-time without damage, claims, or
accidents. One step further gets us to the perfect route percentage, the percentage of routes with
100-percent perfect deliveries.

5. Warehouse Operations Quality Indicators

The most critical quality indicators for Distribution Center operations are inventory accuracy,
picking accuracy, shipping accuracy, and warehouse damage percentage.

Inventory accuracy =Number of warehouse locations without discrepancies

Total number of warehouse locations

Picking accuracy =Number of lines picked without errors

Total number of lines picked

Shipping accuracy =Number of lines shipped without errors

Total number of lines shipped

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Warehouse damage percentage =$ Value of warehouse damages per year

$ Value shipped per year

3.8 CYCLE TIME MEASURES OF LOGISTICS PERFORMANCE

The total logistics cycle time (TLCT) includes order entry time (OET), order processing time
(OPT), purchase order cycle time (POCT), if the product is not available from stock),
warehouse order cycle time (WOCT), and in-transit time (ITT).

TLCT = OET +OPT +[POCT * (1-OFR)] +WOCT +ITT

OET is the elapsed time from order placement until completed order entry and capture for
processing. For orders received by mail, the order entry time includes ITT, waiting time for
order entry, and OET. For orders received by fax, the OET includes fax transmission time,
waiting time for order entry, and the keying and/or scanning time for order entry. For orders
received by phone, the OET includes the waiting time for the customer, the conversation time,
and the keying time for the order entry specialist. For orders received electronically, the OET is
reduced to the transmission time for the order. The OPT clock starts when the order is entered
in and captured by the order processing system and stops when the order is released to the
warehouse (or factory) for picking. The OPT includes the time to verify customer information,
verify for credit clearance, batch for schedule for release, and dwell for release to the
warehouse for assembly.

The POCT is simply the customer order cycle time you receive from your supplier. The POCT
clock starts when you place your order with your supplier and stops when the order is received
at your designated location. POCT is included in the TLCT when the product is not available
from stock.

The WOCT clock starts when the order is released to the warehouse management system and
stops when the order is picked, packed, and staged for shipping. The WOCT includes the time
to schedule, pick, assemble, pack, and stage the order for shipping. The ITT clock starts when
the order is ready for shipping and stops when the order is delivered at the customer’s
designated location. ITT includes waiting for loading, travel time, and unloading time at the
customer site.

Logistics management has evolved from part of marketing in a particular company, through
integration with operations in that company, to common approaches to the design and flow of
materials and products along channels by all member companies (Sadler & Hines; 2002:227)

Global competition has four prominent characteristics. First, companies competing globally
seek to create standardized, yet customized marketing (globalized market). Second, product
life cycles are shortening, sometime lasting less than one year. This is true for certain high-tech
products such as computers and peripherals, photography items, and audiovisual equipment.
Third, more companies are utilizing outsourcing and offshore manufacturing. Fourth,

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marketing and manufacturing activities and strategies tend to converge and be better
coordinated in firms operating globally.

3.9 LOGISTICS RELATIONSHIP AND THIRD- PARTY LOGISTICS (3PL)

The use of third- party logistics (3PL) and supply chain management providers is a growing
trend, as firms seek to gain quick competitive advantage from the development of effective
supply chain strategies.

3PL Services assume some or all of a firm’s sourcing, materials management, and product
distribution responsibilities: charging fee for their services while saving costs (estimated 10 to
20 percent of total logistics costs); and improving service, quality, and profits for their clients.
Essentially, a third- party logistics firm may be defined as an external supplier that performs all
or part of the company’s logistics function

Beyond the concept of a third – party logistics provider, the next evolution may be thought of
as a fourth party logistics provider (4PL), or a provider of “fourth- party logistics” services.
Essentially a supply chain integrator, a 4PL is thought of as a firm that “assembles and
manages the resources, capabilities, and technology of its own organization with those of
complementary service providers to deliver a comprehensive supply chain solution” as Stated
in the work of (Langley et al., 2006:442).

Many firms have directed significant attention toward working more closely with supply
chain partners, including not only customers and suppliers but also various types of logistics
suppliers. Considering that one of the fundamental objectives of effective supply chain
management is to achieve coordination and integration among participating organizations, the
development of more meaningful “relationships” through the supply chain has become a high
priority especially in logistics activities.

Generally, there are two types of logistics relationships. The first is what may be termed
vertical relationships; these refer to the traditional linkages between firms in the supply chain
such as retailers, distributors, manufacturers, and parts and material suppliers.

The second type of logistics relationship is horizontal in nature and includes those business
agreements between firms that have “parallel” or cooperating positions in logistics process.

3.10 THE ROLE OF WAREHOUSE IN THE SUPPLY CHAIN MANAGEMENT

The warehouse is a point in the logistics system where a firm stores or holds raw materials;
semi finished goods, or finished goods for varying periods of time (Langley et al., 2006:285)

Warehouse as value adding roles is described as follows: Consolidation, Product mixing,

Service, Contingency protection, Smooth Operation.

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Basic Warehousing Decisions

a. Location Selection

Location refers to the geographical setting of supply chain facilities. It also includes the
decisions related to which activities should be performed in each facility. The responsiveness
versus efficiency trade-off here is the decision whether to centralize activities in fewer
locations to gain economies of scale and efficiency, or to decentralize activities in many
locations close to customers and suppliers in order for operations to be more responsive.

When making location decisions, managers need to consider a range of factors that relate to a
given location including the cost of facilities, the cost of labor, skills available in the
workforce, infrastructure conditions, taxes and tariffs, and proximity to suppliers and
customers.

Location decisions tend to be very strategic decisions because they commit large amounts of
money to long-term plans.

Location decisions have strong impacts on the cost and performance characteristics of a supply
chain. Once the size, number, and location of facilities is determined, that also defines the
number of possible paths through which products can flow on the way to the final customer.

Location decisions reflect a company’s basic strategy for building and delivering its products
to market.

b. Warehouse Space Arrangement

In arranging warehousing space, a company has two basic alternatives: private (or leased)
ownership of facilities or use of public warehouses.

One of the basic warehousing decisions is whether to use private or public warehousing. In
other words, should the company purchase, build or lease its own warehouse (s) or should it
rent public warehouse space on needed basis.
3.11 Self-Assessment Questions
1. Briefly describe logistics role in supply chain management
2. Discuss and elaborate on the following statement: "The selection of a superior
warehouse can create substantial competitive advantage."
3. Why are logistics costs very high in every industry? Elucidate.
4. How has transportation cost, as a percentage of total logistics cost, tracked since 1980?
5. Describe the logistics value creation in supply chain management.
6. Describe the fundamental approaches and differences between third party logistics and
own logistics service providers
7. Compare and contrast different performance measures of logistics
8. How does the "quest for quality" affect logistical operations? Does the concept of total
quality have relevancy when applied to logistics?

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9. Discuss uncertainty evolution of logistics.
10. Briefly describe different logistics costs in the supply chain.

3.12 Chapter Summary

Paralleling advances in management theory and information systems, logistics has evolved in
scope and influence in the private sector since the mid to late 1940s. In the 1950s and ‘60s, the
military was the only organization using the term logistics. There was no true concept of
logistics in private industry at that time. Instead, departmental silos including material
handling, warehousing, machining, accounting, marketing, and so on, were the norm.
The five phases of logistics development are—workplace logistics, facility logistics, corporate
logistics, supply chain logistics, and global logistics.

Logistics is the process that links supply chains into integrated operations. The cost of
performing logistics is a major expenditure for most businesses. Logistical is measured in
terms of financial, quality, productivity and cycle time performance measures. Lean logistics is
all about providing the essential customer service attributes at the lowest possible total cost.
The actual work of logistics is functional in nature. Facility locations must be established to
form a network, information must be formulated and shared, transportation must be arranged,
inventory must be deployed, and, to the extent required, warehousing, materials handling, and
packaging activities must be performed. The traditional orientation was to perform each
functional task as well as possible with limited consideration given to how one work area
impacted another. Because the work of logistics is extremely detailed and complex, there is a
natural tendency to focus on performing functions. While functional excellence is important, it
must be supportive of overall logistical competency.

The functions of logistics combine into the three primary operational processes of market
distribution, manufacturing support, and procurement. To achieve internal integration, the
inventory and information flows between these areas must be coordinated. In supply chain
synchronization, the operational focus is the logistics performance cycle.
The performance cycle is also the primary unit of analysis in logistical design.
The challenge is to design a supply chain capable of performing the required logistical work as
rapidly but, even more important, as consistently as possible. Unexpected delays, as well as
faster than expected performance, can combine to increase or decrease the elapsed time
required to complete a performance cycle. Both early and late delivery are undesirable and
unacceptable from an operational perspective.

Key terms:
• Logistics is the flow of material, information, and money between consumers and
suppliers
• Workplace logistics is the flow of material at a single workstation.
• Facility logistics is the flow of material between workstations within the four walls of a
facility (that is, interwork station and intra-facility)

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 • Corporate logistics is the flow of material and information between the facilities and
processes of a corporation (inter workstation, inter-facility, and intra-corporate)
• Supply chain logistics is the flow of material, information, and money between
corporations (inter-workstation, inter-facility, inter-corporate, and intra-chain).
• Global logistics (is the flow of material, information, and money between countries
• Customer response links logistics externally to the customer base and internally to sales
and marketing
• Logistics optimization-objective to minimize the total logistics costs (TLC), including
inventory carrying costs, response time costs (warehousing and transportation), and lost
sales costs.
• Measures of Logistics performance-different measurement metrics used to measure the
performance of logistics in the supply chain.

Case for Analysis:

Cisco's sales were growing by 100 percent per year in the mid-90s. Employment was swelling
to keep pace and supply chain costs were unacceptably high. Product life cycles continued to
shorten. Demands for reliability, flexibility, and speed escalated at an alarming rate. To keep
pace, Cisco undertook a wholesale revamping of its business processes, from design and
forecasting to raw materials acquisition, production, distribution, and customer follow-up.
The creation of Cisco's global networked business model arose in multiple departments at the
same time, out of a shared realization of the need for change. Within this model, Cisco views
its supply chain as a fabric of relationships, rather than in a linear fashion. The goal was to
transcend the internal focus of Enterprise Resource Planning (ERP) systems to embrace a
networked supply chain of all trading partners. Primary goals were servicing the customer
better, coping with huge growth, and driving down costs. Utilizing the Internet, it is pursuing a
single enterprise strategy.

Today Cisco relies on five contract manufacturers for nearly 60 percent of final assembling and
testing and 100 percent of basic production. Through strict oversight and a clear set of
standards, Cisco ensures that every partner achieves the same high level of quality. All 14 of its
global manufacturing sites, along with two distributors, are linked via a single enterprise
extranet. The quest for a single enterprise has tied Cisco to its suppliers in unprecedented ways.
Product now flows from first- and second-tier suppliers without the documentation and
notifications on which most supply chains rely. Instead of responding to specific work orders,
contract manufacturers turn out components according to a daily build plan derived from a
single forecast shared throughout the supply chain. Items move either to Cisco or directly to its
customers.

Payment occurs automatically upon receipt; there are no purchase orders, invoices, or
traditional acknowledgments. In exchange for getting paid sooner, suppliers are required to

60
aggressively attack their cost structures but not to the point where they can't make a profit. "It's
not a partnership if you're putting the other guy out of business," says Barbara Siverts, manager
of supply chain solutions within Cisco's Internet Business Solutions unit.
Cisco cites at least $128 million in annual savings from its single enterprise strategy. It has
reduced time to market by 25 percent, while hitting 97 percent of delivery targets. Inventories
have been cut nearly in half. Order cycle time has declined from 6 to 8 weeks 4 years ago to
between 1 and 3 weeks now. Under a program known as dynamic replenishment, demand
signals flow instantly to contract manufacturers. Inventories can be monitored by all supply
chain partners on a real time basis.
Some 55 percent of product now moves directly from supplier to customer, bypassing Cisco
altogether. This has removed several days from the order cycle. Direct fulfillment means
reduced inventories, labor costs, and shipping expenses. Cisco pegs savings at $10 per unit or
around $12 million a year. Working with UPS, Cisco took control of the outbound supply
chain, allowing for time definite delivery throughout Europe within 5 to 8 days, via a single
point of contact. With Oracle's inventory control system hooked directly into UPS'S logistics
management system. Cisco now tracks product to destination on a real time basis. The extra
measure of control allows it to intercept, reroute, or reconfigure orders on short notice.
Through deferred delivery, Cisco ensures that a component won't arrive at the customer's dock
until it's ready to be installed.

Cisco's outsourcing strategy took another step forward recently, with the decision to turn over
shipping and warehousing functions to FedEx Corp. The air, ground, and logistics services
provider will manage a merge-in-transit operation for direct shipment to end customers,
resulting in the near elimination of Cisco-operated warehouses within 5 years.

Question: How did logistics management play in the success of CISCO’s Supply Chain
Management?
Source: Adopted and modified from the book Supply Chain Logistics Management (Bowersox
et al., 2002).

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 CHAPTER FOUR

MANAGING INVENTORY FLOWS IN THE SUPPLY CHAIN

In this chapter you will be expected to cover the following:-

4.1 Basic concepts of inventory in the supply chain

4.2 Purposes of inventory in the supply chain
4.3 Inventory performance measurement
4.4 Inventory deployment
4.5 Inventory control policies
4.6 Inventory management systems
4.7 Inventory costs
4.8 Self-Assessment Questions
4.9 Chapter Summary

Chapter Objectives

After reading this chapter, you will be able to:

recognize the need for inventory minimization in supply chain

link inventory management with supply chain profitability

identify relevant inventory costs to focus on

formulate inventory control systems

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4.1 DEFINITION

Inventory is physical resource that a firm holds in stock with the intent of selling it or
transforming it into a more valuable state. Inventory System refers to a set of policies and
controls that monitors levels of inventory and determines what levels should be maintained,
when stock should be replenished, and how large orders should be placed.

4.2 PURPOSE OF INVENTORY IN LOGISTICS SYSTEMS- According to Ballou,

(1978), the following are among the purposes of inventory:

 Improves the customer service

 Allows economies of Production

 Permits purchase and transportation economies

 Hedges against price changes

 Protects against demand and lead-time uncertainties

 Hedges against contingencies

Or [ASCHNER (1990)]:

Demand/supply fluctuations

Anticipation

Transportation

Hedging

Lot size

Or [Lambert & Stock (1993)]:

 Economies of scale

 Balancing supply and demand

 Specialization

 Protection from uncertainties

 Inventory as a buffer

There are five initiatives that lead to increased return on inventory and increased inventory
availability at the same time. These are:

1. Improved forecast accuracy

63
 2. Reduced cycle times

3. Lower purchase order/setup costs

4. Improved inventory visibility

5. Lower inventory carrying costs

These five initiatives are the foundation of any lasting progress in logistics and supply chain
management.

Recognition of the critical role of inventory has launched a variety of industry wide inventory
reduction initiatives, including efficient consumer response (ECR) and efficient foodservice
response (EFR) in the food and grocery industry, quick response (QR) in the textiles industry,
continuous flow manufacturing (CFM) in electronics manufacturing and just-in-time (JIT) in
auto manufacturing. Despite all of these initiatives to reduce inventory in the supply chain,
there remain legitimate, value-added forms of inventory in the supply chain, including service
inventory, pipeline inventory, contingency inventory, safety stock, efficient manufacturing
inventory, and efficient procurement inventory.

Service inventory (SI) is in place to provide acceptable response time to customers.

Pipeline inventory (PI) is in transit to/from customers and suppliers.

Contingency inventory (CI) protects against unusual occurrences including strikes and natural
disasters. Safety stock (SS) is in place to provide acceptable customer service levels in the face
of random demand during replenishment lead times.

Efficient manufacturing inventory (EMI) is in place to leverage the cost of manufacturing

setups.

Efficient procurement inventory (EPI) is in place for special opportunities to procure product at
lower prices than normal.

The challenge facing inventory managers is to ensure that efficient inventory levels are in place
in each of these inventory categories. Inventory levels should be minimized while satisfying
customer service requirements.

There are six aspects of inventory management:

• Inventory levels
• Stock outs
• Planning parameters
• Financial terms
• Demand terms
• Decision variables
1. Inventory Levels
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Inventory levels are expressed with a variety of terminology and from a variety of perspectives.
Common reference terms include on-hand stock (OHS), net stock (NS), and net inventory
position (NIP).

On-hand stock is the number of units of inventory physically in storage.

For a distribution center, the OHS is the number of units on-hand in the distribution center. For
a domestic company, the corporate on-hand stock (COHS) is the inventories physically on-
hand in all distribution centers. For an international company, the sum of all inventory on-hand
in the international network of distribution centers is the global on-hand stock (GOHS).

Net stock (NS) is the OHS less units on backorder (UOB).

NS = OHS - UOB

The NIP is the OHS plus units on order (UOO), plus pipeline inventory (PI) less units UOB
less allocated inventory (AI).

NIP = OHS + UOO + PI - UOB - AI

2. Stock-out Conditions

Never being out of stock is like having an insurance policy with no deductible. The inventory
carrying cost for never being out of stock is infinite, literally. As a result, not all demand can or
should be satisfied directly from the shelf. This is because stock-outs are costly situations in
terms of customer service and material handling. Managing unsatisfied demand is a critical
dimension of inventory management.

There are three possible responses to unsatisfied demand: backordering, substitutions, and lost
sales. The appropriate response depends on the unique characteristics of each item and
customer.

In backordering, the quantity requested by the customer is placed on a separate order called a
backorder, and the special order is filled as soon as the product is available from internal and/or
external sources. In some cases, the backorder is shipped directly from its original source to the
customer. Backordering is commonplace when there is no other source for a product (that is, in
captive markets).

Substitutions occur when a product acceptable to the customer is substituted for the product
that is not available. Lost sales occur when the unsatisfied demand is lost. Lost sales are
common in retail situations where there are many alternative outlets for a product.

Lost sales are critically expensive for A items where the unsatisfied demand may result in
negative publicity and/or the customer’s purchase of B or C items depends on the availability
of the A items. Lost sales for B and C items are not as critical as ‘A’ items.

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The difference in the penalties for shortages in A, B, and C items is reflected in the shortage
factor (SF). The shortage factor is an index applied to the selling price to reflect the magnitude
of the damage of a lost sale. For example, shortages of core items may generate such negative
customer reaction that customers begin to complain publicly about shortages. In those cases,
the shortage factor may be as high as 200 to 300 percent.

3. Planning Parameters

We will use five key planning parameters to define the unique inventory management
parameters for an item or enterprise:

• Unit selling price (USP)

• Unit inventory value (UIV)

• Inventory carrying rate (ICR)

• Purchase order cost (POC)

• Setup cost (SUC)

The USP for an item is the price paid by a customer for an item.

The UIV for a purchased item is the price paid for the item; the UIV for a manufactured item is
the cost of manufacturing the item.

The ICR is the percent of the UIV used to compute the ICC for an item.

The ICR includes:

• Opportunity cost of capital (the rate of return that could reasonably be achieved
for each dollar had not been invested in inventory)
• Storage and material handling
• Loss due to obsolescence, damage, and/or pilferage
• Insurance and taxes

The POC is the cost of placing a purchase order with a vendor. Those costs include:

• Order forms
• Postage
• Telecommunications
• Authorization
• Purchase order planning
• Purchase order entry time
• Purchase order processing time
• Purchase order inspection time
• Purchase order follow-up time

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 • Purchasing management
• Office space
• Office supplies
• Purchase order entry systems
• Tracking and expediting

The most expensive items on the list are the labor related items. Hence, automating purchase
order processing typically yields significant labor cost reductions and productivity
improvements.

4. Financial Terms

We will use four key financial terms in discussing inventory management:

• Average inventory value (AIV)

• Inventory carrying cost (ICC)
• Lost sales cost (LSC)
• Total policy cost (TPC)

AIV is the average value of the total inventory investment over the course of a year. It should
be computed as the average of several on-hand inventory values measured at random times
during the year. (The on-hand inventory value [or total inventory investment] at any point in
time is the sum of the unit inventory values for all items.)

ICC is the annual cost of carrying (or holding) the AIV. It is computed by multiplying the AIV
by the ICR

ICC =AIV * ICR

For example, if the AIV in a warehouse is $10,000,000 and the inventory carrying rate is 30
percent per year, then the ICC in the warehouse is =$30,000,000/year.

LSC is the revenue lost when we are not able to satisfy customer demand.

The lost sales cost for an item is computed by multiplying the annual sales potential (that is,
sales that would have occurred if all demand was satisfied) by the portion of sales that we were
not able to satisfy by the shortage factor.

LSC =AD *USP *(1 - UFR) * SF

In the equation, UFR stands for the unit fill rate, the percent of unit demand that is satisfied
from on-hand stock.

For example, if the annual demand (AD) for an item is 1,000 units, the unit selling price is
$2.00; the UFR is 90 percent, and the shortage factor is 50 percent, then the LSC for the item
is:

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 LSC =1,000 units/year * $2.00/unit *(1 - 0.9)* 0.5 = $100/year

The total lost sales cost is the sum of the lost sales costs for all the items.

The inventory policy cost (IPC) for an item is the sum of the inventory carrying and lost sales
costs for the item.

5. Demand Terms

Every item has a unique set of demand characteristics. Some of those characteristics can be
represented mathematically including

• Annual demand (AD)

• Forecast annual demand (FAD)
• Lead time (L)/LT
• Lead time demand (LD)
• Forecast lead time demand (FLD)
• Standard deviation of lead time demand (SDLD)

The AD for an item is the number of units requested for an item during a year. The FAD is the
forecasted (or expected) annual number of units requested by customers. The L for an item is
the elapsed time from the placement of the replenishment order until the item is available to
satisfy customer demand. Lead time demand is the historic number of units requested by
customers during an L. The FLD is the forecasted (or expected) number of units that will be
requested by customers during an L. The SDLD is a measure of the variability of the demand
during an L. The greater the variability in L demand, the greater the need for safety stock to
protect against large demand spikes during an L.

6. Decision Variables

Throughout our study of inventory management, we will be working to identify optimal values
for a variety of decision variables including:

• Economic order quantity (EOQ)

• Unit fill rate (UFR)
• Optimal safety stock (SS) level
• Reorder point (ROP)
• Order-up-to-level (OUL)
• Review time period (RTP)

The EOQ is the number of units per replenishment order that minimizes the total cost of
ordering and carrying the inventory associated with the order.

The higher the order quantity, the greater the inventory level. However, the higher the order
quantity, the fewer times we will need to order and the lower the resulting ordering cost. The
formula to compute the EOQ is as follows:

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 EOQ = [(2 * FAD * POC) / (UNI * ICR)]1/2

The UFR for an item is the portion of the total number of units requested by customers that we
have available to provide to the customer. As discussed previously, the higher the UFR, the
lower the lost sales cost. However, the higher the UFR, the greater the inventory required to
provide it and the greater the resulting inventory carrying cost. The optimal UFR is found at
the point that minimizes the total policy cost (sum of lost sales and inventory carrying cost)
associated with various fill rates.

The literal definition of SS is the amount of inventory on-hand when replenishment arrives
(The average SS is the average on hand inventory at the end of several replenishment cycles.

Safety stock is required to support promised levels of inventory availability when the demand
during an L or the length of an L are variable. For example, if replenishment is delayed or if
the demand during an L is much greater than normal, SS is in place to fulfill demand until the
replenishment arrives or to satisfy some portion of the excess demand. There would be no need
for SS if we knew exactly what quantity the customers wanted, when they wanted it, and
exactly when replenishment would arrive. To the extent there is uncertainty in any of those
three variables, we need SS to provide anything better than 50 percent inventory availability.

The ROP is the inventory level at which a replenishment order is placed.

The ROP is typically set at the LD plus the safety stock.

ROP =LD +SS

The OUL is the level of inventory a replenishment quantity should yield when it is placed.

The main differential between the use of OULs and EOQs is that order sizes vary in an OUL
program.

4.3 INVENTORY PERFORMANCE MEASUREMENT

The key financial indicators for inventory performance are the average inventory investment
and the associated inventory carrying cost. The key productivity indicators of inventory
performance are inventory turnover and the number of items managed by an inventory planner.
The key quality indicators of inventory performance are forecast accuracy and fill rates. These
measures should be available at the SKU, family, country, and business unit level in real-time.
The inventory management organization should be held accountable for performance in each
of these interdependent indicators, with their evaluation based on their ability to meet
predefined goals for performance in each area. Each of these metrics is defined in detail in the
following section.

1. Inventory Investment

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The average inventory investment is computed as the average over time of the sum of the
inventory values for individual items. The average inventory value (AIV) of an item at any
particular time is the product of its average inventory level (AIL) and its unit inventory value
(UIV). To improve cash flow, some companies are particularly concerned about their average
inventory investment.

2. Inventory Carrying Cost

Inventory carrying cost (ICC) is the product of the AIV and the inventory carrying rate (ICR).
The ICR includes the cost of investing in inventory, storing and handling, obsolescence, taxes,
insurance, and shrinkage (due to damage and/or pilferage)

ICC = ICR *AIV

3. Inventory Turns

Inventory is one of the essential logistics resources. Just as we are concerned with the
productivity and utilization of people, space, and vehicles, we are even more concerned with
the productivity of inventory. The productivity of inventory is typically measured as the
inventory turnover rate (ITR). The ITR is simply expressed as the ratio of annual dollar sales
(at cost, ADS) to the AIV.

ITR = ADS/ AIV

4. Customer Service Levels and Fill Rates

In the context of inventory management, customer service levels indicate the overall inventory
availability, typically measured as the first-time-fill-rate (FTFR). As the target FTFR is
increased, the overall inventory level, investment, and carrying cost increases, while LSC are
reduced. The sum of the two related costs—inventory carrying and lost sales— is the inventory
policy cost. The least-cost FTFR should be targeted for each item and/or family of items.

4.4 INVENTORY CONTROL POLICY AND REPLENISHMENT DESIGN

As the case in any type of system, there needs to be a reliable control policy for the operation
of an inventory system. The choice of the control system depends on the complexity of the
operating scenario, the number of items that need to be controlled, the number of locations
where inventory may be housed, and the availability of timely information to support the
inventory control policy.

We will consider here three types of inventory control policies:

• Distribution inventory control

• Manufacturing inventory control

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 • Situational inventory control
1. Distribution Inventory Control

There are nine popular distribution inventory control policies organized into three categories:

Manual inventory control:

• Two-Bin Systems (2BS)
• Visual Review (VR)

Basic replenishment schemes:

• Re-Order Point (ROP) with Economic Order Quantities (EOQ) — ROP/EOQ)

• Re-Order Point (ROP) with Order Up to Levels (OUL) =ROP/OUL
• Review Time Period (RTP) with Order Up to Levels(OUL) — RTP/OUL)
• Review Time Period with Re-Order Points and Order-Up-To-Levels — RTP/ROP/OUL

Advanced control policies:

• Joint Replenishment Programs (JRP)

• Distribution Requirements Planning (DRP)
• Continuous Replenishment Programs (CRP)

We will consider the operation, advantages, disadvantages, and proper applications for each
control policy.

1. Manual Inventory Control

The most common manual inventory control systems are two-bin systems and visual review.

Two-Bin Systems (2BS): In a 2BS, two, side-by-side locations are dedicated to an item. When
the on-hand inventory in one location is depleted, an order large enough to fill the depleted
location is placed, and the inventory in the other location begins to be withdrawn. This
normally takes place with a manual visual review.

The 2BS is common in small manufacturing operations where a location may be a tote or pallet
with component parts at an assembly station or in small warehouses where a location may be a
lane in a flow rack or a compartment in a shelving unit.

The advantage of the 2BS is its simplicity. Many homes work on 2BSs for items ranging from
potato chips to milk. The disadvantage is lack of reliability if the operators are not disciplined
to monitor the inventory levels and/or if housekeeping obscures the inventory levels from the
view of the operators.

Visual Review: Under VR, the on-hand inventory in each location is visually inspected and
based on the inspector’s judgment and/or using visual aids a replenishment order for an item
may be placed. VR is common in small retail outlets and warehouses that lack the technology
required to support automated inventory control policies.
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As the case with the 2BS, the advantage of visual inventory control is its simplicity. Most
homes are managed with visual inventory control. The disadvantage is the lack of reliability if
the workforce is undisciplined and/or if the housekeeping practices do not permit good
sightlines for the products.

2. Basic Replenishment Schemes

There are four basic replenishment designs in use in industry: (ROP, EOQ), (ROP, OUL),
(RTP, OUL), and (RTP, ROP, OUL).

(ROP, EOQ) Under continuous review, the EOQ is ordered when the inventory position drops
to or below the reorder point. This is the simplest of the four basic inventory control policies.
The ROP is typically set at the safety stock plus the forecasted lead time demand. One
advantage is the use of the EOQ, which minimizes the sum of the ordering and inventory
carrying costs. One disadvantage is the need to continuously review the inventory levels.

(ROP, OUL) Under continuous review, a variable amount of inventory sufficient to bring the
inventory position up to the OUL is ordered when the inventory position drops to or below the
ROP. The OUL is set to yield a target stock out probability.

(RTP, OUL) Every RTP, a variable replenishment quantity is ordered to bring the inventory
position up to the OUL. One advantage is the periodic versus continuous consideration of
inventory levels. The periods can be common for a variety of items and can be used in joint
replenishment schemes. One disadvantage is the excess inventory that may be required to
support this policy because inventory is ordered every period regardless of the inventory level.
Another disadvantage is that lumpy or seasonal demand during a review period may lead to
stock outs before the next review time period.

(RTP, ROP, OUL) Every RTP, a variable replenishment quantity (OUL — I) is ordered to
bring the inventory position up to the OUL if the inventory position is at or below the ROP.
This is generally the least costly of the four basic control policies; however, it is also the most
difficult to understand and may lead to stock outs for those periods where the ending inventory
is nearly at the ROP.

3. Advanced Inventory Control Policies

The advanced inventory control policies defined here are

• Joint, coordinated replenishments

• Distribution requirements planning (DRP)
• Continuous replenishment

1. Joint, Coordinated Replenishments

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To leverage the cost of ordering, joint, coordinated purchases should be arranged for those
items with common economic time supplies. (The economic time supply [ETS] is the optimal
time between replenishments based on the EOQ for the item. The ETS is expressed in years as
the EOQ divided by the FAD. (The ETS is expressed in days by multiplying the ETS in years
by the number of business days per year.) Based on the ETS profiles, fixed cycle replenishment
schedules should be established with each vendor. A dedicated volume should be scheduled on
the cycle with forecasted purchase orders converted to firm POs at the latest possible date. To
take advantage of handling and transportation economies, order quantities should round up or
down to case, layer, pallet, and/or container quantities.

2. Distribution Requirements Planning (DRP)

Distribution Requirements Planning (DRP) is a methodology for forecasting, calculating, and

summarizing shipping requirements between locations in a distribution network.

DRP treats distribution hierarchies like bills-of-material in computing requirements.

3. Continuous Replenishment

Continuous replenishment is “the practice of partnering between distribution channel members

that changes the traditional replenishment process from distributor-generated purchase orders,
usually based on EOQs, to the replenishment of products based on actual and forecasted
demand.”

As the case at the retail level, an order is placed with a supplier for an item when the inventory
level reaches or dips below the ROP for the item. In the most advanced inventory control
systems, the forecasted retail and wholesale replenishment orders are calculated, collaborated,
and communicated in advance.

Best practices in replenishment schemes combine the best features of these policies with
considerations for joint purchasing, efficient handling increments, and capacity constraints.

4.5 INVENTORY DEPLOYMENT

Inventory deployment is the assignment and allocation of inventory to levels and/or facilities in
a logistics network. World-class practices in inventory deployment incorporate:

• Optimal positioning
• Dynamic redeployment
• Postponement
• Four-wall inventory management
• Global inventory visibility
1. Optimal Inventory Positioning

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In the simplest deployment scheme, all inventories are housed in a single, central distribution
center. Though the least inventory cost option, the single Distribution Center deployment
model is usually inadequate to meet rapid response time requirements. (We have one client that
must deliver parts to a global client base within 2 hours of receiving an order. That is
physically impossible from a single Distribution Center.) Hence, inventory must often be
deployed in locations (regional and local) closer to customer locations. The most difficult
challenge is to determine the amount and timing of the deployment.

A compromise and often optimal deployment scheme is to deploy A items all the way to level
3, B items to level 2, and hold C items centrally at level 1. A items are the most critical to the
customer and must be delivered quickly to support a segmented customer service policy. In
addition, A items are frequently delivered and the transportation cost to deliver them from a
central Distribution Center is often prohibitive. C items are the least critical to the customer
and the inventory investment required to forecast and position C items locally is often
prohibitive.

2. Dynamic Redeployment
Once a plan for inventory positioning has been planned and executed, changes in the business
environment and/or item characteristics quickly obsolete the original plan. Good deployment
systems constantly review the efficiency of the current deployment and recommend
redeployment scenarios. The redeployments should rebalance inventory levels (matching
overages and shortages) at the lowest possible transportation cost and with the least impact of
stock outs in the network.
3. Postponement
Another critical inventory deployment decision is the timing of the customization and
positioning of inventory. This deployment decision is sometimes referred to as postponement.
The premise of postponement is that inventory investments can be minimized by delaying
decisions related to the configuration of an item in manufacturing (manufacturing
postponement) or assembly (assembly postponement) and to the positioning of an item in
distribution (distribution postponement). The opposite of postponement is speculation—
manufacturing/assembly speculation and distribution speculation.
4. Four-Wall Inventory Management
Four-wall inventory management is the management of inventory within the four walls of a
warehouse or distribution center. The impact of inventory management within a warehouse or
DC on overall inventory investments and total supply chain performance is often
underestimated. This is especially the case in the face of SKU proliferation, smaller shipment
sizes, lower margins for error, and shrinking order ship times The most important disciplines of
four-wall inventory management are:
• ABC cycle counting
• Container and location tracking
• Real-time warehouse management systems

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 i. ABC Cycle Counting

The discipline of cycle counting requires counting a portion of the warehouse locations each
day (in lieu of a single annual count of all locations known as a physical inventory). As a
result, each item and location is counted once during a counting cycle. For example, if one
percent of the items/locations are counted each day, then each item is counted every 100 days.
The advantages of cycle counting include avoiding the massive disruption of operations
inherent in annual physical inventory counts, obtaining discrepancy notifications closer to the
time of occurrence so that corrective action is more likely to occur, and the ability to count
different items/locations on different cycles. Some items, due to their value and/or velocity, are
more critical to the overall inventory and shipping accuracy than are other items. Those A
items should be counted more frequently than the other items. A cycle counting schedule based
on the value and/or velocity of the items is called ABC cycle counting.

ii. Container and Location Tracking

Container and location tracking simply requires that every container (tote, case, pallet, trailer,
railcar, and so on) and every location (bin, half-bin, pallet opening, staging position, and so on)
be automatically identified by bar code scanning or RF tagging.

. These new fashioned technologies are current generation means of implementing the old-
fashion practice of having a place for everything and keeping everything in its place.

iii. Real-Time Warehouse Management Systems

Real-time warehouse management systems are required to support container and location
tracking. Due to intensified cross-docking, value-added activities and shrinking order cycle
times, batch warehouse management systems cannot keep pace with inventory movements in
the 21st century warehouse.

5. Global Inventory Visibility

Our human nature is to lack trust in the things we can’t see. Wherever there are places we
can’t “see” inventory in the supply chain (called supply chain blind spots), we tend to order
excess to cover our lack of trust. Some customers place the same order multiple times if they
are not notified of a delivery date or a status on the order. Some players in the supply chain
inflate order sizes to cover “unforeseen” circumstances that may occur in the “blind spots” or
“black holes” in the supply chain.

The only way to solve this problem is to provide true global inventory visibility by item, by
order, by location, and in-transit. This capability is sometimes referred to as the glass pipeline.
The best example of this glass pipeline capability in the logistics world is most likely the Total
Asset Visibility (TAV) program within the U.S. Army. The program was developed to enable a
commanding officer located on a battlefield anywhere in the world to know within real-time
what assets are in his control in close proximity and their specific location within a container

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4.6 INVENTORY MANAGEMENT SYSTEMS

Inventory management system is a set of techniques that are used to manage the inventory
levels within different companies in a supply chain. The aim is to reduce the cost of inventory
as much as possible while still maintaining the service levels that customers require. Inventory
management takes its major inputs from the demand forecasts for products and the prices of
products. With these two inputs, inventory management is an ongoing process of balancing
product inventory levels to meet demand and exploiting economies of scale to get the best
product prices.

There are three kinds of inventory: 1) cycle inventory; 2) seasonal inventory; and 3) safety
inventory. Cycle inventory and seasonal inventory are both influenced by economy of scale
considerations. The cost structure of the companies in any supply chain will suggest certain
levels of inventory based on production costs and inventory carrying cost. Safety inventory is
influenced by the predictability of product demand. The less predictable product demand is, the
higher the level of safety inventory is required to cover unexpected swings in demand. The
inventory management operation in a company or an entire supply chain is composed of a
blend of activities related to managing the three different types of inventory. Each type of
inventory has its own specific challenges and the mix of these challenges will vary from one
company to another and from one supply chain to another.

Inventory is spread throughout the supply chain and includes everything from raw material to
work in process to finished goods that are held by the manufacturers, distributors, and retailers
in a supply chain.

Again, managers must decide where they want to position themselves in the trade-off between
responsiveness and efficiency. Holding large amounts of inventory allows a company or an
entire supply chain to be very responsive to fluctuations in customer demand. However, the
creation and storage of inventory is a cost and to achieve high levels of efficiency, the cost of
inventory should be kept as low as possible. There are three basic decisions to make regarding
the creation and holding of inventory:

1. Cycle Inventory—This is the amount of inventory needed to satisfy demand for the product
in the period between purchases of the product. Companies tend to produce and to purchase in
large lots in order to gain the advantages that economies of scale can bring. However, with
large lots also comes an increased carrying cost. Carrying costs come from the cost to store,
handle, and insure the inventory. Managers face the trade-off between the reduced cost of
ordering and better prices offered by purchasing product in large lots and the increased
carrying cost of the cycle inventory that comes with purchasing in large lots.

2. Safety Inventory—Inventory that is held as a buffer against uncertainty.

If demand forecasting could be done with perfect accuracy then the only inventory that would
be needed would be cycle inventory. But, since every forecast has some degree of uncertainty

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in it, we cover that uncertainty to a greater or lesser degree by holding additional inventory in
case demand is suddenly greater than anticipated. The trade-off here is to weigh the costs of
carrying extra inventory against the costs of losing sales due to insufficient inventory.

3. Seasonal Inventory—this is inventory that is built up in anticipation of predictable increases

in demand that occur at certain times of the year. For example, it is predictable that demand for
anti-freeze will increase in the winter. If a company that makes anti-freeze has a fixed
production rate that is expensive to change, then it will try to manufacture product at a steady
rate all year long and build up inventory during periods of low demand to cover for periods of
high demand that will exceed its production rate. The alternative to building up seasonal
inventory is to invest in flexible manufacturing facilities that can quickly change their rate of
production of different products to respond to increases in demand. In this case, the trade-off is
between the cost of carrying seasonal inventory and the cost of having more flexible
production capabilities.

Effective management of the flow of inventory in supply chains is one of the key factors for
success. The supply chain management orientation during the 1990s brought attention to the
importance of reducing inventory levels in supply chains to reduce landed cost at the end of the
supply chain.

The planning, storing, moving, and accounting for inventory is the basis for all logistics.
Inventory availability is the most important aspect of customer service. Inventory carrying
costs are typically the most expensive costs of logistics. It is very difficult to convert physical
inventory into a liquid asset, hence, inventory is a very risky investment .The goal of inventory
management is to increase the financial return on inventory while simultaneously increasing
customer service levels (Frazelle, 2002:91).

The bullwhip effect in supply chain management suggests that demand variability increases as
one moves up a supply chain. It is a distortion of information throughout the network, which
leads to over or under production and mis-match in demand and Supply.

Some factors that aggravate demand amplification /bullwhip effect are:-

Poor demand forecasting which may be un intentional or caused by forecasts by ambitious

sales department, uncertainty in the quality of information being passed between echelons,
distinguishing periodic economic & seasonal demand swings from fundamental changes in
consumers attitudes ,unreliable delivery service compensated for by additional inventory
investment, and lead time delays during supply (Gupta & Sahay, 2007:10-11).

Purposes for Holding Inventory

Langley et al., (2006: 193-196) identified the Rationale for holding inventory for firms
traditionally as follows:

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 1. Batching Economies/Cycle Stocks

Batching economies or cycle stocks usually arise from three sources-acquisition, production,
and/or transportation. Scale economies are often associated with all three, which can result in
accumulation of stock that will not be used or sold immediately- which means there will be
cycle stocks or inventory that will be used up or sold over some period of time.

2. Uncertainty/Safety Stocks

All businesses are usually faced with uncertainty, which can arise from a variety of sources.
On the demand or customer side, there is usually uncertainty about how many customers will
buy and when. On the supply side, there may be uncertainty about obtaining what is needed
from venders or suppliers and about how long it will take for fulfillment of the order.

3. Time/In-transit and Work-in-process Stocks

The time associated with transportation, for example, vendor to manufacturing plant, and the
time needed to assemble or produce a complex product (automobile or computer) mean that,
even while goods or materials are in motion, there is an inventory cost associated with the time
period. The longer the time, the higher the cost. The time period for in-transit inventory should
be evaluated in terms of the appropriate trade-offs.

4. Seasonal Stocks

Seasonality can occur on the inbound side of a company’s logistics system or the outbound
side or both for those products whose demand is peak or low during certain seasons that may
demand accumulation of inventory to satisfy the demand for particular season.

5. Anticipatory Stocks

A fifth reason for inventory arises when companies anticipate some unusual event, for
example, strike, significant price increase, a major shortage of supply due to weather or
political unrest, and so on.

4.7 Inventory Costs

Inventory costs are important for three major reasons. First, inventory costs represent a
significant component of total logistics in many companies. Second, the inventory levels that a
firm maintains at points in its logistics system will affect the level of service the firm can
provide to its customers. Third, cost trade-off decisions in logistics frequently depend up on
and ultimately affect inventory carrying costs.

Inventory Costs include:

 Ordering cost

 Overstock cost

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 Stock out cost/under stocking cost/ down time out

 Inventory carrying cost

Inventory Carrying Costs include:

Direct costs comprise of capital costs, storage space cost, service cost – Insurance, risk cost,
obsolescence, damage, and shrinkage. Indirect costs include business risk – lost sales,
customers, opportunity costs – inability to invest in alternatives, incremental increases in
infrastructure costs, facilities, transportation, and service companies. Fill rate planning is the
process of determining optimal service levels and inventory turns for each item. It is one of the
most difficult planning decisions in all of logistics (Frazelle, 2002:124). As stated by Frazelle
(2002: 94), Inventory Types and Roles for Inventory in the Supply Chain are identified as
follows:

Table 4.1 Inventory types and Roles in Supply chain management

No. Type Role Benefit

1 Lot size/Cycle stock Order in batches versus one at a time Purchase discounts, Reduced setups
to achieve economies of scale in
setups, purchases, transportation and Lower flight, material handling, and
so on. administration costs

2 Safety stock/Demand Insurance against high/low demand, Reduced lost sales and back orders, Increased
fluctuation and high /low lead times customer service, lower freight, and reduced
customer response costs

3 Contingency/supply/f Insurance against interrupted supply Reduced downtime and overtime

luctuation/ (that is; strikes, natural disasters).
Reduced lost sales cost

4 Anticipation Level out production (that is, to meet Reduced overtime, subcontracting
seasonal sales, promotions, and so on).
Higher manufacturing capacity utilization

5 In-transit/pipeline Moving/staging between/within Mobile warehousing

facilities.

6 Hedge/opportunity Provide hedge against price increases. Lower material costs

7 Dead /obsolete stock idle To be disposed timely

4.8 Self-Assessment Questions

1. How does the cost of carrying inventory impact the traditional earnings statement of the
enterprise?
2. Discuss the relationship between service level, uncertainty, safety stock, and order
quantity. How can trade-offs between these elements be made?
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 3. Discuss the disproportionate risk of holding inventory by retailers, wholesalers, and
manufacturers. Why has there been a trend to push inventory back up the channel of
distribution?
4. What is the bull whip effect of inventory across supply chain echelons?
5. What are the different methods of inventory ordering systems?
6. Explain the different inventory management policies?
7. Illustrate the difference between inventory hedging, buffering and speculation.
8. What advantage does DRP have over a fair share method of inventory deployment?
9. Discuss the importance of collaboration in the developing of supply chain inventory
strategies. Provide an example.
10. Customer-based inventory management strategies allow the use of different availability
levels for specific customers. Discuss the rationale for such a strategy.
11. Are such strategies discriminatory? Justify your position.

4.9 Chapter Summary

Inventory typically represents the second largest component of logistics cost next to
transportation. The risks associated with holding inventory increase as products move down the
supply chain closer to the customer because the potential of having the product in the wrong
place or form increases and costs have been incurred to move the product down the channel. In
addition to the risk of lost sales due to stock outs because adequate inventory is not available,
other risks include obsolescence, pilferage, and damage. Further more, the cost of carrying
inventory is significantly influenced by the cost of the capital tied up in the inventory.
Geographic specialization, decoupling, supply demand balancing, and buffering uncertainty
provide the basic rationale for maintaining inventory. While there is substantial interest in
reducing overall supply chain inventory, inventory does add value and can result in lower
overall supply chain costs with appropriate trade-offs.

From a logistics perspective, the major controllable inventory elements relate to replenishment
cycle stock, safety stock, and in-transit stock. The appropriate replenishment cycle stock is
determined using an EOQ formula to reflect the trade-off between storage and ordering cost.
Safety stock depends on the mean and variance of daily demand and replenishment
performance cycle. In-transit stock depends on the transport mode and time waiting at
terminals.
Inventory management uses a combination of reactive and planning logics. Reactive logic is
most appropriate for items with low volume, high demand, and high performance cycle
uncertainty because it postpones the risk of inventory speculation. Inventory planning logic is
appropriate for high-volume items with relatively stable demand. Inventory planning methods
offer the potential for effective inventory management because they take advantage of
improved information and economies of scale. Adaptive logic combines the two alternatives
depending on product and market conditions. Collaboration offers a way for parties in the
supply chain to jointly gain inventory efficiency and effectiveness.

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Key Terms
Inventory-stock of goods held for future purpose
Inventory costs- costs associated to carrying or acquiring inventory
EOQ- inventory ordering model which makes both inventory carrying and ordering cost at
minimum and minimize total inventory cost.
Inventory optimization- an objective function to bring inventory investment at minimum while
serving customers to their minimum requirements.

Case: CRP Benefits

Companies trying to develop efficient consumer response initiatives traditionally begin with
replenishment.
Continuous Replenishment Programs (CRP) have been most widely implemented. Proctor &
Gamble (P&G) was among the first companies to test CRP initiative. Forty percent of P&G's
case volume is handled by CRP. Due to the task's complexity, P&G has contracted with IBM
as its solution provider. IBM uses a program called Continuous Replenishment Service, a total
service offering that includes all necessary EDI connections, continuous replenishment
software, training, a help desk, and complete processing of the data which includes automated
replenishment ordering. P&G has found the outsourcing of CRP to be highly effective and
more cost-efficient. According to Ralph Drayer, vice president of ECR for P&G Worldwide,
IBM's continuous replenishment service "has allowed many manufacturers new to CRP to go
from zero to 30 percent of their volume on CRP in a matter of months."
P&G is managing inventories for most large food, drug, and mass merchandise retailers.
P&G's customer service representatives use CRP to monitor the movement of goods at the
retailer's distribution center, basing everyday or basic goods replenishments on movement,
inventory, and the short-term forecast. The everyday replenishment process is handled by the
software without the need for human intervention unless there are exceptions that fall outside
the established parameters. These customer service representatives maintain a close
collaborative relationship with their retail partners to forecast promotional replenishments
more accurately. The P&G representative and the retailer's category manager make a decision
on how much promotional product to order; this is manually fed into the IBM CRP database.
The program then predicts the retailer's total replenishment needs.
Retailers experienced the following benefits from participating in a CRP relationship with
P&G: Inventory turns increased 107%.
Inventory levels were reduced by 12.5 days, translating into a cash flow improvement of 12.5
days.
Store service levels increased by 2%.
Store service levels average 99% or 99.5% for most chain drug CRP customers.

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Total retail sales for P&G products managed via CRP were up 2%.
Retail savings from reductions in storage and handling costs were 20 cents a case.
P&G also received numerous benefits:
Shipments of perfect orders (complete, on-time, invoiced correctly, and delivered without
damage) increased by 5%.
Damage rates for CRP accounts decreased by 19%.
Returns were reduced by 36%.
Plant surge savings (surges generated because of the variability of shipments; CRP has leveled
the peaks and valley of demand) were I0 cents a case at the plant level.
Delivery expenses declined by 20 cents a case due to the more productive use of cube space in
transit.

Question:
How do you see the application of CRP in other industries? Discuss
Source: Liz Parks, "CRP Investment pays Off in Many Ways," Drug Store News, February 1,
1999, p. 26.

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 CHAPTER FIVE

THE ROLE OF TRANSPORTATION IN SUPPLY CHAIN MANAGEMENT

In this chapter you will learn the following concepts:-

5.1 Basic concepts of transportation

5.2 Role of transportation in logistics

5.3 Forms of transportation

5.4 Transportation performance measures

5.5 Transportation management

5.6 Self- Assessment Questions

5.7 Chapter Summary

Objectives

After reading this chapter, you will be able to:

indicate the role of transportation in supply chain

understand how to measure transportation performance

develop a routing plan and schedule for a shipment

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5.1 TRANSPORTATION

This refers to the movement of everything from raw material to finished goods between
different facilities in a supply chain. In transportation, the trade-off between responsiveness
and efficiency is manifested in the choice of transport mode. Fast modes of transport such as
airplanes are very responsive but also more costly. Slower modes such as ship and rail are very
cost efficient but not as responsive. Since transportation costs can be as much as a third of the
operating cost of a supply chain, decisions made here are very important.

There are six basic modes of transport that a company can choose from:

1. Ship- which is very cost efficient but also the slowest mode of transport. It is limited to use
between locations that are situated next to navigable waterways and facilities such as harbors
and canals.

2. Rail- which is also very cost efficient but can be slow. This mode is also restricted to use
between locations that are served by rail lines.

3. Pipelines- can be very efficient but are restricted to commodities that are liquids or gases
such as water, oil, and natural gas.

4. Trucks- are a relatively quick and very flexible mode of transport.

Trucks can go almost anywhere. The cost of this mode is prone to fluctuations though, as the
cost of fuel fluctuates and the condition of roads varies.

5. Airplanes- are very fast mode of transport and are very responsive.

This is also the most expensive mode and it is somewhat limited by the availability of
appropriate airport facilities.

6. Electronic Transport- is the fastest mode of transport and it is very flexible and cost
efficient. However, it can only be used for movement of certain types of products such as
electric energy, data, and products composed of data such as music, pictures, and text.

Someday, technology, that allows us to convert matter to energy and back to matter again may
completely rewrite the theory and practice of supply chain management. Given these different
modes of transportation and the location of the facilities in a supply chain, managers need to
design routes and networks for moving products. A route is the path through which products
move and networks are composed of the collection of the paths and facilities connected by
those paths. As a general rule, the higher the value of a product (such as electronic components
or pharmaceuticals), the more its transport network should emphasize responsiveness and the
lower the value of a product (such as bulk commodities like grain or lumber), the more its
network should emphasize efficiency.

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 Transportation is what allows products to move from point of origin to point of consumption
throughout the supply chain and is thus responsible for creating time utility and place utility.

A study shows that transportation costs, which represent approximately 40 to 50 percent of

total logistics costs and 4 to 10 percent of the product selling prices for many companies, may
represent logistics management’s major concern. Transport decisions directly affect the total
logistics costs, costs in other functional areas of the firm, and costs within other logistics
channel members.

In many cases, firms are forced to use outside agents or third – party transportation services to
move items in to foreign locations effectively.

5.2 THE ROLE OF TRANSPORTATION IN LOGISTICS

Conceptually, a company’s logistics supply chain is a series of fixed points where the goods
come to rest and transportation links:-bridge over buyer-seller gap, and Knowledge of the
transportation system is fundamental to the efficient and economical operation of a company’s
logistics function, (value-added function).

A supply chain becomes increasingly longer in our global economy; the transportation function
is connecting buyers and sellers that may be tens of thousands of miles apart. This increased
spatial gap results in greater transportation costs. A study indicated that both inbound and out
bound transportation costs 30.1 percent of sales which requires close management.

“Logistics and transportation managers face a very different environment today than merely a
few years ago. Continued economic deregulation , increased safety and social regulation,
escalating customer expectations, increased globalization, improved technologies, labor and
equipment shortages, and the continually changing face of the transportation service industry
present today’s managers with an array of challenges and opportunities that contrast
dramatically, with those of a decade ago”( Stank and Goldsby, 2000).

In order to meet ever-increasing expectations, the basic work of transportation has changed
from operationally meeting low cost or high service criteria to providing a strategic edge by
simultaneously meeting elevated service requirements and increasingly lower costs. Besides,
successful mangers today require a broad view of transportation management’s role and
responsibilities in an integrated supply chain.

Transportation services play a central role in seamless supply chain operations, moving
inbound materials from supply sites to manufacturing facilities, repositioning inventory among
different plants and distribution centers, and delivering finished products to customers.

5.3 LEGAL FORMS OF TRANSPORTATION

Transportation service companies are classified legally as either common, contract, exempt, or
private carriers.

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 1. Common Carriers- offer transportation services to all shippers at published rates
between designated locations.
2. Contract carriers- are also for hire carriers like common carriers; however, they are not
bound to serve the general public.
3. Exempt carriers- are also for hire carriers, but they are exempt from regulation of
services rates.

5.4 FACTORS TO BE CONSIDERED IN TRANSPORTATION MANAGEMENT

Transportation is a vital strategic link between organizations in a supply chain and must
therefore be managed effectively to meet customer due dates and other shipping requirements
at a reasonable cost.

i. Transportation Supply Base Reduction

Reducing the supply base can provide a number of advantages to the organization. Using fewer
transportation providers enables the firm to select and use only the best-performing suppliers,
resulting in better over all levels of service.

ii. Mode and Carrier Selection

When attempting to minimize transportation costs and/or improve customer service along the
supply chain, firms must identify the most desirable transportation modes and carriers available
for the various markets they serve as well as for their inbound purchased materials.

iii. Contracting Transportation Services

A contract assures a specific package of services and prices and increases the ability of the
shipper to control delivery dates, damages payments, or problem remedies.

iv. Outsourcing the transportation Function

Outsourcing transportation and other related services like warehousing, customs clearance, and
shipment consolidation has become more widespread today, as firms seek to increase service
levels, decrease costs, reengineer internal processes, and concentrate more resources on core
functions.

v. Measuring Transportation Performance

Measuring transportation performance allows the firm to identify problem areas and then make
changes, resulting in improved transportation services. Measures of performance can be
compared against predetermined standards, competitive benchmarks, or previous period
performances to identify problems. These are transportation cost, percent on-time deliveries,
and average transit time (Wisner et al., 2005:300).

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The overall goal in transportation should be to connect sourcing locations with customers at the
lowest possible transportation cost within the constraints of the customer service policy
(Frazelle, 2002:171).

vi. Creating Strategic Carrier Alliances

Building and managing an effective supply chain network often includes the creation of
alliances with providers of transportation services.

The carrier selection decision is a specialized purchasing process whereby a firm purchases the
services of a carrier to provide the necessary link among logistics facilities

vii. e- Commerce and Transportation

Nowadays, customers are demanding web- enabled shipment execution capabilities, on-line
payment capabilities, and real-time shipment status information.

viii. Supply Chain Visibility Technologies

For supply chains to be successful, time is definitely a factor that must be managed, and e-
commerce technologies are helping companies to achieve tremendous time related benefits by
providing supply chain visibility for customers, shippers, and transportation providers.

Activity 11

Take few minutes and defend your position on how transportation contributes to company
competitiveness, economic growth, quality of life and supply chain profitability.

5.5 TRANSPORTATION PERFORMANCE MEASURES

Logistics measurement system should hold the logistics manager accountable in four categories
of measures: finance, productivity, quality, and response time.

Transportation performance measures fall in to four categories as well as their use in

transportation performance benchmarking and project justification are explained in this section.

1. Financial Metrics

Transportation financial metrics should include total transportation costs and related ratios, as
well as economic values for fleet assets.

i. Total Transportation Costs and Cost Ratios- A detailed estimate of total transportation
cost incorporates the following expense and capital elements:

• Freight, inbound and outbound

• Fleet ownership costs,

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 • Driver/operator wages and benefits
• Terminal ownership costs
• Planner/manager wages and benefits
• Office space ownership costs
• Fleet leasing
• Maintenance facility ownership costs
• Terminal leasing
• Transportation management systems software ownership costs
• Office lease and utilities
• Transportation computing infrastructure ownership costs
• EDI/VAN and telecommunications
• Transportation infrastructure fees ownership costs (ports, bridges, and so on)
• Maintenance
• Third-party transportation fees
• Fuel
• Customs brokerage and freight forwarding fees
• Security, and
• Packaging materials
ii. Transportation Asset Economic Value Analysis- Private fleet operators often
underestimate the capital consumption and economic value generation potential of the
fleet. Many of manufacturing clients who also operate a private fleet overlook the
financial implications of fleet ownership because they are typically so focused on the
manufacturing assets and because their accounting models are not typically
configured to monitor the financial performance of transportation assets.

.To help monitor the capital consumption and value creation potential of logistics assets, a
logistics financial performance indicator is developed as logistics value added (LVA). LVA is
based on Stern-Stewart’s trademarked indicator, economic value added (EVA). The EVA of a
corporation is computed as the difference between after-tax profit and cost of capital
ownership: EVA = (1 - t )* (R - E) - CI * CCR, where;

T=Tax rate (percent/year)

R = Revenue ($/year)

E = Expense ($/year)

CI = Capital investment ($)

CCR = Capital carrying rate (percent/year)

The LVA of a logistics asset is computed as the difference between the asset’s profitability
(generated revenue less associated expenses) and cost of ownership for the asset. The

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computation highlights the financial viability of specific logistics assets and can be used in
determining when or if to replace, eliminate, lease, or acquire logistics assets.

2. Productivity Metrics

Transportation productivity metrics fall in two categories: transportation asset productivity and
transportation operator productivity.

i. Transportation Asset Productivity and Utilization:- The two main categories of

transportation assets are containers and vehicles. Containers include over-the-road
containers, ocean containers, air containers, and so on. The utilization of a container must
incorporate the weight and cube utilization since container capacity is restricted in both
dimensions. Container utilization (CU) is computed as:

• CU =Max {Cube utilization, Weight utilization}

• Cube utilization = Occupied cube/(Length * width * height)
• Weight utilization = Load weight/Container weight capacity

For a load weighing 35,000 pounds and occupying 2,720 cubic feet in a container with a
weight capacity of 44,000 pounds and a length, width, and height of 40 feet, 8.5 feet, and 9
feet, the CU is

• Cube utilization = 2,720 ft3/(40' * 8.5' *9') =2,720 ft3/ 3,060 ft3= 89%
• Weight utilization = 35,000 lbs./44,000 lbs. = 79.5%
• CU = Max {89%, 79.5%} =89%

Transportation vehicles (trucks, airplanes, locomotives, and ocean vessels) consume vehicle
operating hours (VOH), vehicle available hours (VAH), and capital investment. The desired
outputs for a vehicle include the number of deliveries, pounds delivered, cube delivered,
dollars delivered, miles travelled, and/or ton-miles delivered. Some helpful output to
consumption ratios are

• Vehicle utilization = Operating hours/Available hours

• Vehicle yield = Delivered value/Vehicle investment cost
• Deliveries per operating hour
• Ton-miles delivered per vehicle
• Ton-miles per operating hour
• Cube-pounds per mile
• Delivered cube per operating hour
• Delivered pounds per operating hour
ii. Transportation Operator Productivity:- The metrics for transportation operator productivity
do not differ that greatly from vehicle productivity because each vehicle is manned by an
operator. The most common bases for assessing transportation operator productivity are the
number of stops, miles traveled, dollars delivered, cases delivered, pounds delivered, or pallets
delivered per person-hour.

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 3. Quality Metrics

Transportation quality and reliability are just as important, if not more important, than cycle
time. A shipment delivered quickly to the wrong location or with damage is of no use to the
shipper or the shipper’s customer. A carrier with an average delivery time of 48 hours who
always delivers in 48 hours may be preferred over one with an average of 24 hours if the latter
delivers in less than 24 hours a majority of the time, but occasionally delivers in 96 hours. We
need just as comprehensive a set of indicators for the delivery quality of our private fleet or
carrier base as we do for speed or productivity. We like to recommend the following set of
transportation quality indicators to our clients as a starting point in transportation quality
management:

• Claims-free shipment percentage- The percentage of shipments without claims for

each driver or carrier on each lane at each location.
• Damage-free shipment percentage- The percentage of shipments without damage
for each driver or carrier on each lane at each location.
• Distance between accidents- The miles or kilometers between accidents for each
driver, carrier, and lane.
• On-time arrival percentage (OTAP)- The percentage of shipments that arrive on-
time for each driver, carrier, and lane
• On-time departure percentage (OTDP) - The percentage of loads that depart on-time
for each driver, carrier, and lane.
• Perfect delivery percentage (PDP)- Similar to the perfect order percentage concept
for logistics as a whole, the PDP assesses the percentage of shipments delivered
without defects, including damage, documentation, arrival time, arrival location,
loss, accidents, and claims of any kind for each delivery, driver, lane, and carrier.
• Perfect Route Percentage (PRP)- The percentage of routes or trips without an
imperfect delivery.
4. Cycle Time Metrics

Our society is fascinated with time management. The transportation industry is no different.

As evidenced by the proliferation of dot.coms offering to recover service failure guarantees,

time is literally money in the transportation industry. Quicker transit, loading, and unloading
times translate into greater asset utilization, which translates into greater leveraging of the
corporation’s capital.

Cycle time metrics are the most natural indicators of transportation performance.

Some of the most popular cycle time indicators for transportation include:

• In-transit time (ITT)- Point-to-point in-transit times by driver, carrier, lane, and
location.

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 • In-transit time variability- Point-to-point in-transit time variability by driver, carrier,
land, and location.
• Vehicle load/unload time -Vehicle loading and unloading times at each
pickup/delivery location by driver, carrier, lane, and location.
• Detention time -Time spent waiting for loading or unloading at a pickup/delivery
location due to dock congestion and/or delays caused by the shipper or consignee.
• Delayed in traffic time -The time spent idling or at reduced speed due to traffic
congestion for each driver, carrier, lane, and pickup/delivery location.

It is not uncommon in cycle time analyses to learn that a large percentage of the operating time
of any vehicle is spent waiting or in delays.

The worldwide transportation infrastructure and the interface points within it were not
designed to support the volume or activity or the pace of change currently experienced in the
transportation industry. Hence, an effective transportation cycle time analysis should examine
each component of the cycle time in an attempt to reveal bottlenecks and potential
opportunities for improvement.

5.6 FLEET, CONTAINER, AND YARD MANAGEMENT

If we decide to operate our own fleet, then our transportation management solution must
address fleet, container, and yard management. Fleet, container, and yard management
activities include the following:

• Sizing and configuring the fleet of vehicles and/or containers

• Acquiring or replacing individual vehicles and/or containers
• Maintaining vehicles and containers
• Identifying and tracking vehicles and containers
• Planning and managing docks, yards, and ports
1. Fleet Sizing, Configuration, and Financing

The objective in fleet sizing is to employ through ownership, lease, and/or rental the fewest
number of vehicles and containers possible to meet the hourly, daily, weekly, monthly, and
annual shipping requirements. The decision is much like the decision of how much inventory
to make available to customers. Increasing availability yields fewer lost sales, improved
customer service, and higher inventory carrying costs. In fleet sizing, increased availability
yields fewer lost sales, shorter customer cycle times, improved customer service, but higher
fleet costs.

This same analysis should be performed for each type of vehicle or container chosen as a part
of the fleet operations. These fleet sizing projections should be developed a few times during
the year and at any time when a major shift in demand patterns occurs. In some cases, the cost
of vehicle shortages can be estimated and a cost of shortage versus cost of ownership analysis

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can be made to determine the optimal fleet size. The overall fleet requirements can be
minimized by:

• Utilizing standard and modular-sized cases, pallets, and transport containers

• Aggressively monitoring fleet utilization levels over each segment of the
transportation network during each period of the year
• Maintaining total fleet visibility, including loading times, unloading times, transit
times, and maintenance times
• Choosing low-use periods to conduct routine maintenance
• Monitoring and charging for fleet detention by suppliers, customers, and/or carriers
• Utilizing alternative coverage means during super-peak periods to avoid carrying
the burden of an oversized fleet.
2. Fleet Acquisition and Replacement

Once the size of the fleet has been determined, the means of acquiring the fleet must be
determined. A variety of acquisition options are available, including direct, private ownership,
leasing, and dedicated contract carriage.

The analysis to determine one method or a mix of methods of ownership should be made like
any other major financial decision by considering the costs of ownership, the cost of capital,
the impact on customer service, internal and external philosophies/reactions to outsourcing,
and the competitive advantage or disadvantage of either method.

As with most other physical assets, the condition of the fleet deteriorates over time. Hence,
elements of the fleet must nearly continuously be considered for replacement. Over the life of
the asset, the condition of the asset continues to decline and the cost of maintenance continues
to increase.

At some point, projected maintenance costs exceed the annualized cost of replacing the asset.

3. Fleet Maintenance and Security

World-class fleet maintenance is one means of reducing the ownership cost of the fleet by
delaying potential replacements and improving customer service through improved reliability.

Security is one of the world’s fastest growing industries and continue to be threat of pirates for
international transportation service provision especially water transport across Indian Ocean.
Intensified global trade, broader and more frequent logistics partnering, increased information
sharing in the logistics chain, and more use of third and fourth parties in supply chain activities
make a seedbed for security violations. In addition to information security, fleet security
programs have never been more important as a part of overall corporate security.

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 4. Vehicle/Container Identification, Tracking, and Communications

The ability to automatically identify, truck, and communicate with stationary and in-transit
vehicles and containers is a critical enabler in support of real-time shipment tracking.
Fortunately, technology in this area is advancing faster than in any other area of transportation
management. The advances have been motivated to a great extent by a mammoth failure in
container/shipment tracking.

To combat this, the U.S. Department of Defense, for instance, began an aggressive campaign
called Total Asset Visibility. One of the great advances stemming from that campaign was the
use of bar coding, radio frequency communication, radio-frequency tags, and advanced global
positioning systems for use in commercial transportation management. As long as each
container has a bar code license plate, then bar code scanners can be used to automatically
identify each container with handheld or automatic scanners.

Radio frequency communications can be used in conjunction with bar code scanning and then
to relate any identified container with its contents, enclosed shipments, and location. Radio
frequency tags in conjunction with tag readers or antennae are a step beyond bar codes since
the tags are permanently implanted in the container, are far more durable than bar codes, can
be read from or written to, and can be read and identified automatically with stationary
antennae, which can read the tag or write to the tag as long as the tag is within a few hundred
meters of the tag.

The next advance in Radio frequency tag technology will most likely be the use of advanced
global positioning systems and related satellites to provide real-time global tracking of every
container equipped with the appropriate RF tag.

On-board vehicle communications have improved dramatically as well. The most recent
advance is a system called TruckMail, developed by QualComm, which equips every cab with
an on-board computer and perpetual, online e-mail via a special satellite link. The system is
used by the driver to report the status and exceptions in his/her route and is used by
headquarters to update route and delivery information online in real time.

5. Yard, Dock, and Port Management

Yard, dock, and port management is perhaps the most overlooked area in all of transportation
management. Container yards, docks, and ports are typically the nodes in the transportation
network with the least systems support, the least management sophistication, the least
container tracking capabilities, the most crime, and the most frequent source of delays and
cycle time variability. However, as the margin for error in all supply chain operations and
communications is reduced still further, the container yards, docks, and ports of the world will
have to be transformed into hubs of real-time communications, value-added services, and on-
time reliability.

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Some world-class yard/dock/port management practices include:

• secured driver-load verification

• on-site, automatic driver routing
• intelligent dock assignment
• advanced crew and dock/berth scheduling
• yard/dock/port staging location tracking and management
i. Secured Driver-Load Pickup Verification

As mentioned previously, transportation security is an integral and increasingly important link

in overall corporate security. One of the most common transportation security violation
scenarios is for a scab driver to pick up a load. Sapporo, a Japanese beverage company,
combats this scheme by requiring drivers to identify themselves, their assigned vehicle, their
assigned container, and their assigned loads with a smart card before the automated loading
system would release the load to them.

ii. On-Site, Automatic Driver Routing

Another frustrating source of wasted time and capital in the yard/dock/port is the time spent by
drivers on-site waiting for and looking for their assigned dock or berth. On-board
communications and electronic maps have helped to some extent, but a recent innovation has
nearly eliminated the frustrations and inefficiencies. The device is a voice-activated system that
identifies and verifies the driver by his/her voice print, tells the driver in synthesized voice the
assigned dock number, and enunciates the directions to the assigned dock

iii. Efficient Dock/Berth Assignment

Whether it is a load of pallets inbound to a warehouse from a supplier or a load of ocean
containers due into port at the completion of an overseas journey, one objective in assigning
the inbound vehicle to a dock/berth is to minimize the handling distance and time in unloading.
iv. Advanced Crew and Dock/Berth Scheduling
Supply chain operations and activities are reaching higher degrees of synchronization around
the world. Inbound and outbound operations are scheduled to tighter and tighter timelines.
Eventually, docks, berths, and their associated loading/unloading crews will be scheduled in
cargo operations with the same rigor and sophistication employed in passenger air
transportation. Unfortunately, yard/dock/port management systems are severely
underdeveloped in comparison with the requirements that are on the near horizon.
v. Yard/Dock/Port Staging Location Tracking and Management

A good simple rule of thumb for yard/dock/port staging location management is the old adage,
“a place for everything and everything in its place.” It is amazing to see container loads with
values sometimes in excess of $10,000,000 haphazardly staged in unmarked locations without
container identification. However, you can walk inside a nearby warehouse and see a pallet of
copy paper tagged with a bar code or RF tag, each case of which is perfectly labeled, and the
entire load assigned to a neatly kept and perpetually tracked location identified by one or more

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bar code labels. The same disciplined rigor and degree of automation used to locate products in
most warehouse operations needs to be extended outdoors where even larger quantities or
higher value are many times misplaced due to poor location marking and management

5.7 FREIGHT AND DOCUMENT MANAGEMENT

The last of the five transportation management activities is freight and document management.
Because over $500 billion is paid annually in freight bills in the United States alone, freight
management and the associated activity of transportation document management is one of the
most lucrative (if done properly) and expensive (if done poorly) aspects of transportation
management.

Here, we will cover world-class practices in negotiating, paying, and auditing freight and
transportation document management

1. Freight Rate Negotiations

Due to the rapid consolidation of the rail carriage industry, the Ocean Shipping Reform Act,
inter-modalism within and between trucking carriers, electronic shipment bidding, new
transportation modes like the FastShip and CargoLifter, and the mainstreaming of time-definite
deliveries, freight rate negotiations are not the three bids and a cloud of dust events they used
to be. Today’s negotiations require much more research and advance planning than at any time
in the past. The preparation is nearly the same as that required in advance of an entire redesign
of the transportation strategy.

These preparations emphasize one more time the criticality of online transportation activity
profiling and decisions support as a key capability in transportation management.

Shippers should come to the negotiating table ready with • Historical and projected shipping
volumes between each origin-destination pair:

• Required delivery times and on-time reliability performance

• Required value-added services
• Guidelines for claims and conflict resolution
• Historical carrier performance records, volumes, and rates
• Required information systems support capability
• Preferred payment terms and rate structures
• Knowledge of the carrier’s competitive position, market share, and underutilized
capacity
• Knowledge of the carrier’s current and future customer base
• Knowledge of recent or projected shifts in the carrier’s organization structure
• Carrier hot buttons

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 2. Freight Bill Payment

As mentioned previously, over $500 billion in freight bills are paid in the United States alone.
The cost of paying, processing, and auditing those bills was recently estimated to be in excess
of $40 billion! Done inefficiently, just the process of paying freight bills can become a major
cost center for any organization. Three basic alternative procedures for freight bill payment
exist: payment-on-invoice, positive pay, and outsourcing.

In pay-on-invoice, the shipper waits for an invoice from a carrier, verifies it, and pays it
directly.

This procedure is fraught with mistakes and overbilling by carriers.

The mistakes and overbilling have given birth to an entire industry known as freight bill
auditing, another potentially costly process for the organization to undertake.

Another method of paying freight bills is a procedure sometimes referred to as positive pay. In
the positive pay procedure, the shipper computes the freight bill associated with any shipment
and releases funds to the carrier without an invoice. This procedure eliminates the need for the
shipper to audit freight bills and the carrier’s invoicing, but requires an earlier release of the
shipper’s funds and requires the shipper to maintain freight rates in their system. The procedure
normally pays for itself quickly by the reduction in carrier overcharges in related paper
handling.

The third freight bill payment technique is outsourcing. In outsourcing freight bill payments, a
third-party bill payer is contracted on a per-transaction basis to provide a variety of services
related to freight bill payments, including simply paying the bills, maintaining rates, auditing
freight bills, analyzing freight bills, and helping the shipper to prepare for freight rate
negotiations.

3. Auditing Freight Bills

Auditing freight bills is necessary to recover mistakes and overcharges made by carriers in
their invoicing process. Third-party freight bill auditors typically receive a percentage of the
overcharges they identify as their fee.

Done internally, freight bill auditing can pay for itself through the savings in overcharge
recovery fees. However, auditing freight bills internally requires the shipper to maintain freight
rates internally.

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5.8 TRANSPORTATION MANAGEMENT SYSTEMS (TMSS)

The marketplace for TMSs is perhaps the most fragmented of all the marketplaces for logistics
software. Most transportation applications accomplish a single execution or planning task for a
single mode of transportation.

Based on the world-class transportation practices recommended focus of TMS requirements

areas are summarized here:

• Transportation data warehousing and data mining

• Transportation performance measurement
• Transportation network design and simulation
• Inbound/outbound consolidation planning
• Shipment and load planning
• Mode and carrier selection
• Optimal and dynamic routing and scheduling
• Online shipment bidding, rating, and tracing
• Carrier management and measurement
• Fleet/container tracking, management, and maintenance
• Dock/yard/port management
• Freight bill payment and audit

5.9 TRANSPORTATION ORGANIZATION DESIGN AND DEVELOPMENT

The transportation industry and the transportation activity within most major enterprises are
more stressed today than ever before in recent memory.

Any transportation professional working today feels the stress of the need to move more,
smaller loads more often with less margin for error in the face of a severe driver shortage and
increasing fuel costs. It seems convincing that a major source of the difficulty is the lack of
strategic planning and organization development within transportation companies, within the
transportation activities of most major corporations, and within the government authorities that
have regulated transportation activities over the years.

Though the oldest of what we now call logistics activities, somehow transportation is the least
developed organizationally. The planning disciplines and supporting systems that are
characteristic of the customer service organization, inventory management organization, supply
organization, and even the warehousing organization are not as developed in transportation and
distribution organizations. We recommend the following set of initiatives and programs be
implemented within the transportation activities of our major clients.

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5.10 CORE CARRIER PROGRAMS AND CARRIER RELATIONSHIP MANAGEMENT

Similar to supplier relationship management programs, carrier relationship management

programs are designed to formalize the communication, partnering, negotiating, and
performance monitoring aspects of carrier management. At the heart of most carrier
relationship management programs is a set of guidelines for selecting core carriers; the
minority of carriers who carry a majority of the enterprise’s weight, cube, and shipments

Activity 12

Comment on the relevance of core carrier concept.

5.11 Self-Assessment Questions

1. Compare and contrast the transport principles of economy of scale and economy of
distance. Illustrate how they combine to create efficient transportation.
2. Describe the six modes of transportation, identifying the most significant characteristic of
each.
3. Why is motor carrier freight transportation the most preferred method of product shipment?
4. How small shipments are consolidated and reached their final destination? Discuss with
examples.
5. Why is it important for a logistics manager to have a degree of understanding of
transportation regulatory history?
6. What is the role of transportation in supply chain integration of activities in the order
fulfillment cycle?
7. How do transport leasing companies differ from, private and exempt carriers?
8. Discuss the fundamental difference between TOFC and COFC. What is multimodal
transportation?
9. Explain the value proposition offered by freight forwarding. Provide an example that
illustrates why shippers would be attracted to using the services of a freight forwarder as
contrasted to arranging their own transportation.
10. Discuss with example how to manage documents during transportation of goods from
origin to destination.

5.12 Chapter Summary

Transportation is a key activity in logistics because it moves products through the various
stages of production and ultimately to the consumer. It is important that logistics managers
have appreciation and understanding of the history of regulation to fully appreciate the logic
underlying today's transportation system. The transportation system has six modes of
operation-rail, motor, water, pipeline, air, and electronic. Each mode has specific attributes that
render it the transportation choice appropriate for a specific movement. Traditional transport
supply consisted of a large number of specialized carriers, each limiting operations to one
specific mode.

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The original lack of coordinated transportation resulted in inefficiencies and high cost.
Deregulation introduced competitive pricing and carrier flexibility. It became common for
carriers to combine multimodal services and offer specialized services to individual customers.
As a result, a wide range of specialized transport service is now available to satisfy specific
customer requirements.
There are three legal forms of carriers; common, private and exempt. Transportation
management incorporates a wide range of functions like net work design, routing, scheduling,
transport document management, transportation performance measurement, yard/dock
management and the like.

Key Terms:
Transportation- relocating of goods from areas of origin to destination for place utility.
Carrier-a transportation company engaged in transport service rendering
Transport mode- means used to relocate the goods from one location to another
Freight- goods shipped on different transport modes to reach final destination
Freight rate- price charged for transportation service

Case for Analysis:

ABC Company entered in to a contractual agreement with the government to run five projects
located at different sites.

As the company is young in its establishment, it has to utilize its few transport equipment and
machineries shared among the five projects including transport service provided to its
employees. In the lack of proper person /manager responsible for this duty, sometimes top
level managers engage in allocating transport equipment and machineries to different project
sites and yet to be ineffective and inefficient. Some project sites lack, the necessary
machineries because of lack of transport equipment to mobilize the machineries and other sites
are congested with more resources because of allocation difficulties.

On the other hand, the top management is interested in optimizing the transportation service
management with the existing resources to all the projects, even if workers are complaining of
shortage of transportation equipment resources. Besides, the top management is convinced of
the problem that lies on its management of the existing resources and tried to solve it with
transport management with out adding new resources to the existing service.

Question:

What is your position to the manager’s argument and how do you solve this problem?

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 CHAPTER SIX

PRODUCTION/OPERATIONS ISSUES IN SUPPLY CHAIN MANAGEMENT

In this chapter you will learn the following concepts:-

6.1 Basic concepts of production in supply chain management

6.2 Demand forecasting
6.3 Aggregate production planning and management
6.4 Collaborative planning, forecasting and replenishment
6.5 Enterprise resource planning
6.6 Management Process
6.7 Supply Chain decision making areas
6.8 Benchmarking in Supply Chain
6.9 Self-Assessment Questions
6.10 Chapter Summary

Objectives

After reading this chapter, you will be able to:

perform demand forecasting

develop feasible aggregate production plan

describe the relevance of ERP system

distinguish between quick response, JIT & TQM

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6.1 PRODUCTION

Production refers to the capacity of a supply chain to make, store and deliver products. The
facilities of production are factories and warehouses. The fundamental problem that managers
face when making production decisions is how to resolve the trade-off between responsiveness
and efficiency. If factories and warehouses are built with a lot of excess capacity, they can be
very flexible and respond quickly to wide swings in product demand. Facilities where all or
almost all capacity is being used are not capable of responding easily to fluctuations in
demand. On the other hand, capacity costs money and excess capacity is idle capacity not in
use and not generating revenue. So, the more excess capacity that exists, the less efficient the
operation becomes. Factories can be built to accommodate one of two approaches to
manufacturing:

1. Product focus—A factory that takes a product focus performs the range of different
operations required to make a given product line from fabrication of different product parts to
assembling of these parts.

2. Functional focus— a functional approach concentrates on performing just a few operations

such as only making a select group of parts or only doing assembling. These functions can be
applied to making many different kinds of products. A product approach tends to result in
developing expertise about a given set of products at the expense of expertise about any
particular function. A functional approach results in expertise about particular functions instead
of expertise in a given product. Companies need to decide which approach or what mix of
these two approaches will give them the capability and expertise they need to best respond to
customer demands.

As with factories, warehouses too can be built to accommodate different approaches. There are
three main approaches to use in warehousing:

1. Stock keeping unit (SKU) storage— in this traditional approach, all of a given type of
product is stored together. This is an efficient and easy to understand the way to store products.

2. Job lot storage—in this approach, all the different products related to the needs of a certain
type of customer or related to the needs of a particular job are stored together. This allows for
an efficient picking and packing operation but usually requires more storage space than the
traditional SKU storage approach.

3. Cross-docking—an approach that was pioneered by Wal-Mart in its drive to increase

efficiencies in its supply chain. In this approach, product is not actually warehoused in the
facility. Instead, the facility is used to house a process where trucks from suppliers arrive and
unload large quantities of different products. These large lots are then broken down into

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smaller lots. Smaller lots of different products are recombined according to the needs of the
day and quickly loaded onto outbound trucks that deliver the products to their final destination.

The business environment of the 1990s has been characterized as increasingly dynamic in
terms of increasing technological complexity, demanding markets, explosion of knowledge,
and increasing global competition (Mentzer, 2002:184).

The evolution and growth of production in intra-firm was from craft production at the
beginning of the 20th century evolved in to mass production in the early 20th century and then
lean production in 1950s to 1960s.

Inter-firm production was started with Just-in-time (JIT) philosophy first developed at Toyota
which is a process based to require items at the right qualities, and in the exact quantities
precisely as they are needed which in turn requires early involvement and close relationship
with suppliers.

The structuring of global competition has encouraged the development of supply chain
management. The new types of supply chain production that rely on a supply chain orientation
and effective supply chain management are dispersed production and build to order production
(Mentzer, 2002:1977).

Dispersed production or manufacturing is the concept of manufacturing in the location that is

most appropriate for that specific task, while build to order production or demand driven
manufacturing is a relatively new concept that very few companies have been able to achieve
because a well coordinated supply chain is required. By integrating within a single system such
functions as transportation, production, and planning a supply chain becomes truly demand
driven , and build to stock is been replaced by build to order.

6.2 DEMAND FORECASTING

6.2.1 Definition

Forecasting provides an estimate of future demand and the basis for planning and sound
business decisions. In order for supply chain integration to be successful, suppliers must be
able to accurately forecast demand so they can produce and deliver the right quantities
demanded by their customers in a timely and cost- effective fashion.

Supply chain management decisions are based on forecasts that define which products will be
required, what amount of these products will be called for, and when they will be needed. The
demand forecast becomes the basis for companies to plan their internal operations and to
cooperate among each other to meet market demand.
The forecast is a specific definition of what will be sold, when, and where. The forecast defines
the requirements that the supply chain must schedule the inventory and resources to fulfill.
Since there are still many logistics and supply chain activities that must be completed in
anticipation of a sale, forecasting remains as a critical capability for planning.

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All forecasts deal with four major variables that combine to determine what market conditions
will be like. Those variables are:

1. Demand,
2. Supply,
3. Product Characteristics, and
4. Competitive Environment

Each of these variables is discussed in the sections below.

Demand refers to the overall market demand for a group of related products or services. Is the
market growing or declining? If so, what is the yearly or quarterly rate of growth or decline?
Or maybe the market is relatively mature and demand is steady at a level that has been
predictable for some period of years. Also, many products have a seasonal demand pattern. For
example, snow skis and heating oil are more in demand in the winter and tennis rackets and
sun screen are more in demand in the summer. Perhaps the market is a developing market—the
products or services are new and there is not much historical data on demand or the demand
varies widely because new customers are just being introduced to the products. Markets where
there is little historical data and lots of variability are the most difficult when it comes to
demand forecasting.

Supply is determined by the number of producers of a product and by the lead times that are
associated with a product. The more producers there are of a product and the shorter the lead
times, the more predictable this variable is. When there are only a few suppliers or when lead
times are longer, there is more potential uncertainty in a market. Like variability in demand,
uncertainty in supply makes forecasting more difficult. Also, longer lead times associated with
a product require a longer time horizon over which forecasts must be done. Supply chain
forecasts must cover a time period that encompasses the combined lead times of all the
components that go into the creation of a final product.

Product characteristics include the features of a product that influence customer demand for the
product. Is the product new and developing quickly like many electronic products or is the
product mature and changing slowly or not at all, as is the case with many commodity
products? Forecasts for mature products can cover longer timeframes than forecasts for
products that are developing quickly. It is also important to know whether a product will steal
demand away from another product. Can it be substituted for another product? Or will the use
of a product drive the complementary use of a related product? Products that either compete
with or complement each other should be forecasted together.

Competitive environment refers to the actions of a company and its competitors. What is the
market share of a company? Regardless of whether the total size of a market is growing or
shrinking, what is the trend in an individual company’s market share? Is it growing or
declining?

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What is the market share trend of competitors? Market share trends can be influenced by
product promotions and price wars, so forecasts should take into account such events that are
planned for the upcoming period. Forecasts should also account for anticipated promotions and
price wars that will be initiated by competitors.
6.2.2 Forecast Components
The forecast is generally a monthly or weekly figure for each Stock Keeping Unit (SKU) and
distribution location. While the forecasted quantity is generally a single figure, the value is
actually made up of six components: (1) base demand, (2) seasonal, (3) trend, (4) cyclic, (5)
promotion, and (6) irregular. Assuming the base demand as the average sales level, the other
components, except for irregular, are indices or factors that are multiplied by the base level to
make a positive or negative adjustment.
The resulting forecast model is:
Ft = (Bt x St x T x Ct x Pt) +I
Where,
Ft = Forecast quantity for period t;
Bt = Base level demand for period t;
St = Seasonality factor for period t;
T = Trend component-index reflecting increase or decrease per time
period;
Ct = Cyclical factor for period t;
Pt = Promotional factor for period t; and
I = Irregular or random quantity
The base demand is the quantity that remains after the remaining components have been
removed. A good estimate of base demand is the average over an extended time. The base
demand is the appropriate forecast for items that have no seasonality, trend, cyclic, or
promotional components.
The seasonal component is a generally recurring upward and downward movement in the
demand pattern, usually on an annual basis. An example is the annual demand for toys, which
peaks just prior to Christmas and then declines during the first three quarters of the year.
The trend component is defined as the long-range general movement in periodic sales over an
extended period of time. This trend may be positive, negative, or neutral in direction. A
positive trend means that sales are increasing across time. For example, the trend for personal
computer sales during the decade of the 1990s was increasing.
Over the product life cycle, the trend direction may change a number of times.
Unlike the other forecast components, the trend component influences base demand in the
succeeding time periods.
The specific relationship is: Bt + 1= Bt x T
Where,
Bt+ 1 = Base demand in period t + 1;
Bt = Base demand in period t; and
T = Periodic trend index

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The trend index with a value greater than 1.0 indicates that periodic demand is increasing while
a value less than 1.0 indicates a declining trend.
The cyclic component is characterized by swings in the demand pattern lasting more than a
year. These cycles may be either upward or downward. An example is the business cycle in
which the economy typically swings from recessionary to expansionary cycles every 3 to 5
years. The demand for housing, as well as the resulting demands for major appliances, is
typically tied to this business cycle.
The promotional component characterizes demand swings initiated by the firm's marketing
activities, such as advertising, deals, or promotions.
The irregular component includes the random or unpredictable quantities that do not fit within
the other categories. Due to its random nature, this component is impossible to predict. When
developing a forecast process, the objective is to minimize the magnitude of the random
component by tracking and predicting the other components.
Activity 13
Is demand forecasting really important? Comment on it from supply chain management view
point.

6.2.3 Forecast Technique Categories

There are four basic methods to use when doing forecasts. Most forecasts are done using
various combinations of these four methods. Chopra and Meindl define these methods as:

1. Qualitative
2. Causal
3. Time Series
4. Simulation
The qualitative techniques use data such as expert opinion and special information to forecast
the future. A qualitative technique may or may not consider the past.
Time series techniques focus entirely on historical patterns and pattern changes to generate
forecasts.
Causal techniques, such as regression, use refined and specific information regarding variables
to develop a relationship between a lead event and forecasted activity.
Simulation Techniques refer to a combination of causal and time series techniques.
1. Qualitative- Qualitative techniques rely heavily on expertise and are quite costly and
time consuming. They are ideal for situations where little historical data and much
managerial judgment are required. Using input from the sales force as the basis of
the forecast for a new region or a new product is an example of a supply chain
application of a qualitative forecast technique. However, qualitative methods are
generally not appropriate for supply chain forecasting because of the time required to
generate the detailed SKU forecasts necessary. Qualitative forecasts are developed
using surveys, panels, and consensus meetings.

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Qualitative methods rely upon a person’s intuition or subjective opinions about a market.
These methods are most appropriate when there is little historical data to work with. When a
new line of products is introduced, people can make forecasts based on comparisons with other
products or situations that they consider similar. People can forecast using production adoption
curves that they feel reflect what will happen in the market.

ii. Time Series- Time series techniques are statistical methods utilized when historical
sales data containing relatively clear and stable relationships and trends are
available.
Using historical sales data, time series analysis is used to identify seasonality, cyclical patterns,
and trends. Once individual forecast components are identified, time series techniques assume
the future will reflect the past. This implies that past demand patterns will continue into the
future. This assumption is often reasonably correct in the short term, so these techniques are
most appropriate for short-range forecasting.
When the rate of growth or trend changes significantly, the demand pattern experiences a
turning point. Since time series techniques use historical demand patterns and weighted
averages of data points, they are typically not sensitive to turning points.
As a result, other approaches must be integrated with time series techniques to determine when
turning points will likely occur.

Time series methods are the most common forms of forecasting.

They are based on the assumption that historical patterns of demand are good indicators of
future demand. These methods are best when there is a reliable body of historical data and the
markets being forecasted are stable and have demand patterns that do not vary much from one
year to the next. Mathematical techniques such as moving averages and exponential smoothing
are used to create forecasts based on time series data. These techniques are employed by most
forecasting software packages.
Time series techniques include a variety of methods that analyze the pattern and movement of
historical data to establish recurring characteristics. Based upon specific characteristics,
techniques of varying sophistication can be used to develop time series forecasts. Let’s see two
time series techniques in order of increasing complexity: (1) moving averages, (2) exponential
smoothing.
Moving average forecasting uses an average of the most recent period's sales.
The average may use any number of previous time periods although 1,3,4, and 12 period
averages are common. A l-period moving average results in next period's forecast being
projected by last period's sales. A 12-period moving average, such as monthly, uses the
average of the last 12 periods. Each time a new period of actual data becomes available, it
replaces the oldest time period's data; thus, the number of time periods included in the average
is held constant.
Although moving averages are easy to calculate, there are several limitations.

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Most significantly, they are unresponsive or sluggish to change and a great amount of historical
data must be maintained and updated to calculate forecasts. If the historical sales variations are
large, average or mean value cannot be relied upon to render useful forecasts.
Mathematically, moving average is expressed as:

Moving Average, Ft =∑St-i

n
Where,
Ft = Moving average forecast for time period t;
St-i = Sales for time period i; and
n = Total number of time periods.
For example, an April moving forecast based on sales of 120, 150, and 90 for the previous
3 months is calculated as follows:
Forecast for April =120+150+90=120
3
To partially overcome these deficiencies, weighted moving averages have been introduced as
refinements. The weight places more emphasis on recent observations.
Exponential smoothing is a form of weighted moving average. Exponential smoothing bases
the estimate of future sales on the weighted average of the previous demand and forecast
levels. The new forecast is a function of the old forecast incremented by some fraction of the
differential between the old forecast and actual sales realized. The increment of adjustment is
called the alpha factor. The basic format of the model is:

Ft=αDt-1+ (1-α) Ft-1

Where,
Ft = Forecasted sales for a time period t;
Ft-1 = Forecast for time period t - 1;
Dt-1 = Actual demand for time period t - 1; and
α = Alpha factor or smoothing constant (0 <α<1.0).
To illustrate, assume that the forecasts for the most recent time period were 100 and actual
sales experience was 110 units. Further, assume that the alpha factor being employed is 0.2.
Then, by substitution,

Ft=αDt-1+ (1-α) Ft-1

0.2(110) + (1-0.2)100=102
iii. Causal Forecasting by regression estimates sales for a SKU based on values of other
independent factors. If a good relationship can be identified, such as between
expected price and consumption, the information can be used to effectively predict
requirements.
Causal methods of forecasting assume that demand is strongly related to particular
environmental or market factors. For instance, demand for commercial loans is often closely
correlated to interest rates. So if interest rate cuts are expected in the next period of time, then

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loan forecasts can be derived using a causal relationship with interest rates. Another strong
causal relationship exists between price and demand. If prices are lowered, demand can be
expected to increase and if prices are raised, demand can be expected to fall
Causal or regression forecasting works well when a leading variable such as price can be
identified. However, such situations are not particularly common for supply chain applications.
If the SKU forecast is based upon a single factor, it is referred to as simple regression analysis.
The use of more than one forecast factor is multiple regression. Regression forecasts use the
correlation between a leading or predictable event and the dependent demand SKU'S sales. No
cause-effect relationship need exists between the product's sale and the independent event if a
high degree of correlation is consistently present. A correlation assumes that the forecasted
sales are preceded by some leading independent factor such as the sale of a related product.
However, the most reliable use of regression forecasting of sales is based on a cause-effect
relationship. Since regression can effectively consider external factors and events, causal
techniques are more appropriate for long-term or aggregate forecasting.
For example, causal techniques are commonly used to generate annual or national sales
forecasts.
iv. Simulation methods use combinations of causal and time series methods to imitate the
behavior of consumers under different circumstances. This method can be used to
answer questions such as what will happen to revenue if prices on a line of products
are lowered or what will happen to market share if a competitor introduces a
competing product or opens a store nearby.

Forecast Error
Forecast accuracy refers to the difference between forecasts and corresponding actual sales.
Forecast accuracy improvement requires error measurement and analysis.
There are three steps for reducing forecast error. First, appropriate measures must be defined.
Second, measurement level must be identified. Finally, feedback loops must be defined to
improve forecast efforts.

Error Measurement
Forecast error can be measured on either an absolute or a relative basis by using a number of
methods. While forecast error can be defined generally as the difference between actual
demand and forecast, a more precise definition is needed for calculation and comparison.

6.3 COLLABORATIVE PLANNING, FORECASTING AND REPLENISHMENT (CPFR)

The American Production and Inventory Control Society (APICS) defines collaborative
planning, forecasting and replenishment (CPFR) as a collaboration process whereby supply
chain trading partners can jointly plan key supply chain activities from production and delivery
of raw materials to production and delivery of final products to end customers. Collaboration
encompasses business planning, sales forecasting, and all operations required to replenish raw
materials and finished goods.

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The real value of CPFR comes from an exchange of forecasting information rather than from
more sophisticated forecasting algorithms to improve forecasting accuracy .CPFR is an
approach that addresses the requirements for good demand management. The benefits of CPFR
include the following: Strengthens partner relationships, provides analysis of sales and order
forecasts upstream and downstream, uses point – of – sale data, seasonal activity, promotes
new product introductions, and stores openings or closings to improve forecast accuracy,
manages the demand chain by exception and proactively eliminates problems before they
appear, allows collaboration on future requirements and plans, and integrates planning,
forecasting and logistics activities.

6.4 AGGREGATE PLANNING AND INVENTORY MANAGEMENT

6.4.1 Definitions

Operations scheduling and inventory management are two of the most critical activities of an
organization; they directly influence how effectively the organization deploys its assets and
capacity in producing goods and services.

i. Operations Planning

Operations’ planning is usually hierarchical and can be divided in to three broad categories:

1) Long-range, (2) Intermediate or medium range, and (3) short-range planning horizons.
The aggregate production plan sets the aggregate output rate, workforce size, utilization
and inventory, and/or backlog levels for an entire facility. The materials requirement
planning (MRP) is a short- range materials plan.

The MRP, also known as little MRP or MRP – I, is the detailed planning process for
components and parts to support the master production schedule.

Material Requirements Planning (MRP) - A software tool which enables a manufacturer to

plan, allocate and track material and financial resources for a production process.

Manufacturing Resource Planning (MRP-II) is an outgrowth and extension of the closed – loop
MRP system. It incorporates the business and sales plans with the closed loop MRP system and
has simulation capabilities to answer “what if” types of planning questions.

Distribution Requirement planning /DRP/ - describes the time- phased net requirements from
warehouses and distribution centers.

Aggregate production planning- is the process of choosing an optimal blend of production

rates, work force levels, and inventory levels. It is the development of monthly or quarterly
production requirements for product groups or families that will meet the estimates of demand.
• Provides the quantity and timing of production for intermediate future (usually 3 to
18 months into future)

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 • Combines (‘aggregates’) production – Often expressed in common units
Example: Hours, dollars, equivalents
• Involves capacity and demand variables
Aggregate Planning Goals include:
٧

• minimizing cost related to labor, inventory and plant & equipment;

• meeting demand
• using capacity efficiently
• meeting inventory policy
Master Production Schedule
• Provides weekly product requirements over 6 to 12 month time horizon
• Shows items to be produced
– End item, customer order, module
Strategies for Meeting Fluctuating Demand
Capacity Options — change capacity:
– changing inventory levels
– varying work force size by hiring or layoffs
– varying production capacity through overtime or under time
– subcontracting
– using part-time workers
Demand Options — change demand:
– influencing demand
– back ordering during high demand periods
– counter seasonal product mixing

6.4.2 Policy Considerations in Aggregate Planning

 Flexibility

• Are work force and inventories maintained at a level sufficient to meet

unexpected demand?

 Work force stability

• Improves quality, productivity, union relations

 Production rate stability

• Makes materials planning easier, reduces uncertainty in physical distribution

 Production capacity

• Will overtime reduce quality? When will physical capacity (space, machinery,
equipment) become inadequate?

 Customer service

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 • Have lead time and stock availability goals been met?

6.5 THE DEVELOPMENT OF ENTERPRISE RESOURCE PLANNING (ERP)

6.5.1 Meaning of ERP

While traditional or legacy MRP systems continue to be used and modified to include other
functional areas of an organization, the emergence and growth of supply chain management, e-
commerce, and global operation have created the need to exchange information directly with
suppliers, customers, and foreign branches of organizations.

The concept of the manufacturing information system thus evolved to directly connect all
functional areas and operations of an organization and, in some cases, its suppliers and
customers via common software infrastructure and database; this type of manufacturing
information system is now commonly referred to as Enterprise Resource Planning.

Enterprise Resource Planning (ERP) is a term used to refer to a system that links individual
applications (for example, accounting and manufacturing applications) into a single application
that integrates the data and business processes of the entire business.

A typical focal firm’s supply chain management integrator (ERP) is illustrated on the
following figure.

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Figure 6.1 ERP System for a typical firm

6.5.2 Origins of ERP Systems

ERP systems grew out of a function called materials requirements planning

(MRP) which was used to allocate resources for a manufacturing operation

MRP systems software ultimately became very complex allowing for
efficiencies of scale not previously possible

Even more sophisticated MRP II systems began to replace MRP systems in
the 1980s

By the early 1990s, other enterprise activities were being incorporated into
ERP systems

Today, an ERP system can encompass, but is not limited to, the following
functions:
o sales and order entry
o raw materials, inventory, purchasing, production scheduling, and
shipping
o accounting
o human resources

Resource and production planning

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 6.5.3 Major ERP Systems

SAP R/3

Oracle

PeopleSoft (have been merged by Oracle)

Toyota uses PeopleSoft and SAP

Microsoft Dynamics (formerly Microsoft Business Solutions - Great Plains)

6.6 Process Management: Just- In-Time and Total Quality Management Issues
in Supply Chain Management

6.6.1 Just-In-Time (JIT)

In the 1990s, Supply Chain management emerged as a paradigm that combined several
initiatives that were already in use, including quick response (QR), efficient consumer response
(ECR), Just-in-time (JIT), and Japanese Keiretsu relationships (Wisner et al., 2005:208)

The first two are concerned with speed and flexibility, while keiretsu involves partnership
arrangements.

JIT emphasizes reduction of waste, continuous improvement, and the synchronization of

material flows from within the organization and eventually including the organization’s
immediate suppliers and customers.

JIT is an overall operating philosophy of waste reduction and value enhancement that can
include a number of activities or elements.
6.6.2 Total Quality Management (TQM) and Supply Chain Management

Like JIT, TQM is an enterprise wide philosophy, encompassing suppliers and customers,
((Wisner et al., 2005:218)). It emphasizes a commitment by the organization to strive toward
excellence in the production of services and products that customers want.

The Elements of Total Quality Management

The philosophy and tools of TQM are borrowed from a number of resources including the
philosophies of a number of quality professionals such as W. Edwards Deming, Philp Crosby,
and Joseph Juran; the Malcolm Baldrige National Quality Award, the International
Organization for standardization ISO 9000 quality standards, and statistical process control
techniques developed by Walter Shewart, (Wisner et al., and 2005:219)

Total Quality Management (TQM) was advocated by Quality management Guru, Edward
Deming known as “Deming’s fourteen points for Quality Management”. Others identified in
promoting quality management in organizations from source to end, the supply chain, Crosby’s
Four Absolutes of Quality, Juran’s Quality Trilogy were among others.

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 6.7 SUPPLY CHAIN DECISION CLASSIFICATION

1. The strategic level decisions - Include the designing of logistics network by considering
production facilities, stocking points, and supply nodes and deciding on their capacity and
technology. The production related decisions include what products and variants to
produce, which plants to produce them in, allocation of suppliers to plants, plants to
distribution centers, and distribution centers to customer zones.
2. Tactical Decisions

The tactical level decisions prescribe the material flow policy throughout the network designed
at strategy level. These decisions involve production, inventory and transportation decisions,
e.g. setting of production level at all plants.

3. Operational Decisions

Operational decisions focus on detailed production scheduling. These decisions include the
construction of the master production schedules, scheduling production on machines,
equipment maintenance, and determination of the optimal levels of order quantities and reorder
points

6.8. BENCHMARKING IN SUPPLY CHAIN OPERATIONS

One method of shaping an organization is to benchmark from a strategic and tactical
perspective.
Types of benchmarking:
• Internal benchmarking is a way of identifying best practice within a group and
share it perhaps resulting in cross-functional and/or cross-site teams.
• Competitive benchmarking is literally comparisons with competitors; data
collection and reliability may be a problem and there is a need to ensure similarity
(e.g., size).
• Functional or generic benchmarking compares specific functions (e.g., logistics);
the comparison is with the best in class or best in the industry. It is easier to
obtain information and often there are “clubs” that share data openly.
The benchmarking process:
• There needs to be planning. The subject needs to be identified, data collection
methods agreed upon, and agreement to the plan by those involved. The need to
be realistic about the scope of the process is paramount.
• The data needs analysis — is the competition better? And by how much?
Why are they better? What can be learned? How can the learning be applied?
• The data gathered should be used to define the goals to establish or maintain
superiority; these should then be incorporated into the overall planning process.
• The plan should be an action plan identifying clearly who will do what and
establish completion dates; similarly, a monitoring process should be embodied in
the plan to measure progress and ensure benchmarking becomes integral.
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The goal of benchmarking is to keep or regain a company’s competitive edge.
Benchmarking is a business management tool for defining feasible change goals. It is a process
of continuously comparing and measuring an organization against business leaders anywhere
in the world to gain information that will help the organization to take action to improve
performance.
The ability to gain superiority is dependent upon a detailed understanding of the company’s
own operations and those of others, and the ability to incorporate these to develop performance
improvements. Even if you know that one system is better than another, a detailed analysis of
the other system is necessary to understand and to explain the difference in performances.
The theoretical basis of benchmarking is the notion that consumers do not buy goods or
services but rather buy the attributes of those goods or services; hence, success in the
marketplace rests on creating products whose attributes match what the market wants and
needs. An operational system for evaluating the ‘appropriateness’ of a product’s attributes – its
ability to satisfy consumer needs – is constructed and illustrated with reference to several types
of industrial sensors. The method encourages managers to ask continually: ‘what business am I
in’. Or ask the question:
 How do I create value for my customers?
That question, in turn, leads to several others:
 Who are my customers?
 What particular aspects or characteristics of my product are especially important in
creating value?
 How can I best enhance those value-creating properties?
Knowledge of the market value that is attached to each of the most important attributes of a
technology-based product is important information for managers.
Many businesses are built on products that have a single outstanding characteristic that none of
the competing products can match, while satisfying minimal standards in other characteristics.
There are several types of benchmarking:
1. Internal benchmarking: a comparison of internal operations.
2. Competitive benchmarking: specific competitor – to – competitor comparison for the
product of interest.
3. Functional benchmarking: comparisons of similar functions within the same broad
industry or industry leaders.
4. Generic benchmarking: comparison of business functions or processes regardless of
industry.

One of the proposed benchmarking procedures includes the following steps:

1. Systematize benchmarking goals.
2. Identify relevant objects to be benchmarked.
3. Assess the applicability of the current benchmarking procedure.
4. Find typical illustrative examples for benchmarking.
5. Identify potential problems and further research opportunities.

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Some examples include:
Business process benchmarking – The goal is principally concerned with the company’s effort
to achieve long-term competitive and customer advantages.
One way that benchmarking is very useful, is in the identification of non value-added activities
within the enterprise.
Benchmarking in application systems management – Both standard and applications software
are benchmarked with the following objectives:
• To compare different software packages of a certain type in order to select the one most
capable of meeting particular requirements.
• To compare different releases of one product in order to control quality enhancement.
Benchmarking in infrastructure management – The main purpose of software process
benchmarking for a company is to learn about its own technological opportunities by learning
about other similar operations.
Hardware benchmarking – Hardware systems benchmarking is conducted with two goals in
mind:
• To compare different systems on different platforms running the same application.
• To compare different machines.
Organizational benchmarking – The goals of such benchmarking studies focus on the
following.
 To find the best way of using information in the organization so as to optimize
information system benefits.
 To establish the best workable solution to combine information from different sources.
 To establish the best programme for promoting cooperation and communication within
the organization.

6.9 Self-Assessment Questions:

1. Briefly describe the concept of production /operation management?

2. “Operation management is a value adding process”. Elucidate.
3. “Operation management is a buffered function from its external environment” explain.
4. What are the competitive dimensions of operations strategy?
5. What is core competency?
6. What is aggregate production planning?
7. Discuss difference among MRPI,MRPII and ERP
8. Discuss the concept of continuous improvement
9. How do the concepts of JIT and TQM work in the Supply Chain Management context?
Discuss.
10. Discuss operations decision making areas.

6.10 Chapter Summary

Production refers to the capacity of a supply chain to make and store products. The Make
category includes the operations required to develop and build the products and services that a

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supply chain provides. Operations that are in this category are: product design; production
management; and facility management. The Deliver category of operations encompasses the
activities that are part of receiving customer orders and delivering products to customers. The
two main operations are order entry/order fulfillment and product delivery. These two
operations constitute the core connections between companies in a supply chain.
The relentless pressure on profit margins that free markets create is a driving force behind the
growth of outsourcing.

Forecasting provides an estimate of future demand and the basis for planning and sound
business decisions.

There are four basic methods to use when doing forecasts: qualitative, time series, causal, and
simulation.

JIT is an overall operating philosophy of waste reduction and value enhancement that can
include a number of activities or elements

TQM-emphasizes a commitment by the organization to strive toward excellence in the

production of services and products that customers want .

Key Terms

Operation/Production- value adding activity for transforming raw materials in to finished

goods which has utility

JIT- A management philosophy for elimination of waste related to inventory by closely

working with supplier as partner

TQM- A management philosophy to improve quality of products from source to end.

Demand forecasting- estimation of company’s future demand is using different methods from
which production is initiated.

Case for Analysis:

Green Company has six plants engaged in production of building and construction materials in
the construction industry. As the company has to manage its intra-supply chain (functional
integration), it faced the following problems.

One of its plant, 40 kilometers away from the main operating area because of its age faced
frequent machine breakdown.

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The Asphalt plant which is erected at the cost of $one million functions only for a few periods
in days and remains idle for the whole year.

The third plant located 24 kilometers from the main office experienced quality problem when
its products rejected frequently by users and regulatory bodies for construction purpose.

The other plant which is meant for lumber production installed five years ago, is not
commenced its production.

The machineries of the company are too old so that either they have to be replaced or
frequently repaired for being old and purchased from old company. The company’s inventory
is not well organized and its management is so poor that it is vulnerable to embezzlement and
theft.

On the other hand, the company is implementing the supply chain management approach to its
production by implementing activities like third party logistics (3pl), outsourcing, and sub-
contracting of certain activities, but faced a number of coordination and relationship problems
within the company and with its partners.

However, in order to adopt a supply chain management approach by the company from source
to end, it presupposes strong functional integration (intra-supply chain integration) which the
company lacks.

Question:

Suppose the organization approached you to implement supply chain management, how do you
implement in this company?

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 CHAPTER SEVEN

CUSTOMER RELATIONSHIP MANAGEMENT

In this chapter you will learn the following concepts:

7.1 Customer Response Fundamentals and Notations

7.2 Customers activity profiling
7.3 Customer Response Performance measurement
7.4 Customer Relationship Management
7.5 CRM Success Factors
7.6 Role of CRM in Supply chain management
7.7 Self-Assessment Questions
7.8 Chapter Summary

Objective

After reading this chapter, you will be able to:

demonstrate the significance of maintaining sustainable customer relationship

explain how CRM benefits the supply chain

conduct Customer Response performance measurement

identify CRM success factors in their context

Consider the following study made on customer behavior (Fortune, One World Distribution):

• Seventy-five percent of the reasons customers leave a company has nothing to do with
the product.
• Of dissatisfied customers, 98 percent will never complain—they will just leave.
• Eighty-five percent of dissatisfied customers tell nine people; 13 percent tell 20 people.
A satisfied customer tells five people.
• It implies, in the next 6 years, 80 percent of your customers will leave, 65 percent due
to something you did.
• A 5 percent retention rate will increase profits from 25 to 55 percent.

Customer demand is the fountainhead for all logistics activities. Fulfilling customer orders
creates the need for all logistics resources and activities.

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7.1 CUSTOMER RESPONSE FUNDAMENTALS AND NOTATIONS

Before developing the customer response master plan, each organization must make a clear
distinction between the customers and consumers of its products and services. The consumer is
the last party in the logistics chain. The consumer is the party who uses the product for the
purpose it was ultimately designed for. The customer is the party who buys the product. The
customer may or may not be the last party in the logistics chain. Depending on where you are
in the supply chain, you may have no idea who is consuming your product, but you should
always have a good relationship with the customer of the product. There are five activities in
customer response (CR):

• Customer service policy design

• Customer satisfaction monitoring
• Order entry
• Order processing
• Invoicing and collections

The customer response master plan must address short, middle, and long-term designs for CR
measures and goals, processes, systems requirements, and organization requirements.

7.2 CUSTOMER ACTIVITY PROFILING

In the customer activity profile (CAP), we are trying to rank and categorize customers and
SKUs in preparation for creating a customer service policy and to profile order sizes in
anticipation of developing a logistics operations strategy. The three main customer activity
profiles are the:

• Customer Sales Activity Profile (CSAP)

• Item Sales Activity Profile (ISAP)
• Customer-Item Sales Activity Profile (CISAP)
1. Customer Sales Activity Profile (CSAP)

The customer sales activity profile ranks the customers by sales and unit volume and classifies
them into A, B, and C categories. The A category is typically comprised of the top 5 percent of
customers and normally accounts for approximately 80 percent of the sales activity; the B
category, the next 15 percent of customers normally accounting for approximately 15 percent
of sales; and the C category, the remaining 80 percent of customers accounting for the last 5
percent of sales. These three categories often make up natural dividing points in the creation of
a segmented customer service policy. If possible, a customer profitability profile based on the
cost to serve each customer may be used to weed out certain customers from the customer
service profile.

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2. Item Sales Activity Profile (ISAP)

The item sales activity profile ranks and classifies items based on dollars and unit sales. The A
category is typically comprised of the top 5 percent of items and normally accounts for
approximately 80 percent of sales activity; the B category, the next 15 percent of items
normally accounting for approximately 15 percent of sales; and the C category, the remaining
80 percent of items accounting for the last 5 percent of sales. These three categories often make
up natural dividing points in the creation of a segmented customer service policy.

If possible, an item profitability profile can be used to weed out some items from the customer
service profile.

3. Customer-Item Sales Activity Profile (CISAP)

One of the most useful customer activity profiles is the customer-item sales activity profile.
The customer-item sales activity profile is a joint distribution revealing the amount of dollars
or unit sales accomplished in nine or more segments of business. The profile reveals the
amount of sales accomplished on A items going to A customers, B items going to B customers.
. . C items going to C customers. It highlights the dramatic differences in the logistics activities
in different channels of the same enterprise.

For example, there are typically very few customers, very few items, high volumes, high
revenues, and intense competition in the AA segment. There are typically very many
customers, very many items, low volumes, low revenues, and little-to-no competition in the CC
category. The logistics strategy should reflect these stark contrasts.

A useful variation of the CISAP is the customer-item SKU activity profile. This profile
indicates the number of SKUs or items that are purchased in different business segments. It is
often useful in weeding out items from the service profile.

7.3 CUSTOMER RESPONSE PERFORMANCE MEASURES

Customer response performance measures must incorporate financial, productivity, response

time, and quality indicators.

1. Customer Response Financial Performance Indicators

The primary financial indicator for customer response performance is the total response cost
(TRC), including the expense and capital charges for the customer response workforce,
computer hardware and software, office space for customer response managers and operators,
and telecommunications.

In advanced logistics organizations, the customer response financial indicators extend to

include the cost and profitability by customer, lane, region, and SKU.

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 2. Customer Response Productivity Performance Indicators

The primary productivity indicator for customer service and order processing is the number of
customer orders processed per person-hour. Through customer service automation, methods
including Internet ordering, EDI, automated contact management, call-center automation,
and/or touchtone ordering the productivity and quality of customer service and order
processing can be drastically improved.

3. Customer Response Quality Performance Indicators

The principal indicators of quality in customer response are order entry accuracy (OEA), order
status communication accuracy, invoice accuracy, first time-fill-rate (FTFR), and the overall
customer satisfaction (customer satisfaction index).

Order entry accuracy (OEA) = Orders entered exactly as specified by the customer

Total orders entered

Order status communication accuracy = Orders for which order status is communicated correctly

Total orders with status communication requests

Invoice accuracy = Invoices with perfect match of items, quantities, prices, and totals

Total invoices

First-time-fill-rate = Total units shipped

Total units requested

4. Customer Response Cycle Time Indicators

The principal response time indicators for customer response are the order entry time (OET)
and the order processing time (OPT). The OET is the elapsed time from order initiation until
the order is entered and captured by our business system. It includes any wait times that may
be encountered by the customer over the phone or Internet and/or any system delays
encountered by customer service representatives. The order processing time is the elapsed time
from order entry until release to the warehouse for order picking.

Activity 14

How do you rate the companies you are familiar with in terms of customer response?

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7.4 CUSTOMER RELATIONSHIP MANAGEMENT (CRM)

Customer relationship management (CRM) can be the single strongest weapon you have as a
manager to ensure that customers become and remain loyal.

Customer Relationship Management is a comprehensive approach for creating, maintaining

and expanding customer relationships

Let’s take a closer look at what this definition implies.

First, consider the word “comprehensive.” CRM does not belong just to sales and marketing. It
is not the sole responsibility of the customer service group. Nor is it the brainchild of the
information technology team. While any one of these areas may be the internal champion for
CRM in your organization, in point of fact, CRM must be a way of doing business that touches
all areas. When CRM is delegated to one area of an organization, such as IT, customer
relationships will suffer. Likewise, when an area is left out of CRM planning, the organization
puts at risk the very customer relationships it seeks to maintain.

The second key word in our definition is “approach.” An approach, according to Webster, is “a
way of treating or dealing with something.” CRM is a way of thinking about and dealing with
customer relationships. We might also use the word strategy here because, done well, CRM
involves a clear plan. In fact, we believe that your CRM strategy can actually serve as a
benchmark for every other strategy in your organization. Any organizational strategy that
doesn’t serve to create, maintain or expand relationships with your target customers doesn’t
serve the organization. Strategy sets the direction for your organization. And any strategy that
gets in the way of customer relationships is going to send the organization in a wrong direction.

You can also consider this from a department or area level. Just as the larger organization has
strategies—plans—for shareholder management, logistics, marketing, and the like, your
department or area has its own set of strategies for employee.

Consider the situation all too familiar to call center environments, where pressure to keep calls
short goes head to head with taking the time necessary to create a positive customer
experience. Now, let’s look at the words, “creating, maintaining and expanding.”

CRM is about the entire customer cycle. Marketing efforts, armed with this customer
intelligence, are more successful at both finding brand new customers and cultivating a deeper
share of wallet from current customers. Customer contacts, informed by detailed information
about customer preferences, are more satisfying.

Customers are categorized in to two:

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 1. External customers –Those outside the organization who buy the goods and services the
organization sells.
2. Internal customers- A way of defining another group inside the organization whose
work depends on the work of your group. Therefore, they are your “customers.” It’s
your responsibility to deliver what they need so they can do their jobs properly.

7.5 CRM SUCCESS FACTORS

Here, we will focus on five of the most important ones. Organizations that implement CRM
with a strong return on investment share these characteristics:

1. Strong internal partnerships around the CRM strategy- We said earlier that CRM is a
way of doing business that touches all areas of your organization. This means that you
and your management peers need to form strong internal partnerships around CRM. If
you and your organization are early on the road to CRM implementation, now is the
time to bring your CRM needs to the table, and to be open to listening to the CRM
needs of other areas. You may find that you have requirements that are, at least
potentially, in conflict. Resist the temptation to go to war for what you need.

If your organization has gone off the partnership road with CRM, then now is the time to come
back together and rebuild partnership with the area that is currently championing CRM.

Let them know that you appreciate what they have done. Let them know what data you have to
offer and help them understand how you plan to use the data you request from them.

2. Employees at all levels and all areas accurately collect information for the CRM
system- Employees are most likely to comply appropriately with your CRM system
when they understand what information is to be captured and why it is important. They
are also more likely to trust and use CRM data when they know how and why it was
collected.
3. CRM tools are customer- and employee-friendly

CRM tools should be integrated into your systems as seamlessly as possible, making them a
natural part of the customer service interaction. A major manufacturer of specialty pet foods
redesigned the pop-up screens for its toll-free consumer phone line. In the original design, the
final pop-up screen prompted the representative to ask the caller’s name and address. Yet,
representatives had found that it was easier and felt more natural to ask, “What’s your name?”
and “Where are you calling from?” and “What’s your pet’s name?” at the start of the call.

4. Report out only the data you use, and use the data you report

Just because your CRM tool can run a report doesn’t mean it should. Refer back to your CRM
strategy, and then run the data you will actually use. And share that data with your team.

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 5. Don’t go high-tech when low-tech will do

Organizations that successfully implement CRM look for the simplest solution when
implementing their CRM strategy. A low-tech solution that works for the people who actually
use it is more effective than a high tech solution that is cumbersome, costly and apt to be
discarded or inconsistently implemented.

Customer relationship management is necessary once a supplying company first establishes a

relationship with a customer. Finding a new customer costs five times as much as keeping an
old customer, is the motivation behind customer relationship management.

In the long term, value continues to be demonstrated to customers through reliable, On-time
delivery, high quality products and services, competitive pricing, innovative new products and
services, attention to customer needs, and the flexibility to respond to those needs adequately.

Today, customer relationship management, or CRM, has come to be associated with automated
transaction and communication application- a suite of software modules or a portion of a larger
enterprise resource planning systems.

CRM is defined as: “Interactions across an organization’s traditional and electronic interfaces--
to keep track of customers, learning about each one’s likes and dislikes from various sources
like transaction records, call center logs, web site clicks, and search engine queries.”, as quoted
in (Wisner et al., 2005:312).

“Customer Relationship Management is a comprehensive approach for creating, maintaining

and expanding customer relationships (Kristin and Carol, 2002:3).”

Organizations that implement CRM with a strong return on investment share these
characteristics ((Kristin and Carol, 2002): Strong internal partnerships around the CRM
strategy, employees at all levels and all areas accurately collect information for the CRM,
CRM tools are customer- and employee-friendly, report out only the data you use, and use the
data you report, don’t go high-tech when low-tech will do.

7.6 CRM ROLE IN SUPPLY CHAIN MANAGEMENT

In today’s global economy with the relaxed foreign trade regime, the customer has suddenly
become powerful. Besides, they are more demanding and desire maximum value from
products.

Building and maintaining strong relationships with goods suppliers enhances value along the
supply chain & creates profits for supply chain participants.

In an integrated supply chain setting, the need to be a good supplier to adequately meet the
needs of supply chain customer- partners is paramount to the success of supply chains.

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As products make their way along the supply chain to the end user, close, trusting, and high
performance relationship must be created among all of the supplier- customer pairs along the
way.

Customer service is often cited as a key objective of supply chain management; however, only
if service offerings create value for customers will they lead to behaviors that improve supply
chain performance.

SCM is the securing, coordinating and maintaining of formal links with all parties that perform
a vital function. In order to do this, one needs first to develop a SCM process map describing
the activities of all members involved in the supply chain and the relationships among them in
successfully achieving the SCM goals and objectives. Information and communication
technologies changed the way firms conduct transactions, particularly in understanding and
restricting relationships. These relationships include business-to-business (B2B), business-to-
consumer (B2C), Consumer-to-business (C2B), and consumer-to-consumer (C2C).
Relationship creation and maintenance helps to breed future success. Communicating benefits
of relationships, clarifying customer needs and expectations, assisting in problem solving and
conflict resolution improving performance measures with suppliers, and creating competitive
advantage help to maintain effective relationships. How effectively a firm develops its supply
chain depends on how it understands these relationships and builds partnerships with all
relevant supply chain members.

Many practitioners of SCM have recognized that effectively managing the flow of materials
across the supply chain as one of the important strategic success factor. This is because the
costs involved of providing end customers and supply chain member organizations with the
materials requires, in the right quantities, in the desired form, with the appropriate
documentation, at the desired location, at the right time, and at the lowest possible cost are very
high. Technology will help in managing inventory flow and supply within a given supply
channel and is key in evaluating and in reducing resource consuming process.
7.7 Self-Assessment Questions
1. Explain the differences between transactional and relationship marketing. How do
these differences lead to increasing emphasis on logistical performance in supply chain
management?
2. Briefly state the concept of CRM? How it differs from the concept of customer service
and customer handling?
3. What is meant by availability in logistics customer service? Provide examples of the
different ways to monitor a firm's performance in availability.
4. Compare and contrast speed, consistency, and flexibility as operational performance
activities.
5. Why is perfect order service so difficult to achieve?
6. What is quality from customers point of view?
7. What is the difference between customer satisfaction and customer value creation in the
supply chain management? Discuss.

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 8. Compare and contrast the customer service, customer satisfaction, and customer
success philosophies of supply chain management.
9. What is meant by value-added services? Why are these services considered essential in
a customer success program?
10. What is the difference between make to order and make to stock strategy to customer
service? Describe.

7.8 Chapter Summary

The fundamental rationale for logistics is the need to accommodate customers, whether those
customers are end users, intermediate, or even internal. The marketing concept provides the
foundation for customer accommodation with its fundamental focus on customer needs rather
than on products or services, the requirement to view and position products and services in a
customer context, identification of market segments which differ in needs, and commitment
that volume is secondary to profit.

In a supply chain context, customer requirements related to spatial convenience, lot size,
waiting time, and variety and assortment must be accommodated by logistical operations.
Organizations build their platform for accommodation on three levels of increasing
commitment. The first of these is basic logistics customer service. To be competitive, a firm
needs a basic service capability that balances availability, operational performance, and
reliability for all customers. The level of commitment to each dimension of service requires
careful consideration of competitive performance and cost benefit analysis. The highest level
of commitment is perfect order performance, which requires zero defects in logistics
operations. Such high-level commitment is generally reserved for a firm's key customers.
Going beyond basic service to create customer satisfaction represents the second level of
customer accommodation. Where basic service focuses on the organization's internal
operational performance, customer satisfaction focuses on customers, their expectations, and
their perceptions of supplier performance. Customer expectations extend beyond typical
logistical operational considerations and include factors related to communication, credibility
access, responsiveness, and customer-specific knowledge as well as reliability and
responsiveness of operations.
Failure to satisfy customers can arise from lack of knowledge about customer expectations,
improper standards of performance, performance failure, poor communication, or incorrect
customer perception of performance.

Key Terms:
Customer Relationship Management- is a comprehensive approach for creating, maintaining
and expanding customer relationships.
Customer response performance measures- Performance measurement approach that
incorporates financial, productivity, response time, and quality indicators.

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Case: Groceries delivered to your door step
Several grocers are attempting to offer greater convenience to customers by offering electronic
order placement and home delivery. This simple concept is quite complex to implement
effectively. The most important factor influencing consumer-direct channel adoption and
customer loyalty is the ability to consistently pick and deliver perfect orders. However, it is
complex and expensive to structure a low-cost logistics system to provide these desired service
levels. Consumer-direct logistics focuses on fulfilling demand at the household level through
consistent delivery of perfect orders as it ensures a continuous supply of product at the lowest
possible cost. A dedicated fulfillment center is preferred for greater picking accuracy, order
customization, fill rates, and operational flexibility, but produces significantly higher operating
margins than a traditional grocery store model.

Product fulfillment is the highest direct cost of processing an order, due to the goal of a
consistent perfect order. This process typically includes household-level customization in high
impact perishable and prepared meat categories that mandate different temperature controls
and date-management practices. For example, some consumers prefer green bananas to yellow
bananas or rare roast beef sliced thin to the standard sliced product. Given an average 60-item
order and a 99 percent picking accuracy at the individual item level, only 55 percent of all
orders would be perfectly filled. The operator's challenge is to incorporate household-level
specification in a high-volume, scalable operating environment where customers are ordering
electronically. Delivery capabilities involve the physical logistics of moving products directly
to the customer's home. Most providers unitize products from across three temperature zones
into a secure container and load it into a multi-temperature vehicle to maintain proper
temperatures across the home-delivery chill chain.

Unique characteristics of the grocery business (e.g., number of items per order, customer
preferences within a given SKU, temperature maintenance requirements for different products)
emphasize the difficulty of designing a logistics system to deliver perfect orders to each
customer every time.

Question:
How do you evaluate the grocer’s CRM approach?
Source: Frank F. Bntt, 'The Logistics of Consumer-Direct," Progressive Grocer, May 1998, p.
39.

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 CHAPTER EIGHT

SUPPLY CHAIN INTEGRATION, LOGISTICS AND SUPPLY CHAIN INFORMATION

SYSTEMS

In this chapter you will learn the following concepts:

8.1 Introduction
8.2 Different levels of Supply chain integration
8.3 Logistics and supply chain information systems
8.4 Contemporary logistics information technologies
8.5 Self-Assessment Questions
8.6 Chapter Summary

Objectives
After studying this chapter, you will be able to:

explain supply chain integration mechanisms

demonstrate the role of logistics information systems in supply chain integration

comment on supply chain integration model

8.1 INTRODUCTION

The development of integrated SCM increased the importance of logistical activities to move
materials in a timely and cost effective manner across the supply chain.

Supply Chain Management Evolution can be grouped in to four stages:

Stage 1 Internally Focused:

• Functional silos

• Top-down management

• Internal measures used to monitor performance

• Reactive, short-term planning

• No internal integration

Stage 2 Functional Integration

• Realization of efficiencies gained by internal integration

• Focus on internal flow of goods

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 • Emphasis on cost reduction

Stage 3 Internal Integration

• Measurement of supplier performance and customer service performance

• Realization of integration of goods flow throughout firm

• Focus on logistics and JIT activities to manage flow of goods and information

Stage 4 External Integration

• Extending integration effort to suppliers and customers

• Realization of need to control goods and information to second and third-tier suppliers,
customers

• Emphasis on alliance development and communication capabilities

Vertical integration has given way to “virtual integration.” Companies now focus on their core
competencies, and partner with other companies to create supply chains for fast-moving
markets.

8.2 INTER-FUNCTIONAL INTEGRATION IN SUPPLY CHAIN MANAGEMENT

As a firm begins to divide labor and seek specialization among organizational members, it is
necessary to make certain that every one continues to work toward the common goals of the
organization. Thus, coordination and control of actions among firm members become
imperative,(Hodge et al., 1996; Mintzberg, 1996), as stated in Mentzer (2002:375).

There are three existing dimensions of integration (Mentzer, 2002:377), these are: cooperative
arrangements (mutual adjustment), management controls (direct supervision), and
standardization (standardization of work processes, outputs, skills, and norms).A good example
of functional integration is logistics integration(Ellram&Cooper,1990),as stated in
(Mentzer,2002:294) noting the sub-optimization that occurs if each individual logistics
function attempts to optimize its own results rather than integrate its goals and activities with
other functions to optimize the results of the firm.

The integration of key business processes is essential to effective supply chain management.
Integrative types of e-procurement yields the following benefits to firms: operational agility,
lower costs, superior product/service design, and enhanced profitability.

8.3 INTER-CORPORATE INTEGRATION IN SUPPLY CHAIN MANAGEMENT

“Cooperation is defined as a set of joint actions of firms in close relationship to accomplish

common set of goals that bring mutual benefits” (Mentzer, 2002:396)

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To maintain strategic relationship gain other supply chain trading partners, the cooperation is
identified by the following characteristics; these are: One of a few partners for each major
item, reward sharing, joint improvement driven by mutual interdependence, existence of
conflict resolution mechanisms, open and complete exchange of information, working together
of firms to adapt to changing market place, active involvement of the firms in supply chain
activities.

8.3.1 Antecedents and Consequences of Cooperation

As cooperation is a set of joint actions of firms in a close relationship to accomplish a common

set of goals that bring mutual benefits, there are antecedents of cooperative behavior required
from the firms to fulfill in the supply chain. These are: trust and commitment, cooperative
norms, interdependence, compatibility, manager’s perception of environmental uncertainty,
and extendedness of a relationship. As a number of research findings indicated that cooperative
relationships bring both buyer and supplier improved product quality and productivity, reduced
lead time, quick market entry, and cost reductions, all of which lead to competitive advantage.
Consequences of inter-firm cooperation are benefits that can be sought are categorized as
follows: risk reduction, access to resources, and competitive advantage.

8.4 THE SUPPLY CHAIN INTEGRATION MODEL

The supply chain integration model, starts with the identification of key trading partners, the
development of supply chain strategies; aligning strategies with key process objectives;
developing process performance measures, internally integrating these key processes,
developing supply chain performance measure for each process, externally integrating key
processes with supply chain trading partners, extending process integration to second tier
supply chain participants; and then, finally, reevaluating the integration model Supply chain
integration model is stated by Wisner et al., (2005: 411) as follows:

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Figure 8.1 Supply Chain integration Model

The Supply Chain Integration Model

Identify critical supply Review/establish corporate, marketing, Align supply chain

chain trading partners. manufacturing, sourcing , and logistics strategies and key process
supply chain strategies. objectives.

Develop supply chain

performance measures for each Assess and improve internal Develop internal performance
of the key processes. integration of key supply chain measures for each of the key
processes. processes.

Assess and improve external Extend process integrations to

process integration and supply second-tier supply chain partners Reevaluate annually or
chain performance. and beyond. as required.

8.5 LOGISTICS AND SUPPLY CHAIN INFORMATION SYSTEMS

Information is the basis upon which to make decisions regarding the other four supply chain
drivers. It is the connection between all of the activities and operations in a supply chain. To
the extent that this connection is a strong one, (i.e., the data is accurate, timely, and complete),
the companies in a supply chain will each be able to make good decisions for their own
operations. This will also tend to maximize the profitability of the supply chain as a whole.
That is the way that stock markets or other free markets work and supply chains has many of
the same dynamics as markets. Information is used for two purposes in any supply chain:

1. Coordinating daily activities related to the functioning of the other four supply chain drivers:
production; inventory; location; and transportation. The companies in a supply chain use
available data on product supply and demand to decide on weekly production schedules,
inventory levels, transportation routes, and stocking locations.

2. Forecasting and planning to anticipate and meet future demands. Available information is
used to make tactical forecasts to guide the setting of monthly and quarterly production
schedules and timetables. Information is also used for strategic forecasts to guide decisions
about whether to build new facilities, enter a new market, or exit an existing market.

Within an individual company the trade-off between responsiveness and efficiency involves
weighing the benefits that good information can provide against the cost of acquiring that

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information. Abundant, accurate information can enable very efficient operating decisions and
better forecasts but the cost of building and installing systems to deliver this information can be
very high.

Within the supply chain as a whole, the responsiveness versus efficiency trade-off that
companies make is one of the deciding factor how much information to share with the other
companies and how much information to keep private. The more information about product
supply, customer demand, market forecasts, and production schedules that companies share
with each other, the more responsive everyone can be. Balancing this openness, however, is the
concern that each company has about revealing information that could be used against it by a
competitor. The potential costs associated with increased competition can hurt the profitability
of a company.

A few years ago, we were inclined to argue that not every business needs to take e-commerce
to sell its product. Today, we are hard-pressed to find examples of thriving businesses that
don’t drive on the information superhighway in one way or another (Kristin and Carol,
2002:100)

A key aspect of supply chain management (SCM) is the ability to make strategic decisions
quickly, based on accurate data, and this requires an efficient and effective information system.
Information is vital for supply chain to function. Information sharing is vital when integrating
the supply chain.

One of the major benefits of integrating functional activities through information technology is
reducing associated costs. Integrating helps minimize inventory that builds up at critical
business interfaces while improving transport and warehouse asset utilization and eliminating
duplication of efforts (Gustin, Daugherty, &Stank) as cited in (Mentzer,2002:294).

8.5.1 Logistics Information Systems

(LISs) are the means by which we capture, analyze, and communicate information related to
logistics and supply chain management (Frazelle, 2002:278).

According to Mentzer (2002), information systems are classified in two three: these are,
intrafirm information systems which encompass-decision support systems (DSS), Warehouse
management systems (WMS), Transport management systems (TMS), Intranet and Enterprise
resource planning systems (ERP). On the other hand, inter-firm information systems are-
Electronic data interchange (EDI), and the internet. While Supply chain information systems
use extranet which utilizes internet to communicate and accessed only to members in the
supply chain, some of the Supply chain information systems applications are: accurate point of
sale information (POS), Quick response (QR), efficient consumer response (ECR), vendor-
managed inventory (VMI), and Automatic replenishment (AR).

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Many firms today view effective management of logistics and supply chain activities both as of
prerequisite to overall cost efficiency and as a key to ensuring their ability to competitively
price their products and services.

Logistics is the planning and execution of customer response, inventory management, supply,
transportation, and warehousing.

To execute logistics, we need a customer response system (CRS), an inventory management

system (IMS), a supply management system (SMS), a transportation management system
(TMS), and a warehouse management system (WMS). We call these modules working in
unison the execution layer of a LIS or the logistics execution system (LES). In some circles,
the TMS and WMS modules are referred to as logistics or supply chain execution systems
(SCES).

To plan customer response, we need a customer response planning system (CRPS), an

inventory planning system (IPS), a supply planning system (SPS), a transportation planning
system (TPS); and a warehouse planning system (WPS). These planning systems we call
jointly a logistics planning system (LPS). An even higher level planning system that may or
may not make use of information from the LPS is a supply chain or advanced planning system
(APS)

8.5.2. Quality of Information

Three issues characterize information quality. First, the availability of the information required
to make the possible decisions. Second, the accuracy of the information. Third, the
effectiveness of the various means that are available to communicate needed information.

8.5.3 Supply Chain Management (SCM) Systems

• With the advent of the Internet, e-businesses began to demand different things from
their SCM systems

• Most importantly, SCM systems vendors (largely the same vendors that provide ERP
systems software) had to modify their products to include a Web-based interface

• The ultimate goal of a business ERP system is complete optimization of internal

business processes

The two basic types of SCM system software are:

• Supply Chain Planning software (SCP): uses mathematical models to predict inventory
levels based on the efficient flow of resources into the supply chain

• Supply Chain Execution software (SCE): is used to automate different steps in the
supply chain such as automatically sending purchase orders to vendors when
inventories reach specified levels

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 • Oracle Supply Chain Planning

• Oracle Supply Chain Planning is part of the Oracle E-Business Suite's family of Supply
Chain Management solutions

It includes

– Demand Planning

– Collaborative Planning

– Inventory Optimization

– Manufacturing Scheduling, and

– Global Order Promising

8.5.4 Data Mining/Web Mining/Business Intelligence

• Data mining is the process of using mathematical techniques to look for hidden patterns
in groups of data, thereby discovering previously unknown relationships among the
many pieces of information stored in a database

• A data warehouse is a database that contains huge amounts of data, such as customer
and sales data

8.6 CONTEMPORARY LOGISTICS INFORMATION TECHNOLOGIES

Aside from the internet –based technologies, there are a number of information technologies
that are in common use throughout the logistics and supply chain areas, these are:

 Bar coding – represents the most commonly used automatic identification technology.

 Electronic Data Interchanges (EDI) - is the organization–to – organization, computer- to-

computer exchange of business data in a structured, machine processable format. Its purpose
is to eliminate duplicate data entry and to improve the speed and accuracy of information by
linking computer applications between companies.

 XML (Extensible Markup Language) – is a method of packing information for movement

on the internet. This is a highly efficient way to package information, such that it can be
readily accessible to any person or company having internet or web-based capabilities.

 Data management- The use of hand held devices for data management is popular today, as
is the use of devices for optical scanning.

 Imaging – Another technology that significantly impacts logistics is image processing,

which allows a company, to scan, or take electronic photographs of essential documents,

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 Artificial Intelligence / expert systems – The use of artificial intelligence (AI) and expert
system is becoming increasing prevalent in logistics today.

 Artificial Intelligence (AI) – the portion of computer science that is concerned with making
machines do things that would require intelligence if done by humans, and also as the
“development of computers that perform functions that people perform”

 An expert system is a computer program that “mimcs a human expert”.

 RF Technology – allows user to relay information via electromagnetic energy waves from a
terminal to a base station, which is linked in turn to a host computer.

 RFID in Supply Chain Management

• Innovate ways to identify, locate and monitor goods as they travel through the supply
chain of many industries

Primary Benefits:

• increase accuracy of orders

• reduce inventory handling cost
• improve inventory handling
• fewer misplaced items (in warehouse)
• reduce losses from theft

RFID – Basic Idea- code (unique identifier) is stored in a RFID Tag

• Tag is attached to a product

• Product becomes now unique identifiable

 Use labeling

• Product transmits code from the embedded tag (active tag)

• Reader gets the message (code)

• code needs to be processed

• corresponding action(s) to be taken here

 Computers on board and satellite tracking – In essence, the principles of RF technology

sometimes translate in to “on board” communications and computer capabilities.

8.7 INFORMATION TECHNOLOGY AND THE SUPPLY CHAIN

The link between information technology(IT) which is the supply chain management enabler
and the supply chain management is widely discussed in Chopra and Meindl’s work(2007:571-
590) as shown briefly below.

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8.7.1 Role of Information in a Supply Chain

 Information is the driver that serves as the “glue” to create a coordinated supply chain

 Information must have the following characteristics to be useful:

o accurate

o accessible in a timely manner

o information must be of the right kind

 Information provides the basis for supply chain management decisions

o Inventory

o Transportation

o Facility

8.7.1.1 Characteristics of Useful Supply Chain Information

 Accurate

 Accessible in a timely manner

 The right kind

 Provides supply chain visibility

8.7.1.2 Use of Information in a Supply Chain

Information used at all phases of decision making: strategic, planning, operational

Examples:
o Strategic: location decisions
o Operational: what products will be produced during today’s production run

Inventory: demand patterns, carrying costs, stock out costs, ordering costs

Transportation: costs, customer locations, shipment sizes

Facility: location, capacity, schedules of a facility; need information about trade-offs

between flexibility and efficiency, demand, exchange rates, taxes, etc.

8.7.2 Role of Information Technology in a Supply Chain

 Information technology (IT)

o Hardware and software used throughout the supply chain to gather and analyze
information

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 o Captures and delivers information needed to make good decisions

 Effective use of IT in the supply chain can have a significant impact on supply chain
performance

8.7.3 The Importance of Information in a Supply Chain

Relevant information available throughout the supply chain allows managers to make
decisions that take into account all stages of the supply chain

Allows performance to be optimized for the entire supply chain, not just for one stage –
leads to higher performance for each individual firm in the supply chain

8.7.4 The Supply Chain IT Framework

 The Supply Chain Macro Processes incorporates the following as a frame work:

o Customer Relationship Management (CRM)

o Internal Supply Chain Management (ISCM)

o Supplier Relationship Management (SRM)

o Plus: Transaction Management Foundation

i. Customer Relationship Management

o The processes that take place between an enterprise and its customers
downstream in the supply chain
Key processes:
o Marketing
o Selling
o Order management
o Call/Service center
ii. Internal Supply Chain Management (ISCM)
 Includes all processes involved in planning for and fulfilling a customer order
 ISCM processes:
 Strategic Planning
 Demand Planning
 Supply Planning
 Fulfillment
 Field Service
 There must be strong integration between the ISCM and CRM macro processes.
iii. Supplier Relationship Management
 Those processes focused on the interaction between the enterprise and suppliers that are
upstream in the supply chain
 Key processes:

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 o Design Collaboration
o Source
o Negotiate
o Buy
o Supply Collaboration
 There is a natural fit between ISCM and SRM processes
iv. The Transaction Management Foundation
 Enterprise software systems (ERP)
 Earlier systems focused on automation of simple transactions and the
creation of an integrated method of storing and viewing data across the
enterprise
 Real value of the TMF exists only if decision making is improved
 The extent to which the TMF enables integration across the three macro
processes determines its value

8.7.5 The Future of IT in the Supply Chain

At the highest level, the three SCM macro processes will continue to drive the
evolution of enterprise software

Software focused on the macro processes will become a larger share of the total
enterprise software market and the firms producing this software will become more
successful

Functionality, the ability to integrate across macro processes, and the strength of their
ecosystems, will be keys to success

Select an IT system that addresses the company’s key success factors

Take incremental steps and measure value

Align the level of sophistication with the need for sophistication

Use IT systems to support decision making, not to make decisions

8.8 Self-Assessment Questions

1. Compare and contrast the role of ERP systems and planning systems in enhancing firm
performance and competitiveness.
2. Compare and contrast the role of ERP systems and logistics execution systems.
3. Compare and contrast the role of supply chain ERP systems and advanced planning and
scheduling systems (APS) in enhancing firm and supply chain competitiveness.
4. How can smaller firms remain competitive in the exchange of logistics information?
5. Discuss and compare the role that EDI and the Internet will play in facilitating
communication between supply chain partners.
6. Compare and contrast the role of EDI and the Internet for logistics and supply chain
information exchange.
7. Describe RFID for logistics and supply chain applications.

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 8. Discuss the relative benefits of software purchase, use of third-party providers, and use
of application service providers (ASPs).
9. Compare and contrast the level of firm’s internal and external supply chain integration
10. Discuss the most widely software used by world class firms in their supply chain
integration

8.9 Chapter Summary

Supply chain information systems link logistics activities in an integrated process based on
four levels of functionality. The transaction system provides the foundation by electronically
taking the order, initiating order selection and shipment, and completing appropriate financial
transactions. Management control systems record functional and firm operating performance
and provide appropriate management reporting.
Decision analysis systems assist management in the identification and evaluation of logistics
alternatives. Strategic planning systems provide top management with insight regarding the
impact of strategic changes such as mergers, acquisitions, and competitive actions. While the
transaction system provides the foundation, management control, decision analysis, and
strategic planning systems are becoming critical for high performance supply chain
management.
ERP or legacy systems are the backbone of most SClS because of their integrated database
capabilities and modular transactions. The communication systems facilitate information
exchange internally within the firm's functions as well as externally across global sites and
with other supply chain partners. The execution systems are becoming more critical for
controlling warehouse and transportation operations. Supply chain planning systems will likely
become the critical competitive differentiator for the future as firms strive to improve their
asset productivity through reduced inventory and physical assets.
There are three alternative approaches for obtaining supply chain hardware, software, and
support. While direct ownership remains common, outsourcing and the use of ASPS are
becoming increasingly popular. Outsourcing turns over the entire information technology
responsibility to an outside service provider, while an ASP uses the internet to access key
software applications, particularly for communications and planning.
Remarkable advances have been made to facilitate logistical communication both within a
given firm and among its supply chain partners. EDI, satellite, and more recently XML
continue to enable quicker and more consistent communication between supply chain partners.
Other technologies, such as bar coding, scanning, and radio frequency, are substantially
enhancing the communication effectiveness between logistics information systems and the
physical environment in which they must operate.
The increasing accessibility and capabilities of these information and communication systems
substantially increase the availability and accuracy of supply chain information.
Communication technology advances have dramatically reduced the uncertainty between large
firms, but substantial opportunities remain for improved communications between smaller
firms which make up the majority of supply chain participants. While further communication
system improvement will continue to reduce uncertainty, it is likely that major opportunities

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for future performance enhancers will be through supply chain analysis and strategic planning
systems.

Key Terms:
Supply Chain Integration- Level of cooperation and information sharing among trading
partners in the supply chain management
Logistics Information Systems (LISs) -are the means by which we capture, analyze, and
communicate information related to logistics and supply chain management
Supply chain information systems use extranet which utilizes internet to communicate and
accessed only to members in the supply chain
Information Technology-computers and other telecommunication infrastructures that enable
the integration of supply chain partners through information sharing.

Case: “Power Shedding Crushes Beer Supply”

As indicated in one of the reputed local English newspaper in Ethiopia, “Fortune, Volume 10.
No. 479, July 5, 2009, about how frequent power interruption caused manufacturing firms to
operate below capacity and to the extent of ceasing production and non-existence of their
product in the market.

Survey on Brewery Manufacturing Industry ( The five brewery firms ;namely, BGI Ethiopia
plc, Bedele, Meta Abo, Dashen and Harar brewery share companies ) was made on how power
interruption caused production interruption and affected the forward integration of the supply
chain members , first tier customers of the brewery firms, and discussed as follows;

No diesel generator seems to be able to rescue the major beer and draught producers in
Ethiopia from a blitz of the intensive power shedding that is crippling beer factories which
have recently announced a rapid decline in production.

Nationally dominant BGI Ethiopia PLC and companies with regional strongholds including
Harar, Bedele, Meta and Dashen breweries are not operating at their fullest capacities. The
magnitude of the impact differs from one factory to another but the power blackouts have been
the consistent underlying factor. The production shortfall at the breweries is now affecting
consumers in towns across Ethiopia as their favorable brands have become scare.

For example, at Play Hotel, small eatery at a place called Bermuda in Hawassa town (273 km
away south of Addis Ababa), beer products from BGI, brewers of St. George and Bati’ are
consumed at the highest rate. Harar beer is their closest competitor. However, since early June,
2009, Play is expecting shortage of St. George beer, the leading of BGI’s brands, draught and
bottled beer.

The hotel sought explanation for the cause of the shortage from BGI’s distribution center for
the Hawassa area. The officer in charge of distribution responded that power shedding has

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affected the production process located at its two main factories in Addis Ababa and
Kombolcha. The attempt by the brewery to solve the problems by using diesel generators
doesn’t appear to be working.

St. George beer and draught have been greatly affected by the power shortage but the problem
is not limited to BGI’s products, according to the interview made with finance manager of the
same hotel.

Dashen beer began experiencing a shortage in the middle of June. The second most requested
beer at Panorama food court (PFC) a modern eatery in Addis Ababa as first tier customer is
hard to find. The café is also having difficult time keeping St. George in stock. In the months
just before May, the restaurant used to receive 25 crates (1 crate contains=25 bottles of beer) of
BGI”s leading brand twice a week. Now, they get 15 to 18 crates according to the interview
made with finance manager of the hotel.

BGI has faced a decline in all of its brands after its standby generator at Addis Ababa plant
went out of service. “The shortage is on all brands”, said the marketing manager of the
company. Since the problem started shaking the market in early June, BGI devised a rescue
measure of operating for 24 hours every day of the week at both of its production plants-in
Addis Ababa and Kombolcha. The two factories have the joint capacity of producing 135,000
hectoliters (hl), 50% of which is draught beer monthly before power shortage occurred. The
Addis plant which is under repair right now produces 90,000hl of the total amount. BGI
incurred a 20,000hl scarcity of its product following the break down (As interview made with
the marketing manager of the company)

Despite the dearth, BGI claimed it has an estimated 54% of the current market share and it did
not make changes on the price of the products. In fact, its competitors, and industry observers
agree that BGI has a market share of a little over half nationwide. BGI products are available in
all parts of the country since the two production units at Addis Ababa and Kombolcha work
non-stop, the marketing manager explained. The Kombolcha plant supplies the north,
northwest, northeast and central markets of the company while the Addis Plant supplies the rest
of the country.

In an attempt to offset the shortfall with a temporary solution, the factory in Addis has installed
three generators. However, a few weeks ago, it imported a high capacity generator (2250kv)
that arrived on June26, 2009 and is expected to be up and running after three weeks of
installation. The new “caterpillar” generator, which is now out of order had a capacity of
200kva. This has forced BGI to rent a 600kva generator, the marketing manager said.

Almost all factories are using generators to match capacity with demand and maintain the
status quo. Harar brewery, more than 520 km east of Addis Ababa, produces beer with a
dominant market share in eastern Ethiopia. It has been operating with two generators, one with
1250kva and another with 600kva. The company’s management claims that the two generators
have helped them remain significantly insulated from the blow by power shortage. Except for

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minor deficiency in manpower and some technical problems, the company has not significantly
reduced production due to the power blackout, according to the response from the general
manager of the company. That doesn’t mean the company didn’t face power crisis. They began
facing shortage in May 2009.

This brewery’s major market share is the east and the southern parts of the country. For
example, Tana hotel Harar, located 526km east of Addis, used to get up to 50 crates twice a
week. “Now we get 40 crates”, said the hotel owner and manager, in an interview conducted.

Another major market actor, Meta Abo Brewery, located 24 km to the Southwest of Addis
Ababa, is known for Meta beer and Meta Premium brands. It has faced a huge production
shortfall due to power shedding. This brewery with 22 percent market share nationwide
previously operated with over 90% of its installed capacity before May 2009 producing
400,000 hl annually. The power blackout, however, has dropped the production to only 60%
installed capacity, an interview made with an employee of the company in the production
department.

To alleviate the shortfall in its production, the factory runs every night from 12:00am to 6:am,
according to the same source obtained from the firm. The Meta Abo products are mostly
consumed around central, western, eastern and southern parts of the country.

The other brewer that dominates the western part of the country is Bedele. Its products cover
12% of the national market share. In the pre-blackout time, it produced 350,000 bottles. Now
using one standby generator and a 12:00 a.m. to 6:00 a.m. schedule of production, the factory
produces between 150,000-250,000 bottles depending on the amount of power it uses. Its
regional market share, heavily concentrated on the western part of the country stands, at 85%.

While all the breweries share the same problem, the youngest of the factories, Dashen brewery,
faces not only of the national power shortage but also a scarcity of cork supplies. Previously,
the factory used to take corks, from Metal crown Ethiopia plc; whereas now the cork producer
itself is facing power shortages since early June 2009. This led to the cork producer’s failure to
supply those which depend on its products for their production.

The Metal crown, located 37 km east of Addis Ababa in Dukem town, produces cork for
Bedele and Harar breweries as well as the two soft drink producers (East Africa Bottling and
MOHA soft drinks Factory). “Dashen is one of our main customers and we are trying to satisfy
the need of the factory at any cost”, The Dashen beer factory will get the corks from our head
station in Kenya in a short period of time” said official of the cork company when interviewed.

However, the company has been forced to import corks from the Spanish company, Jose
Combalia plc and from the Kenyan branch of metal crown, according to the general manager
of the company. From June14, 2009 onward our factory has totally stopped taking corks from
Metal Crown Ethiopia PLC, the general manager of Dashen responded to an interview.

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Like the other breweries, Dashen operates with the electricity it gets from 12:00am to 6:00am.
The breweries are, of course, not the only sufferers from this calamity as most factories have
been forced to halt production and send their employees home. Yet, whatever these breweries
do to keep themselves in the market is a temporary solution.

The critical power shortage problem will be reversed under two conditions: either with the
availability of abundant rain in the rainy season or the commissioning of the Tekeze Hydro
power generation plant, whose construction was finalized nearly a year ago and the now
completed Gilgel Gibe II hydro power project

Question:

Can Supply Chain Management be a solution to what brewery firms faced as a severe
problem? Discuss with possible solutions.

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 CHAPTER NINE

PERFORMANCE MEASUREMENT ALONG THE SUPPLY CHAIN

In this chapter you will learn the following concepts:

9.1 Introduction
9.2 Different supply chain performance measurements across time
9.3 Different performance measurement dimensions
9.4 Different supply chain performance measurement models
9.5 Self-Assessment Questions
9.6 Chapter Summary

Objectives
After completing reading this chapter, you will be able to:

describe why performance measurement is necessary along the supply chain

make comparisons of the various performance metrics

9.1 INTRODUCTION

Increasingly, firms are adopting supply chain management (SCM) to improve competitiveness.

Most performance measures used by firms today continue to be the traditional cost- based and
financial statistics reported to the shareholders in the form of annual report, balance sheet, and
income statement data. Costs, revenues, and profits might at first glance seem to be useful
types of performance measures but several problems are associated with using them to gauge
performance (Wisner et al., 2005:437).

Another problem with the use of Costs, revenues, or profits as performance measures is the
difficulty, in most cases, to attribute cost, revenue, or profit contributions to the various
functional units or business units of the organization.

9.2 DIMENSIONS OF PERFORMANCE METRICS

As stated in Langley (2006:484) key performance measures for the periods from 1960s to
2000s were as follows:-

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Table 9.1 Performance Measures

1960s 1970s 1980s 1990s 2000s

Production Manufacturing and Transportation Distribution and Supply chain and customer
costs inventory costs Costs Logistics Costs service costs

9.3 WORLD CLASS PERFORMANCE MEASUREMENT SYSTEMS

As many of the world’s business respond to increased competitive pressures by attempting to

develop and maintain a distinctive competitive advantage, the need to develop effective
performance measurement systems linking firm strategy to operating decisions increases.

Developing World –class performance Measures

Creating effective performance measurement system involves the following steps;

1. Identify the firm’s strategic objectives,

2. Develop an understanding of each functional area’s role and the required capabilities
for achieving the strategic objectives,
3. And identify internal and external trends likely to affect the firm and its performance
over time.

Several authors tried to identify common supply chain performance metrics as summarized in
the work of (Wisner et al., 2005:441) around the following major dimensions; Cost/Price,
Quality, Delivery , Responsiveness and Flexibility, Environment, Technology, Business
Metrics and Total Cost of Ownership.

In a major study done by the performance measurement group from 1995 and 2000, the top
supply chain performers were found to be leading in a number of areas; These are; High levels
of responsiveness and flexibility, high levels of efficiency, use of internet to fundamentally
alter communications among trading partners and perfect order fulfillment is becoming the
new definition of reliability.

Also process measure categories are summarized in to time and quality dimensions as follows:-

i. Time Dimensions

 On-time delivery /receipt, order cycle time, order cycle time variability, and
response time

ii. Quality Dimensions

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 Overall customer satisfaction, processing accuracy, perfect order fulfillment- on- time
delivery, completed order, accurate product selection- damage – free& accurate invoice,
forecast accuracy, planning accuracy, budgets and operating plans, and schedule adherence.

9.4 SUPPLY CHAIN PERFORMANCE MEASUREMENT MODELS

A performance measure is defined as a metric used to quantify the efficiency and/ or

effectiveness of an action; and Performance measurement system is defined as the set of
metrics used to quantify the efficiency and effectiveness of an action.

9.4.1 Trends in Performance Measurement Development

Throughout history, performance measures have been used to assess the success of
organizations. To achieve sustainable business success in the demanding world marketplace, a
company must use relevant performance measures. By the start of the twentieth century, the
nature of organizations had evolved and ownership & management were increasingly
separated. As a result, measures of return on investment were applied so that owners could
monitor the performance that managers were achieving.

Some of performance measurement models/ frameworks, which have been developed by

different researchers with their advancements and limitations, are described below.

9.4.2 Finance Based Performance Measures

Traditional performance measurement systems go back a long way in their origin and
applications. It is thought, for instance, that the double entry bookkeeping was first used in
Venice around the fourteenth century (Zairi, 1996).

Some of Finance based Performance Measurement Systems are:

i. Costs and Accounting Management

The common means of monitoring business performance in today’s industry is based on cost
and management accounting practices. These techniques were developed in the late nineteenth
and early twentieth century’s to meet the needs of expanding manufacturing industries. By the
1930s, fully integrated cost and management accounting systems were developed, regulated,
subjected to independent auditing and linked to external financial operating systems. But,
Johnson & Kaplan argued that: “today’s management accounting information driven by the
procedures and cycles of the organizations reporting system are too late, aggregated, and
distorted to be relevant for managers ’ planning and control decisions.” McNair [1992] also
added “managers need clear, timely, and relevant signals from their internal information
systems to understand root causes or problems, to initiate corrective actions & to support
decisions at all levels of the organization” (Zairi,1996)

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Hence, applying performance measures that solely consist of financial performance measures
cause problems for a company to make proper decisions.

ii. Activity -Based Costing (ABC)

The usefulness of those cost accounting systems has been questioned by several authors in
guiding a company towards strategic competitive decisions, especially related to
manufacturing. The post-war phase saw a paradigm shift in organizations from only financial
measures to both financial and non -financial measures in their objectives and performance
measures (Parida, 2006).

A new approach to cost accounting, known as activity-based costing (ABC), was developed by
Johnson and Kaplan (1987) in the late 1980s as an attempt to resolve some of the fundamental
inadequacies of traditional cost accounting. ABC is concerned with both direct & indirect cost
of activities within a company and their relationships to the manufacture of specific products
rather than to basic functional areas.

In this way, it is believed that ABC results in a more accurate identification of costs than
traditional cost allocation (Tangen, 2004). However, there are researchers who argued that
ABC provides more accurate product costs has never been proved. More importantly, an
improved cost accounting system will not entirely solve the problem with financial measures.
Other measures rather than costs are needed to adequately gauge manufacturing performance
relative to a competitive strategy (Bourne et al., 1997).

However, Traditional Performance Measures have the following limitations:

By the 1980s there was a growing realization that the traditional performance measures were
no longer sufficient to manage organizations competing in modern markets. In recent years,
enormous changes have taken place in technology and production techniques that have made
management accounting systems no longer useful (Lockamy, 1998; Neely1998). These out-of-
date techniques are at best irrelevant and at worst positively harmful (Browne& Devlin1998).

Numerous researchers have exposed ten limitations of these traditional approaches. These
limitations could be summarized as (Akkermans and Oorschot, 2002; Bititci, 1994; Gomes et
al., 2004; Neely1999; Neelyet al., 2000; White, 1996; Yuksel, 2004):

1. They are historical in nature & provide little indications of future performance and
strategic focus;
2. They are too aggregated and distorted for long-term decision -making process;
3. They encourage short-term decision making, like delayed capital investment;
4. They do not report accurately the costs of processes, products, quality, and customers;
5. They are not applicable to new management techniques that give shop -floor operators’
responsibility and autonomy;

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 6. They do not have strategic focus and fail to provide data on quality, flexibility and
responsiveness;
7. They do not penalize overproduction and often inhibit innovation;
8. They encourage managers to minimize variance from standard than to improve
continuously;
9. They are internally rather than externally focused, with little regards for competitors or
customers;
10. They are rarely integrated with one another or aligned to the business process; and
Performance measures are often poorly defined.

9.4.3 Multi-dimensional Performance Measures

Traditional performance measurement systems (based on financial measures) have failed to

identify and integrate all those factors critical in contributing business excellence as mentioned
before. During the last two decades or more a number of performance measurement
frameworks (multiple dimensional) have been developed in academics and business
environments to overcome the drawbacks of traditional measures.

Internationally well-known models/frameworks are identified and described in this section.

These are:

i. Sink and Tuttle Model

A classical approach to a performance measurement system is the Sink and Tuttle model,
which claims that the performance of an organization is a complex interrelationship among
seven performance criteria. These criteria are effectiveness, efficiency, product/ service
quality, productivity, quality of work -life, innovation and profitability (Sink and Tuttle, 1989).
Although much has changed in industry since this model has first been introduced, these seven
performance criteria are still important. However, the model has several major limitations. For
example, it does not consider the need for flexibility, which has increased markedly during the
last few decades. The model is also limited by the fact that it does not consider the customer
perspective (Tangen, 2004).

ii. Performance Measurement Matrix

A performance measurement matrix reflecting the need for a balanced measurement is

proposed by Keegan (1989), who categorized the measures as cost or non -cost, and external or
internal, thus reflecting a greater balance of measures. This framework allows the
organizations to plot their measures and identify the need for adjustment with measurement
focus. But, its drawback is that this simple framework does not reflect all attributes of
measures, yet could accommodate any measures of performance (Neely et al., 1995).

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 iii. Medori & Steeple Integrated Framework

Medori and Steeple (2000) present an integrated framework for auditing and enhancing
performance measurement systems. This approach consists of six detailed described stages.
Similar to most frameworks, the starting point begins with defining the company’s
manufacturing strategy and success factors (stage 1). In the next stage, the primary task is to
match the company’s strategic requirements with six defined competitive priorities (e.g.
product quality, cost, flexibility, time, delivery and future growth; stage 2). Then, the selection
of the most suitable measures takes place by the use of a checklist that contains 105 measures
with full descriptions (stage 3). After the selection of measures, the existing performance
measurement system is audited to identify which existing measures will be kept (stage 4). An
essential activity is the actual implementation of the measures in which each measure is
described by eight elements: title, objective, benchmark, equation, frequency, data source,
responsibility and improvement (stage 5). The last stage is based around the periodic review of
the company’s performance measurement system (stage 6) (Medori and Steeple, 2000).

A major advantage is that it can be used both to design a new performance measurement
system and to enhance an existing one. It also contains a unique description of how
performance measures should be realized. Its limitations are mainly located in stage 2, where a
performance measurement grid is created in order to give the performance measurement
system and its basic design. Little guidance is given here, and the grid is only constructed from
six competitive priorities only (Tangen, 2004).

iv. The Balanced Scorecard

The balanced scorecard (BSC) approach to performance measurement was developed by

Kaplan and Norton in 1992, as a way to align an organization’s performance measures with its
strategic plan and goals, thus improving managerial decision making (Wisner et al., 2005:444)

The BSC is designed to provide managers with a formal framework for achieving a balance
between non financial and financial results across both short-term and long-term planning
horizons. There are three perspectives:

a. Financial perspective: Measures that address revenue growth, product mix, cost
reduction, productivity, asset utilization, and investment strategy.
b. Internal business process perspective: Focuses of performance of the most critical
internal business processes of the organization including quality, flexibility,
innovative elements of processes, and time-based measures.
c. Customer perspective: Measures that focus on customer requirements and
satisfaction including customer satisfaction ratings, customer retention, new
customer acquisition, customer value attributes, customer profitability, and
market share.

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 v. The Supply Chain Operations Reference Model

One of the most recognized methods for integrating supply chains and measuring their
member’s performance is the supply chain operations reference (SCOR) model developed in
1996 by the Supply-Chain Council- a nonprofit global organization of more than 800 firms
interested in supply chain management (Wisner et al.,2005:446, Langley et al., 2006:495)

The SCOR model separates supply chain operations in to five process categories- plan, source,
make, deliver, and return.

These Processes are:-

1. The plan process – encompasses demand and supply planning and management
which require balancing resources with requirements and the establishment and
communication of plans for all other processes in the supply chain which includes
management of business rules, supply chain performances, data collection, inventory,
capital assets, transportation etc.
2. The source process- encompasses sourcing stocked, make – to order and
engineer – to order products or materials which includes, scheduling deliveries,
receiving, transferring, and authorizing vender payments.
3. The make process- encompasses make – to stock, make – to – order, and
engineer – to – order production which includes scheduling production activities,
issuing product, producing and testing, packaging, staging, and releasing.
4. The Deliver process- encompasses ordering, warehousing, transporting and
installation of stocked, made- to – order and engineer – to –order products.
5. The return process encompasses the return of raw materials (to vender) and
receipt of finished goods (returns from customers).

Five critical performance levers have the greatest impact on supply chain performance:
Configuration; management practices; external relationships; organization; and systems .

The SCOR model was developed in the mid-1990s by a cross industry consortium of over 70
companies in the USA called the Supply Chain Council. SCOR defines common supply chain
management processes and matches these with best practice, benchmarked performance
measures and use of software (Power, 2005: 209)

The Supply-Chain Council’s SCOR model suggests the kind of operational data that should be
collected. This data is referred to as “Level 2 Performance Metrics.” In the plan preparation,
useful measures are the cost of planning activities, inventory financing costs, and inventory
days of supply on hand, and forecast accuracy. In the sourcing operation, it is useful to have
data on material acquisition costs, sourcing cycle times, and raw material days of supply.
Useful measures in the make operation are the number of product defects/complaints, make
cycle times, build order attainment rates, and product quality. Suggested delivery operation
measures are fill rates, order management costs, order lead times, and item return rates.

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This data should be collected regularly and trends should be watched. When performance
targets start to be missed, the next step is to investigate the business operations that support that
performance. Again the SCOR model suggests more detailed data that can be collected and
analyzed in each of the four supply chain operating areas. This more detailed data is referred to
as “Level 3 Diagnostic Metrics.” Diagnostic metrics can be used to analyze the complexity and
configuration of the supply chain and also to study specific practices. In the plan operation,
complexity measures are the number and percentage of order changes, number of stock
keeping units (SKUs) carried production volumes, and inventory carrying costs. Configuration
measures track things such as product volume by channel, number of channels, and number of
supply chain locations. Measures of management practices in the plan operation are such
things as planning cycle time, forecast accuracy, and obsolete inventory on hand. In the source
operation, measures of complexity and configuration are number of suppliers, percentage of
purchasing spending by distance, and purchased material by geography. Some practice
measurements are supplier delivery performance, payment period, and percentage of items
purchased by their associated lead time.

Supply Chain Performance Metrics and Diagnostic Measures (Supply-Chain Council SCOR
Model)

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Adopted from the book, Hugos (2002:156), Essentials of supply Chain Management.

9.4.4 MARKET BASED SUPPLY CHAIN PERFORMANCE MEASURE

Two characteristics that describe supply chain performance are responsiveness and efficiency.
We all intuitively know what these two characteristics imply, but now we need to define them
in more precise terms so that they can be measured objectively.

We will use four measurement categories:

• Customer Service

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 • Internal Efficiency
• Demand Flexibility
• Product Development
1. Customer Service

Customer service measures the ability of the supply chain to meet the expectations of its
customers. Depending on the type of market being served, the customers in that market will
have different expectations for customer service. Customers in some markets both expect and
will pay for high levels of product availability and quick delivery of small purchase quantities.
Customers in other markets will accept longer waits for products and will purchase in large
quantities. Whatever the market being served, the supply chain must meet the customer service
expectations of the people in that market.

2. Internal Efficiency

Internal efficiency refers to the ability of a company or a supply chain to operate in such a way
as to generate an appropriate level of profitability. As with customer service, market conditions
vary and what is an appropriate level of profit varies from one market to another. In a risky
developing market the profit margins need to be higher in order to justify the investment of
time and money. In a mature market where there is little uncertainty or risk, profit margins can
be somewhat lower. These markets offer the opportunity to do large volumes of business and
to make up in gross profit what is given up in gross margin.

3. Demand Flexibility

This category measures the ability to respond to uncertainty in levels of product demand. It
shows how much of an increase over current levels of demand can be handled by a company or
a supply chain. It also includes the ability to respond to uncertainty in the range of products
that may be demanded. This ability is often needed in mature markets.

4. Product Development

This encompasses a company and a supply chain’s ability to continue to evolve along with the
markets it serves. It measures the ability to develop and deliver new products in a timely
manner. This ability is necessary when serving developing markets.

9.4.5 A Framework for Performance Measurement

There are other demands that real-world markets place on their supply chains, however, by
using these four performance categories we can create a useful framework. This framework
describes the mix of performance required from companies and supply chains that serve the
four different market quadrants. When a company identifies the markets it serves it can then
define the performance mix required by those markets in order to best respond to the
opportunities they provide.

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Markets in the first quadrant, developing markets, require their supply chains to excel in
product development and customer service. Growth markets require very high levels of
customer service particularly as measured by order fill rates and on-time delivery. Steady
markets require internal efficiency as well as an even broader scope of customer service.
Mature markets require all the internal efficiency and customer service called for by steady
markets. They also require the highest levels of demand flexibility. The most profitable
companies and supply chains are those that deliver the performance called for by their markets.
These organizations are the most profitable because they are the ones most able to respond
effectively to the opportunities offered by their markets. Companies should collect and track a
handful of performance measures that cover these four areas. This will give them valuable
information about how well they are responding to their markets. The metrics that measure
performance in the four areas are applicable to individual companies and also to entire supply
chains. It is harder to gather these metrics for entire supply chains because companies are
reluctant to share data that may be used against them by their competitors or by their customers
or suppliers. There are issues of trust and incentive to work out before these metrics can readily
be collected for an entire supply chain. Nonetheless, when these issues are worked out, these
metrics will help to guide the behavior of the entire supply chain and should benefit all the
participants in that chain over the long term.

A. Customer Service Metrics

Service relates to the ability to anticipate, capture and fulfill customer demand with
personalized products and on-time delivery.

The reason that any company exists is to be of service to its customers. The reason that any
supply chain exists is to serve the market it is attached to. These measures indicate how well a
company serves its customers and how well a supply chain supports its market.

There are two sets of customer service metrics depending on whether the company or supply
chain is in a build to stock (BTS) or build to order (BTO) situation.

1. Build to Stock

A build to stock or BTS situation is one where common commodity products are supplied to a
large market or customer base. These are products such as office supplies, cleaning supplies,
building supplies, and so on. Customers expect to get these products right away any time they
need them. Supply chains for these products must meet this demand by stocking them in
inventory so they are always available. In a BTS environment a customer wants their complete
order to be filled immediately. This may be expensive to provide if customer orders contain a
wide range and number of items. It is costly for companies to carry all those items in stock so
they may have backup plans to provide expedited delivery of items not in stock or substitution
of upgraded items for those not in stock. The order fill rate measures the percentage of total
orders where all items on the order are filled immediately from stock. The line item fill rate is

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the percentage of total line items on all orders that are filled immediately from stock. Used
together, these two measures track customer service from two important perspectives.

Popular metrics for a build to stock situation are:

• Complete Order Fill Rate and Order Line Item Fill Rate
• On-Time Delivery Rate
• Value of Total Backorders and Number of Backorders
• Frequency and Duration of Backorders
• Line Item Return Rate

2. Build to Order

A build to order or BTO situation is one where a customized product is ordered by a customer.
This is any situation where a product is built based on a specific customer order and is
configured to meet a unique set of requirements defined by the customer. An example of this is
the way Boeing builds airplanes for specific customers and their requirements or the way Dell
Computer assembles PCs to fit individual customer orders and specifications. In a BTO
environment, it is important to track both the quoted customer response time and the on-time
completion rate. It is easier for a company to achieve a high on-time completion rate if it
quotes longer customer response times. The question is whether the customer really wants a
short response time or will accept a longer response time. The quoted response time needs to
be aligned with the company’s value proposition and competitive strategy.

Popular metrics for a build to order situation are:

• Quoted Customer Response Time and On-Time Completion Rate

• On-Time Delivery Rate
• Value of Late Orders and Number of Late Orders
• Frequency and Duration of Late Orders
• Number of Warranty Returns and Repair
B. Internal Efficiency Metrics

Internal efficiency refers to the ability of a company or a supply chain to use their assets as
profitably as possible. Assets include anything of tangible value such as plant, equipment,
inventory, and cash. Some popular measures of internal efficiency are:

• Inventory value,
• Inventory turns,
• Return on sales, and
• Cash-to-cash cycle time
1. Inventory Value

This should be measured both at a point in time and also as an average over time. The major
asset involved in a supply chain is the inventory contained throughout the length of the chain.

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Supply chains and the companies that make them up are always looking for ways to reduce
inventory while still delivering high levels of customer service. This means trying to match
inventory availability (supply) with sales (demand) and not having excess inventory left over.
The only time a company would want to let inventory exceed sales is in a growth market where
the value of the inventory will increase. However, markets change and as a rule it is best to
avoid excess inventory.

2. Inventory Turns

This is a way to measure the profitability of inventory by tracking the speed with which it is
sold or turned over during the course of a year. This measure is often referred to as T&E or
“turn and earn.” It is calculated by the equation:

Turns = Annual Cost of Sales / Annual Average Inventory Value

Generally, the higher the turn rate the better, although some lower turning inventory needs to
be available in order to meet customer service and demand flexibility.

3. Return on Sales

Return on sales is a broad measure of how well an operation is being run. It measures how well
fixed and variable costs are managed and also the gross profit generated on sales:

Return on Sales = Earnings before Interest & Tax / Sales

Again, as a rule, the higher the return on sales the better. There are times though when a
company may deliberately reduce this number in order to gain or defend market share or to
incur expenses that are necessary to achieve some other business objectives.

4. Cash-to-Cash Cycle Time

This is the time it takes from when a company pays its suppliers for materials to when it gets
paid by its customers. This time can be estimated with the following formula:

Cash-to-Cash Cycle Time = Inventory Days of Supply +Days Sales Outstanding – Average
Payment Period on Purchases

The shorter this cycle time the better. A company can often make more improvements in their
accounts payable and receivable areas than they can in their inventory levels. Accounts
receivable may be large due to late payments caused by billing errors or selling to customers
who are bad credit risks. These are things a company can manage as well as inventory.

C. Demand Flexibility Metrics

Demand flexibility describes a company’s ability to be responsive to new demands in the

quantity and range of products and to act quickly. A company or supply chain needs

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capabilities in this area in order to cope with uncertainty in the markets they serve. Some
measures of flexibility are:

• Activity Cycle Time

• Upside Flexibility
• Outside Flexibility
1. Activity Cycle Time

The cycle time measures the amount of time it takes to perform a supply chain activity such as
order fulfillment, product design, product assembly, or any other activity that supports the
supply chain. This cycle time can be measured within an individual company or across an
entire supply chain. Order fulfillment within a single company may be fast but that company
may only be filling an order from another company in the supply chain. What is important is
the cycle time for order fulfillment to the ultimate end use customer that the entire supply chain
is there to serve.

2. Upside Flexibility

It is the ability of a company or supply chain to respond quickly to additional order volume for
the products they carry. Normal order volume may be 100 units per week for a product. Can an
order be accommodated that is 25 percent greater one week or will the extra product demand
wind up as a backorder? Upside flexibility can be measured as the percentage increase over the
expected demand for a product that can be accommodated.

3. Outside Flexibility

This is the ability to quickly provide the customer with additional products outside the bundle
of products normally provided. As markets mature and technologies blend, products that were
once considered outside of the range of a company’s offerings can become a logical extension
of its offerings. There is danger in trying to provide customers with a new and unrelated set of
products that have little in common with the existing product bundle. However, there is
opportunity to acquire new customers and sell more to existing customers when outside
flexibility is managed skillfully.

D. Product Development Metrics

Product development measures a company or a supply chain’s ability to design, build, and
deliver new products to serve their markets as those markets evolve over time. Technical
innovations, social change, and economic developments cause a market to change over time.
Measurements in this performance category are often overlooked, but companies do so at their
own peril. A supply chain must keep pace with the market it serves or it will be replaced. The
ability to keep pace with an evolving market can be measured by metrics such as:

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 • Percentage of total products sold that were introduced in the last year
• Percentage of total sales from products introduced in the last year
• Cycle time to develop and deliver a new product

9.5 Self-Assessment Questions

1. Briefly discuss the three objectives for developing and implementing performance
measurement systems.
2. Compare and contrast the time and quality metrics for supply chain performance
measurement
3. Why is the order fill rate considered the most stringent metric?
4. Is the ideal of a perfect order a realistic operational goal?
5. Why is it important that a firm measure customer perception as a regular part of
performance measurement?
6. Why are comprehensive measures of supply chain performance, such as total supply
chain cost, so difficult to develop?
7. Discuss Balanced Score Card model for supply chain performance measurement
8. Why SCOR model is so popular for supply chain performance measurement? Discuss the
metrics used in the SCOR model.
9. Do you believe that activity-based costing represents an equitable basis for allocating
indirect expenses?
10. Suppose you have been asked by a certain firm to assess the impact on return on assets
of outsourcing transportation. Currently, the firm uses a private truck fleet and is
considering a switch to a third-party transportation company. What dimensions are used
to make better decision? Explain
11. Discuss the difference between financial and non-financial supply chain performance
measurement metrics used with example.

9.6 Chapter Summary

Effective management of logistics operations and supply chain integration requires
establishment of a framework for performance assessment and financial controllership. This
framework provides the mechanism to monitor system performance, control activities, and
direct personnel to achieve higher levels of productivity.
Comprehensive performance measurement systems include metrics for each of the logistics
functions. Five critical dimensions of functional performance must be addressed: cost,
customer service, quality, productivity, and asset management. Leading firms extend their
functional measurement systems to include metrics focused on their ability to accommodate
customer requirements. These include measures of absolute performance rather than average
performance, perfect orders, end-consumer focused measures, and customer satisfaction. To
aid in achievement of supply chain integration, leading firms have instituted a set of across-
firm metrics such as inventory days of supply, inventory dwell time, cash-to-cash cycle time,
and total supply chain cost.
Different models are available for supply chain performance measure.

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Traditional accounting practices are typically inadequate for logistics costing.
Effective decision making requires that management is able to match revenues with expenses
incurred to service specific customers, channels, and products. Contribution margin and net
profit represent two alternative formats for cost-revenue analysis.
Activity-based costing provides management the ability to more specifically trace logistics
expenses to the segments that generate revenue. The strategic profit model provides managers
the ability to assess the impact of logistics decisions on profitability, asset utilization, and
return on assets.
It also provides the ability to more accurately assess segments in terms of profit and return on
investment.
SCOR Model is widely applied and accepted by firms for supply chain performance
measurement.

Key Terms
Supply Chain performance Measures- dimensions (Time, quality, finance) used to measure the
effectiveness of supply chain activities in the order fulfillment cycle

Case: Performance Control at Happy Chips, Inc.

Wendell Worthmann, manager of logistics cost analysis for Happy Chips, Inc., was faced with
a difficult task. Harold L. Carter, the new director of logistics had circulated a letter from
Happy Chips’ only mass merchandise customer, Buy 4 Less, complaining of poor operating
performance. Among the problems cited by Buy 4 Less were: (1) frequent stock outs (2) poor
customer service responsiveness and (3) high prices for Happy Chips’ products. The letter
suggested that if Happy Chips were to remain a supplier to Buy 4 Less, it would need to
eliminate stock outs by: (1) providing direct store delivery four times per week (instead of
three) (2) installing an automated order inquiry system to increase customer service
responsiveness ($10,000.00) and (3) decreasing product prices by 5 percent. While the
previous director of logistics would most certainly have begun implementing the suggested
changes, Harold Carter was different. He requested that Wendell prepare a detailed analysis of
Happy Chips’ profitability by segment. He also asked that it should be prepared on a
spreadsheet to permit some basic analysis. This was something that Wendell had never
previously attempted, and it was the first thing to be needed in the morning.

Company Background
Happy Chips, Inc., is the fifth largest potato chip manufacturer in the metropolitan Detroit
market. The company was founded in 1922 and following an unsuccessful attempt at national
expansion has remained primarily a local operation. The company currently manufactures and
distributes one variety of potato chips to three different types of retail accounts: grocery, drug,
and mass merchandise. The largest percentage of business is concentrated in the grocery
segment, with 36 retail customer locations accounting for 40,000 annual unit sales and more
than 50 percent of annual revenue. The drug segment comprises 39 customer locations which

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account for 18,000 annual unit sales and more than 27 percent of annual revenue. In the mass
merchandise segment, Happy Chips has one customer with three locations that account for
22,000 annual unit sales and almost 22 percent of annual revenue. All distribution is store
direct, with delivery drivers handling returns of outdated material and all shelf placement and
merchandising.
Income Statement
Income
Net Sales……………………………………………….$150,400.00
Interest and Other Income…………………………………3,215.00
$153,615
Cost and Expenses
Cost of Goods Sold ……………………………………….84,000.00
Other Manufacturing Expense……………………………… 5,660.00
Marketing, Sales, and Other Expenses ………………………..52,151.20
Interest Expense……………………………………………… 2.473.00
$144,284.20
Earnings before Income Taxes…………………………………. 9,330.80
Income Taxes……………………………………………………..4198.86
Net Earnings………………………………………………………$5131.94
Annual Logistics Costs by Segment
Mass
Cost Category/Segment, Grocery Drug Merchandise
Stocking Cost ($/Delivery) $1.80 $1.20 $2.80
Information Cost (Annual) 1, 000.00 8,000.00 1000.00
Delivery Cost ($/Delivery) 5.00 5.00 6.00
Recently, Happy Chips has actively sought growth in the mass merchandise segment because
of the perceived profit potential. However, while the company is acutely aware of overall
business profitability, there has never been an analysis on a customer segment basis.

Performance Statistics
Wendell recently attended a seminar at a major Midwestern university concerning activity-
based costing. He was anxious to apply the techniques he had learned at the seminar to the
current situation, but was unsure exactly how to proceed. He did not understand the
relationship between activity based costing and segment profitability analysis, but he knew the
first step is either to identify relevant costs. Wendell obtained a copy of Happy Chips’ most
recent income statement (Table 1).
He also knew specific information concerning logistic costs by segment (Table 2).
All deliveries were store-direct with two deliveries per week to grocery stores, one delivery per
week to drug stores and three deliveries per week to mass merchandisers. To obtain feedback
concerning store sales, Happy Chips purchased scanner data from grocery and mass
merchandise stores at an aggregate annual cost of $1,000.00 per segment. The drug store
segment required use of handheld scanners by delivery personnel to track sales. The cost of

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delivery to each store was dependent on the type of vehicle used. Standard route trucks were
used for drug stores and grocery stores, while extended vehicles were used to accommodate the
volume at mass merchandisers.
Trade prices for each unit were different for grocery ($1.90), drug ($2.30). and mass
merchandise ($1.50) customers. Wendell was also aware that Buy 4 Less required Happy
Chips to cover the suggested retail price with a sticker bearing its reduced price. The
machinery required to apply these labels had an annual rental cost of $5,000.00. Labor and
materials cost an additional $.03 per unit.

Conclusion
As Wendell sat in his office compiling information to complete the segment profitability
analysis, he received several unsolicited offers for assistance. Bill Smith, manager marketing,
urged him not to bother with the analysis:
Buy 4 Less is clearly our most important customer. We should immediately implement the
suggested changes. Steve Brown, director of manufacturing, disagreed. He felt the additional
manufacturing cost required to meet Buy 4 Less’ requirements was too high:
We should let Buy 4 Less know what we really think about their special requirements.
Stickers, of all things! What business do they think we are in?
The sales force had a different opinion. Jake Williams felt the grocery segment was most
important:
Just look at that volume! How could they be anything but our best customers?
The broad interest being generated by this assignment worried Wendell. Would he have to
justify his recommendations to everyone in the company? Wendell quietly closed his office
door.
Based on the available information and his own knowledge of ABC systems, Wendell
Worthmann needed to complete a segment profitability analysis and associated spreadsheet
before his meeting with Harold in the morning. With all these interruptions, it was going to be
a long night.

Questions
1. What is the difference between activity-based costing and segment profitability
analysis? How would you counter the arguments by other managers concerning the
most attractive segments? Using relevant costs provided above, determine the
profitability for each of Happy Chips' business segments.
2. Based on your analysis, should Happy Chips consider the changes desired by Buy for
Less? Why or why not?
3. Should Happy Chips eliminate any business segments? Why or why not?
4. If the price to mass merchandise stores were to increase by 20 percent would that
change your answer to the previous question?

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 CHAPTER TEN

RECENT DEVELOPMENTS IN SUPPLY CHAIN MANAGEMENT

In this chapter you will learn the following concepts:

10.1 Green supply chain management
10.2 Ethics in supply chain management
10.3 Corporate social responsibility
10.4 Supply Chain Social responsibility
10.5 Self-Assessment Questions
10.6 Chapter Summary

Objectives

After studying this chapter, you will be able to:

discuss why green supply chain is relevant

demonstrate the basics of SC ethics

explain the contributions of engaging in SC social responsibility

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10.1 GREEN SUPPLY CHAIN MANAGEMENT

10.1.1 Inter-Organizational Knowledge Sharing in Green Supply Chains

Supply chains are formed to achieve a sustainable competitive advantage for all parties
involved. The social and political concerns on environmental issues have encouraged
manufacturing firms to “green” their supply chains. To improve both economic and
environmental performance simultaneously throughout their supply chains, green
manufacturing firms have created networks of suppliers or subcontractors to purchase
environmentally superior products and to build common practices to waste reduction and
operational efficiencies. To reassure regulatory compliance of their business practices green
manufacturing firms often encourage their supply chain partners to develop an environmental
management system (EMS) consistent with the ISO 14000 standards and to obtain the ISO
14001 certification (GEMI – Global Environmental Management Initiative, 2001). The
successful implementation of the EMS involves identifying new techniques and opportunities
for effective management of environmental impacts. As such, green manufacturing firms may
need to help their supply chain partners develop environmental management capabilities by
providing training programs and sharing their green knowledge.

Inter-organizational knowledge sharing in green supply chains involves activities of

transferring or disseminating green knowledge from green manufacturing firms to their
partners with a view to developing new capabilities for effective actions. To achieve the
benefits of inter-organizational knowledge sharing; it is essential for all the parties involved to
be in cooperative relationships. With collaborations between manufacturing firms and their
partners, a base of jointly held knowledge can be created and maintained through knowledge
sharing, thus enhancing mutual understanding and expectations with effective knowledge
sharing. The strategic intent of inter-organizational collaborations for a sustainable competitive
advantage can be achieved by combining the relevant organizational resources and capabilities
of all parties. The value created by collaborative supply chains benefits all parties .However,
competition may occur when the green manufacturing firms and their supply chain partners
need to capture specific business values created in the market or to protect their own interests.
In other words, these parties are in a co-opetition relationship where cooperation and
competition coexist. In the form of inter-organizational knowledge sharing, cooperation has the
potential to increase each party’s knowledge base and, thus, competitiveness, as knowledge is a
source of competitive advantage. As such, firms would rather not share knowledge if they feel
that what they gain from cooperation is outweighed by losses from relinquishing their
monopoly over the knowledge.

External pressures, such as European regulations on take back and on the use of certain
hazardous substances, have been driving firms and governments to turn towards including
firms) in the environmental improvement process of entire supply chains for mainly two

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reasons. First, disruption risks engendered by environmental issues can pass on through
suppliers. For instance, in 2001, Sony had to bear extensive costs for replacing parts, storing,
and repackaging the nearly 1.3 million of its best-selling PlayStation, These PlayStations were
stopped at the Dutch border because unsafe levels of cadmium were detected in the cables of
the consoles (Business Week, 2005). The problem-causing cables were manufactured by
Sony’s suppliers.

Over the past decade, the green supply chain (GSC) has emerged as an important component of
the environmental and supply chain strategies of a number of companies. The GSC
encompasses a broad range of practices from green purchasing to integrated supply chains
flowing from suppliers, to manufacturers, to customers, and to the reverse supply chain, which
is “closing the loop”

Seen from a life-cycle perspective, initiatives striving to achieve the goal of the GSC, a notable
environmental and economic gain of the entire supply, are hard to implement successfully
without the deep involvement of the supply chain partners. In other words, it is crucial to
include firm’s suppliers in the supply chain-wide environmental improvement process.

A growing number of green supply chain management (GSCM) studies have dealt with the
drivers for GSCM, its practices, and the relationships between GSCM and its operational
and/or economic performance. However, scholarly works have primarily focused on large-
sized buying firms; so, they scarcely took into account the drivers to facilitate involvement of
suppliers in green supply chain programs that were likely to be initiated by the government and
large buying firms.

10.1.2 A GSC Initiative

A GSC initiative can be defined as the programs striving to transfer and disseminate
environmental management, in particular advanced environmental management practices,
through the entire supply chain, by using the relationships between large-sized buying firms
and their suppliers. The GSC initiative includes all the programs driven by buying firms and/or
third parties, particularly the government, with the purpose of improving the environmental
performance of suppliers through the buying firms’ influences.

When considering the buying firm-led GSC initiative, which is considered the intersection of
environmental issues with supply chain management, several terms are commonly used such as
green supply, environmental supply chain management , and green supply chain practices
.Although these terms are used often with subtle differences and within different contexts, they
can be understood as a buying firm’s intention to and activities that integrate environmental
issues into supply chain management in order to improve the environmental performance of
suppliers and customers . The third party-led GSC initiative is the environmental program that
facilitates environmental improvement of suppliers within the supply chain designed by
governments, non-for-profit organizations, and trade associations. In particular, government-
led environmental programs are becoming popular in some countries. The British

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government’s Energy-Efficiency Best Practice campaign, the United States Environmental
Protection Agency’s (US EPA) Environmental Technology Best Practice program, and the
Korean government’s Supply Chain Environmental Management (SCEM) initiative are good
examples. Although these initiatives are initiated by governments the core mechanism of
utilizing the relationship between large buying firms and their suppliers is almost identical to
the buying-firms-led GSC initiative.

There are seven types of GSC initiatives identified which support firms in improving their
environmental performance by classifying the organizations involved in arranging them:
governments, trade associations and sector bodies, partnership groups, individual companies,
business support organizations, non-for-profit green business-support organizations, and green
business clubs. Although the term of environmental business-support services interchangeably
used for green or GSC initiatives, the meanings of the terms are exactly the same. In their
classification, the company-driven initiative is equivalent to the buying firm-led GSC initiative
and other organizations-driven initiatives are equivalent to the third party-led GSC initiative.

Why are the governments as well as buying firms, in particular large-sized companies paying
more attention to suppliers?

Suppliers can be a source of environmental risk and a bottleneck in pursuing the goal of a
greener supply chain. In this situation, GSC initiatives are thought to be one of the key
mechanisms used to diffuse more advanced environmental management to less environmental
capable suppliers.

These initiatives are inter-organizational projects between the key-players in the supply chain:
the large-sized lead companies and their upstream and downstream suppliers. Many people
have perceived that a GSC initiative promotes efficiency and synergy among business partners
as well as their lead company. However; a GSC initiative cannot improve one player’s
efficiency and performance individually because the environmental performance of the supply
chain can be achieved only through the interaction of various activities undertaken by each
player. That is why the involvement and participation of suppliers is important in GSC
initiatives.

10.1.3. Greening the Supply Chain: The Reprocessing Flow

 The Reprocessing Flow is a critical part of “Greening the Supply Chain”

 The US Environmental Protection Agency (EPA) originally came up with the concept
of the “4Rs of waste management”: Reduce, Reuse, Reallocate & Recycle

 However, the growth and ongoing development of Remanufacturing must also be

recognized as an important contributor to the greening of the supply chain

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10.1.4 The Sustainable Supply Chain

 The concept of a sustainable SC, although relatively recent, is becoming increasingly

important

 It involves managing the SC - from raw materials to the final consumer, along with the
reprocessing of any waste materials - with the objective of protecting the environment
while also being socially responsible

 The champions of sustainable SCM are no longer the manufacturers, but rather the
retailers in response to public concerns

10.2 SUPPLY CHAIN SOCIAL RESPONSIBILITY

10.2.1 Supply Management Ethical Responsibility (SMER)

Ethics is the study of the standards of conduct that distinguish between right and wrong.
Ethical responsibility was once a nebulous concept that only occupied theoretical discussions
about the role of business in society. Recently, the theoretical discussions of ethical
responsibility spawned an activism that resulted in both negative publicity and earnings impact
for firms such as Nike and Conoco for overseas production problems and litigation processes.

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All of this activity has led to a great deal of concern about ethics in the minds of today’s supply
management (SM) executives. Supply managers, more than any other group within a firm,
encounter daily situations that put ethics to the test. SM can be viewed as “organizing the
optimal flow of high-quality, value-for-money materials or components from a suitable set of
innovative suppliers”

The subject of supply management, and more specifically supply management ethics, has
received insufficient coverage in the past, despite the key role that purchasing plays in a firm’s
overall processes including product design and selection, procurement of transportation and
third-party logistics services, supplier selection, and the management of inventory and supplier
relationships.

Research indicates that social responsibility is comprised of four hierarchically related duties:

1. Economic responsibility – to transact business and provide needed products and

services in a market economy;
2. Legal responsibilities – to obey laws, which represent a form of “codified ethics”;
3. Ethical responsibilities – to transact business in a manner expected and viewed by
society as being fair and reasonable, even though not legally required; and
4. Voluntary/discretionary – to conduct activities that are more “guided by business’s
discretion” than actual responsibility or expectation.

Supply Management ethical responsibility involves:

• Avoidance of showing partiality toward suppliers preferred by upper management;

• Allowing personalities to improperly influence the buying decision;
• Failure to provide prompt, honest responses to customer inquiries and requests;
• Lack of knowledge or skills to competently perform one’s duties;
• Failure to provide products and services of the highest quality in the eyes of the internal
customers;
• Receiving gifts or entertainment that influence, or appear to influence, purchasing
decisions; and
• Failure to identify the customer’s needs and recommend products and services that
meet those needs.

Further, the sensitive practices involving standards of conduct in purchasing are sorted into
nine categories. Of these categories, four represent avoidance of unethical SM behavior. These
are:

1. Acceptance of gifts;
2. Sharp practices, which, though short of fraud, are unscrupulous;
3. Reciprocity, or giving preference to a supplier who is also a customer; and
4. Personal purchases, which are clearly a misuse of trade discounts.

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The five remaining categories represent broad areas in SM where ethical dilemmas could arise
frequently. These are:

1. Competitive bidding;
2. Negotiation;
3. Presale technical or engineering services;
4. Everyday dealings with vendors; and
5. Informal design or production changes.

Supply management ethical responsibility (SMER) as managing the optimal flow of high-
quality, value-for-money materials, components or services from a suitable set of innovative
suppliers in a fair, consistent, and reasonable manner that meets or exceeds societal norms,
even though not legally required.

10.2.2 Corporate Social Responsibility, Corporate Governance, and Ethics

10.2.2.1 Corporate Social Responsibility (CSR)

Organizations in general and business entities in particular cannot survive without society.
They are basically meant to serve society. Hence, they are labeled as social constructs.

[Traditionally], business had been viewed as an economic institution with a sole objective of
profit maximization. Primarily, the justification goes in such a way that business is dependent
on society for acquisition of inputs like material, money and men for selling its produces.
Besides, business converts those inputs in to outputs in the society or at least locates its facility
within the society. And finally, business depends on society to sell its products.

However, in recent times, there has been increasing awareness and acceptance of social
objective as one of business objectives.

Even though corporate social responsibility is the popular name of the concept, many other
names or labels such as the following are also common: corporate responsibility,
organizational responsibility, corporate accountability, corporate ethics (some authors
differentiate), corporate citizenship, community relations, corporate sustainability, stewardship,
triple bottom line and responsible business, to name just a few.

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Meaning and Definition of CSR

The World Business Council on Sustainable Development [WBCSD] has defined corporate
social responsibility as “the commitment of business to contribute to sustainable economic
development, working with employees, their families, the local community and society at large
to improve their quality of life.”

It places CSR in the elements of sustainable development. CSR is viewed as being one of the
three key corporate responsibilities for sustainability that also includes economic responsibility
and environmental responsibility.

Business for Social Responsibility (BSR) (2005) defines CSR as “operating a business in a
manner that meets or exceeds the ethical, legal, commercial, and public expectations that
society has of business.”

Panayiotou, Aravossis, and Moschou (2008, pp 2) defined CSR as “the necessity and the duty
of an entity to behave responsibly, ethically and sustainably and to be transparently
accountable to its stakeholders”.

To the organization, the priority elements of corporate social responsibility are “human rights,
employees’ rights, environmental protection, corporate governance and ethics, supplier
relationship, community involvement, stockholders’ rights, anti-corruption measures, etc.

CSR as Cost

CSR has been viewed as purely cost to the business putting firms under financial strain and
competitive disadvantage.CSR even though looks the burden of business firms, it ultimately
results in societal cost as business firms transfer the cost incurred in discharging social
responsibility to the society by charging higher prices to their produces so as to recover the
cost incurred while performing social initiatives.

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The principles of CSR are blamed for conferring arbitrary power on businesses ultimately
leading to dominance of business firms on social values and cultures. Social responsibility
takes executive times, requires additional and perhaps unique skills leading to failure to
businesses. Finally, CSR is considered, by those opponents of CSR, as obstacle for competition
and free market mechanisms. As a result, resources will be misdirected and the efficiency of
the business system will go down. A business guided by the considerations of social
responsibility will be unable to take sound business decisions.

CSR is a win-win strategy/double sided sword

According to different argumentative theories and empirical studies, CSR is assumed or

proofed to have benefits to the society and to the businesses as well.

According to a result of Chinese enterprises survey carried out by Zu and Song (2008, pp 12)
indicated that engaging in CSR has no disadvantage to businesses rather it was found to be
positively associated with a tremendous increase in sales of the produces.

Porter and Kramer (2006, 56) concluded that CSR benefits not only the society but also the
business because in simple illustration healthy society, which may result from CSR initiatives,
is equally important to the business and to the society

This indicates that CSR has three level benefits. Through the formation of social capital, at one
level it benefits individual managers/owners/employees/ and at second level it benefits
business firms and the society as a whole. And, finally it benefits society, businesses and
individuals by contributing to common good.

CSR Benefits Society, for example,

• The benefits of CSR to the society is not a debatable issue

• CSR Supports society in Solving Problems

• CSR Supports government in development works

• CSR Enhances Sustainable development of a nation

• CSR is a modern Business Strategy

Mittal (2007) and Boehm(2002) listed the benefits of CSR as enhancement of public
reputation, reduction of risks, ease recruitment and better stability of competent employees,
good relations with suppliers, capital providers and government bodies, better market share
and better profitability of business organizations

CSR has a positive influence on the financial performance of firms and therefore benefits not
only society but also the business and owners

CSR and Financial Performance of firms

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The first view is that firms face a trade-off between social responsibility and financial
performance. Those holding this view propose that firms incur costs from socially responsible
actions that put them at an economic disadvantage compared to other, less responsible, firms.
A second, contrasting viewpoint is that the explicit costs of corporate social responsibility are
minimal and that firms may actually benefit from socially responsible actions in terms of
employee morale and productivity

Lee (2008) has demonstrated that most of the recent researches exploring the relationship
between the social performance and financial performance come up with findings that confirm
the presence of positive relationship between them. The trend in their relationship shows the
movement from mutual exclusion to close integration.

CSR and Competitiveness of firms

There are ample examples of empirical experiences of using corporate social responsibility as a
competitive weapon. Competitiveness, as very common in business literature, is the function of
company’s relationship with its environment and ability to provide superior products which
means that as far as a company works to improve its responsibility to customers, employees,
suppliers, general public and government which are all the components of the overall
environment, its competitiveness will be improved.

An empirical study conducted in China showed, consumers prefer to purchase goods and
services from the companies that are socially and environmentally responsible…., 82% of
consumers expressed the desire to do so including 23% who would do so even if the option is
more expensive.

Hemingway (2002) has provided a summary of a good deal of recent studies confirming the
presence of positive relationship between corporate social performance and customer attraction
or retention.

Stakeholders Approach to CSR

• Responsibility towards Customers

– The firm must always remember that its ultimate success is dependent on its
capacity of satisfying its customers.

• Responsibility towards Shareholders

– The stockholders are the owners of the business who have invested their money
in the firms. Hence organizations have a responsibility to the
stockholders/shareholders/owners

• Responsibility towards Employees

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 – The efficiency and success of business heavily depends on the workers managed
and handled to get their willing cooperation and to make them carry out their
tasks with their maximum ability and interest.

• Responsibility towards Suppliers

– Responsibility towards the suppliers emanates from the fact that their survival
and growth (partly or wholly) is dependent upon your survival-and growth.

• Responsibility towards community

Apart from the specific society segments with whom the firm interacts in the course
of conducting its business, an organization also has responsibility towards its
surroundings and the people living in the vicinity of its factory and office

• Responsibility towards the Environment

– All companies – regardless of size or sector – can have positive and negative
impacts on the environment. Negative impacts arise through the direct or
indirect consumption of energy and resources, the generation of waste and
pollutants and the destruction of natural habitats.

The institutional environmental policies, organization structure for environmental impact and
sustainability management; policy and practices for minimization of the usage of materials
resources, reuse and recycling policies and practices and so forth are the performance
indicators that can show the institutional performance level with respect to environmental
issues

CSR Theories

• Stakeholders theory

Stakeholder theory of CSR according to Jones, 1980 as cited in Mele (2006: 7) is related to the
belief that business entities have an obligation to all constituent groups in society in addition to
stockholders and beyond the minimum legal requirements. That is to mean that business
entities shall be held responsible to all internal and external (including remote) constituents that
have interest in the company and get affected by their operations or affects the operation of the
companies

• Political Theories

Business entities should assume social initiatives as governments may lack ability and
capabilities to solve social problems like, for example, environmental problems.

• Enlightened self- interest Theories/ Instrumentality theories

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According to Keim (1978, 33) the enlightened self-interest model is developed by Wallich and
McGowan in 1970. The model states that firms should invest only in projects or activities that
would yield a present value of the private benefit stream that does not exceed the sum of the
discounted private costs.

Furthermore, these investments must be in the interests of owners or investors of capital only.

• Agency Theory

According to Obalola (2008, 540) agency theory suggests the existence of a contract that
results in establishment of a fiduciary relationship between the principal and the agent.

As applied to business firms, this theory propagates the necessity of having contract between
the management (people in charge of discharging social responsibility) and shareholders of the
firm.

• Cause Related Marketing Theory

Cause related marketing theory is another type of theory that explains the motives behind
social involvement of firms.

The famous marketing guru, Philip Kotler has stated that cause related marketing is a form of
societal marketing and practiced for mutual benefits of the marketer and the customer

• Personal Satisfaction/ Altruism Theories

Murray and Montanari (1986,816) citing (Ostlund, 1977) stated that an empirical investigation
that has assessed the view points of Fortune 500 executives towards CSR shows that corporate
social action was driven basically by self-interest of firms.

• Legitimacy Theory

The legitimacy theory, as developed by Davis, states that businesses do have a social contract
with society. Hence, firms that do not operate in accordance with societal values will
eventually lose their legitimacy to exist and will fail to survive. And, hence, the theory implies
that as the political and legal environment are the reflections of societal expectations and
values so as to successfully accomplish the expected societal responsibilities.

Ethical Theories

These theories advocate that firms must accept social responsibilities as an ethical obligation

Corporate Governance
“The governance of the corporation is now as important to the world economy as the
government of countries” James D. Wolfensohn-President, World Bank.

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 “…corporate governance is concerned with holding the balance between economic and
social goals and between individual and communal goals. The governance framework
is there to encourage the efficient use of resources and equally to require accountability
for the stewardship of those resources. The aim is to align as nearly as possible the
interests of individuals, of corporations and of society.”Cadburry,2003
10.2.2.2 Corporate Governance Mechanisms

Governance mechanisms are tools that principals employ to align incentives between principals
and agents and to monitor and control agents.

Depending on the institutional context, the relative importance and influence of these
mechanisms differ. Anglo-Saxon economies in particular are characterized by strong external
governance mechanisms whereas the Rhineland and Japanese governance mechanisms exude a
greater reliance on internal control devices.

Internal governance

Internal governance mechanisms are usually sub-categorized into those involving the use of
board of directors, large shareholders, debt holders and executive compensation schemes.

Board of directors

The board of directors acts as a fulcrum between the owners and controllers of a corporation
and is a crucial link between the shareholders who are providers of capital, and the managers
who are the individuals who use that capital to create value. They are elected by the
shareholders of the firm and have a fiduciary role in relation to fulfilling their responsibilities
towards the shareholders they represent. Their duties and responsibilities involve hiring, firing,
compensating employees and advising top management (Denis, 2001).

The board is also responsible for making sure that the audited financial statements of the
company represent a true and fair picture of the firm’s financial position.

• Boards can consist of a mix of inside and outside directors.

• Inside directors are those that are linked with the controlling shareholders and are those
that hold senior positions in the firm. They are also referred to as executive directors.
These directors are represented on the board because they possess intimate knowledge
about company activities without which the board cannot perform its monitoring role.

On the other hand, outside directors are not employees of the firm. They owe their position on
the board due the specific expertise which they possess in areas that are valuable to the firm.

• Large shareholders

Large shareholdings mitigate the free-riding problems associated with innumerable

atomistic shareholders as they are better able to internalize the costs associated with

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 monitoring management. These shareholders are thus able to address the agency problem in
that they have a general interest in profit maximization and enough control over the assets
of the firm to have their interests’ respected.

• Debt holders

Large creditors or debt holders can assume the role of active monitors. They have large
investments in the firms’ to whom they lend funds and in common with equity owners,
debt holders too require adequate returns on their investments.

• Executive compensation schemes

Executive compensation focus on two principal concerns: the level of executive pay and
the sensitivity of pay to performance. Compensation is determined by the base salary,
bonuses, stock options and long-term incentive plans.

External governance

External governance mechanisms can be further sub-categorized into those involving the use of
takeovers and the influence of the regulatory environment.

Takeovers Prior to the 1980s, corporate governance structures were designed in manner that
shareholder concerns were rarely at the top of the managerial agenda. Hardly any attention was
paid to shareholder interests and management was loyal to the corporation rather than the
shareholder.

However, the 80s and 90s in the United States were characterized by problems related to use of
free-cash flow and the poor performance of conglomerate firms. Takeovers were seen as
mechanism to rectify this malaise. By acquiring control of the firm by purchasing its common
stock, an acquirer can improve the operations of the firm and realize a profit on the increased
value of the acquired shares.

• Legal and regulatory mechanisms

The legislative environment prevailing in an economy can be a significant determinant of the

manner in which firms are governed and the effectiveness with which minority shareholders
and other stakeholders are protected. The levels of investor protection, ownership
concentration, dividend policies, creditor rights and enforcement abilities are dealt here.

Ownership structure

• Ownership structure can typically be examined along the following two dimensions:
concentration and identity.

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 Ownership concentration is usually measured by computing the combined cash flow rights
of the largest or coalitions of large shareholders (for instance, top three or top five
shareholders).

• Identity

The identity of shareholders has important implications for corporate governance as

shareholders differ with regards to their objectives, the manner in which they exercise their
power and this is reflected in company strategy with regard to profit goals, dividends,
capital structure and growth rates. Shareholder identity can be broadly subcategorized into
two dimensions. Firstly, they can be categorized as inside or outside.

10.2.2.3 Ethics

Discipline of dealing with what is good and bad, or right and wrong, or with moral duty
and obligation

10.2.3 CSR in global supply chains

As the nature of many business relations is changing from companies manufacturing goods
within wholly owned facilities in national operations to companies engaging in supply chains
and supplier-based manufacturing across national borders, the concept of CSR is likewise
transforming. CSR is no longer the individual company’s domain; increasingly, it encompasses
the entire supply chain. In other words, multinational companies are not only expected to
behave socially and responsibly within their own juridical walls. They are also held responsible
for environmental and labour practices of their global trading partners such as suppliers, third
party logistics providers, and intermediaries over which they have no ownership .The calls for
CSR in global supply chains should particularly be seen in light of the fact that a large part of
global trade is conducted through systems of governance, which link firms together in various
sourcing and contracting arrangements.

The term “governance” implies that some key actors in the supply chain – often large
multinational corporations –take responsibility for the inter-firm division of labour and specific
participants’ capacities to upgrade their activities. Thus, they are able to control production
over large distances without exercising ownership. The key actors typically located in
developed countries include not only multinational manufacturers, but also large retailers and
brand-name firms. The power held by these corporations’ stems from their market power and
control over key resources needed in the supply chains of which they are part. Given their
power, these actors play a significant role in specifying what should be produced, how and by
whom.

The corporations might also provide technical support to their suppliers to enable them to
achieve the required performance. The growth of ‘global value chains’, through which
Northern buyers control a web of suppliers in the South, has led to calls for them to take

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responsibility not only for aspects such as quality and delivery dates, but also for working
conditions and environmental impacts”.

The pressure exerted on multinational companies comes from both internal and external
stakeholders such as customers, employees, unions, shareholders, business partners,
governments, NGOs and the media, who show an increasing concern for the environmental and
social conditions at offshore production locations, particularly in developing countries . This
concern is largely a result of an escalation of multimedia communication technology, which
makes it more difficult for companies to hide unethical practices at their suppliers. The
escalating flow of information across national and cultural borders has given rise to stories
about multinational companies’ irresponsible practices, such as violation of union rights, use of
child labour, dangerous working conditions, race and gender discrimination, etc.

By now, many multinational companies have responded to the pressure and expectations by
stakeholders by defining, developing and implementing systems and procedures to ensure that
their suppliers comply with social and environmental standards. Although firms choose their
own approach to systematizing the CSR efforts in supply chains, many studies reveal that the
most visible element in the approach of large multinational companies is the employment of
corporate codes of conduct. The number of codes of conduct has grown spectacularly since the
early 1990s.

Levi Strauss & Co.’s code of conduct labeled “Global Sourcing and Operating Guidelines”
from 1991 was the first of its kind in the international apparel industry (see
www.levistrauss.com). Whereas companies in the USA introduced such codes in the early
1990s, the use of codes did not become widespread among European companies until the mid-
1990s .In short, a code of conduct is a document stating a number of social and environmental
standards and principles that a firm’s suppliers are expected to fulfill. Codes of conduct are
increasingly introduced in contracts between a buyer company and its suppliers. They are
typically based on the values with which the individual firm wishes to be associated, and its
principles are often derived from local legislation and international conventions, standards, and
principles, such as UN’s Global Compact, the Global Sullivan Principles, Social
Accountability 8000, ISO 14001, Global Reporting Initiative, and the ILO Declaration on
Fundamental Principles and Rights at Work. In many large multinational companies, the codes
are accompanied by elaborate managerial systems for formulating, enforcing and revising the
standards outlined in the codes (Organization for Economic Co-operation and Development,
2001). However, empirical evidence has shown that many multinational corporations have
struggled with the issue of how to implement their codes of conduct in their global supply
chains.

Although corporate codes of conduct are now widely used by multinational corporations, not
all observers have a positive attitude towards the codes.

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Several empirical studies have been made to investigate how firms work with CSR-related
issues in their supply chains .Most of these studies are not only confined to large multinational
corporations, but include also SMEs.

The ILO has conducted an examination of codes of conduct implementation, which primarily
focused on providing an understanding of the various management systems implemented by
multinational corporations and their suppliers to establish, communicate and evaluate progress
towards attaining the objectives of their codes of conduct. A study is also made on CSR
policies of companies in 15 countries in Europe, North America and Asia.

However, despite many companies’ efforts to engage in CSR-related activities in their supply
chains, there is often a gap between the ethical standards expressed and the actual conditions at
the suppliers.

10.3 SUSTAINABILITY IN SUPPLY CHAINS

Until recently, both theory and practice within SCM have focused on issues such as integration
of processes across supply chain partners, cost-efficiency of supply chains, and customer
service. However, with the increased outsourcing of activities to developing countries and low-
cost countries in Central and Eastern Europe, growing concerns about social and environmental
impacts of production and consumption have led to a renewed interest in issues related to
reverse logistics, environmental management, green supply chain, and sustainable supply
chains.

Reverse logistics is mainly concerned with the role of logistics in product returns, source
reduction, recycling, materials substitution, reuse of materials, waste disposal and refurbish,
repair, and remanufacturing. Apart from source reduction, most of the activities listed are
performed after the consumers have disposed of the products.

Reverse supply chain – or closed-loop supply chain – is a relatively new term which
emphasizes that the management of returns cannot be limited to a single entity in the supply
chain, but has to encompass the entire supply chain from end customers and back to the
original suppliers of raw materials.

Green supply chains and sustainable supply chains are concepts that take a more holistic
systems perspective on the total environmental impacts of the supply chain on resources and
ecological footprints.

Greening the supply chain can save resources, eliminate or reduce waste, and improve
productivity and competitive advantage at the same time. Greening initiatives include

proactive “design for disassembly”, “design for remanufacturing”, use of sustainable raw
materials (e.g. recoverable wood and recycled materials), use of recoverable energy resources
(solar energy, wind and wave energy), use of environmentally friendly transport modes (e.g.

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trains instead of trucks or airfreight), and focus on high capacity utilization of transport modes
and production facilities.

10.4 Self-Assessment Questions:

1. What is Supply management ethical responsibility? Explain.

2. Discuss the concept of Global Supply Chain Initiative?
3. Compare and contrast the difference between corporate social responsibility and Supply
Chain Social Responsibility?
4. How is Green Supply Chain Management possible?
5. Discuss the concept of Sustainable Supply Chain
6. How is ISO 14000 related to green supply chain management? Discuss.
7. Who should be most responsible for environmental pollution among the supply chain
members?
8. How is knowledge workforce utilized in the supply chain management approach?
Discuss.
9. Discuss ethical issues to be followed by the supply chain manager in an organization?
10. How is Global Environmental Management Initiative’s objective coincided with Global
Supply Chain Initiative? Discuss.

10.5 Chapter Summary

Much attention has been paid to the importance of GSC initiatives, which are inter-
organizational projects striving to improve environmental performance as well as economic
efficiency throughout the entire supply chain.
CSR is no longer the individual company’s domain; increasingly, it encompasses the entire
supply chain
All of this activity has led to a great deal of concern about ethics in the minds of today’s supply
management (SM) executives. Supply managers, more than any other group within a firm,
encounter daily situations that put ethics to the test
Greening the supply chain can save resources, eliminate or reduce waste, and improve
productivity and competitive advantage at the same time
With the increased outsourcing of activities to developing countries and low-cost countries in
Central and Eastern Europe, growing concerns about social and environmental impacts of
production and consumption have led to a renewed interest in issues related to reverse logistics,
environmental management, green supply chain, and sustainable supply chains.
Key Terms:
Corporate Social Responsibility (CSR) - it describes the relationship between business and the
larger society and a company’s voluntary activities in the area of environmental and social
issues

Green supply chains and sustainable supply chains are concepts that take a more holistic
systems perspective on the total environmental impacts of the supply chain on resources and
ecological footprints.
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GSC initiative can be defined as the programs striving to transfer and disseminate
environmental management, in particular advanced environmental management practices,
through the entire supply chain, by using the relationships between large-sized buying firms
and their suppliers

Case
The recent world climate change and the consequent global warming, along with earth quake,
sea quake in the Asian countries; floods, droughts ,and famine in African countries made
global leaders to worry about and come up with solutions to mitigate the problems of climate
change occurred as a result of industrial pollution and deforestation.
As a result of global warming, countries started to get victimized. In addition, supply chain
trading partners are indirectly facing the consequences of global warming.

Question:
Do you think that all members in the supply chain are socially responsible for environmental
pollution or legally responsible to protect the environment and hence the global warming?
Debate!

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 CHAPTER ELEVEN

VALUE CHAIN ANALYSIS

In this chapter you will learn the following concepts:-

11.1 The Value Chain and Value Chain Analysis

11.2 The importance of value chain
11.3 Value chain as a decision tool
11.4 Value Chain Approach to MRP for Agricultural Commodities in Ethiopia
11.5 Self-Assessment Questions
11.6 Chapter Summary

Objectives
After reading this chapter, you will be able to:

differentiate value chain from value analysis

provide a practical benefit of value chain

demonstrate value chain approach to Ethiopian agricultural commodities

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 11.1. Value Chain and Value Chain Analysis

The value chain describes the full range of activities which are required to bring a product or
service from conception, through the different phases of production (involving a combination
of physical transformation and the input of various producer services), delivery to final
consumers, and final disposal after use.
The value chain concept is a systems approach that evolved over time drawing from different
disciplines (da Silva and de Souza Filho 2007). The scientific discussion about the vertical
integration of production and distribution processes started in the 1960s. The ‘filière’ concept
was developed at the French Institut National de la Recherche Agronomique (INRA) and the
Centre de Coopération Internationale en Recherche Agronomique pour le Développement
(CIRAD) as an analytical tool to study the ways in which agricultural production systems were
organized in the context of developing countries.
The framework paid special attention to how local production systems are linked to processing
industry, trade, export and final consumption (van den Berg et al 2009). The concept was used
to describe the flow of physical input and services in the production of a final product and in
terms of its concern with quantitative technical relationships. However, ‘filière’, which means,
trade analysis tended to be viewed as having a static character, reflecting relations at a certain
point in time. It did not indicate the growing or shrinking flows either of commodity or
knowledge nor the rise and fall of actors (Roduner 2004).
The concept of the sub-sector, first introduced by Shaffer (1970), was also an important
conceptual development related to value chains. A sub-sector is “an interdependent array of
organizations, resources, laws and institutions involved in producing, processing and
distributing an agricultural commodity”. A sub-sector thus involves a set of activities and
actors and the rules governing those activities (Staatz 1997). Sub-sector analysis encompasses
a meaningful grouping of economic activities linked horizontally and vertically by market
relationships. It involves studying the networks of relationships linking suppliers, processors,
transporters and traders in ways that connect producers and enterprises with final consumers of
goods and services.
In the mid 1980s, Porter developed the value chain analysis as an instrument for identifying the
value of each step in the production process. The concept of value chain is utilized as a
conceptual framework that enterprises can use to detect their sources of competitive advantage.
Porter argued that the sources cannot be detected by looking at a firm as a whole; rather the
firm should be disaggregated in a series of activities. Porter identified (1) primary activities,
which directly contribute to add value to the production of goods and service and (2) support
activities, which have an indirect effect on the final value of the product (van den Berg et al
2009).

The value chain concept had been developed as a tool for competitive analysis and strategy by
Michael Porter where inbound and outbound logistics are primary components of the value

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chain, which is contributing value to the firm’s customers and making the company financially
viable (Langley et al., 2006).

This implies value chain is created as a result of intra-supply chain (functions involved in
primary and supporting activities of the organization to create value) and inter-supply chain
(cooperation of trading partners) in delivering value to the market.

As portrayed by Michael Porter (1985) Value Chain Analysis is presented in the following
figure.

Figure 11.1 Value Chain Analyses (Michael Porter, 1980, 1985)

The primary activities are: inbound logistics, operations, outbound logistics, marketing and
sales and services.

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The goal of these activities is to offer the customer a level of value that exceeds the cost of the
activities thereby resulting in a profit margin (Roduner 2004). Porter introduced the ‘value
system’ as an alternative way of approaching the search of competitive advantage.
A value system includes the activities implemented by all the firms involved in the production
of goods or provision of services, starting from basic raw materials to those engaged in the
delivery to the final consumers. The concept of value system is therefore broader compared to
‘enterprise value chain’ (van den Berg et al 2009). However, in Porter’s framework, the
concept of value system is mostly a tool for assisting executive management in strategic
decisions. The value chain analysis, according to Porter’s approach, is therefore restricted to
the firm level neglecting the analysis of upstream or downstream activities beyond the
company (Fasse et al 2009).

In the real world, of course, value chains are much more complex than this.

Global commodity chains, introduced into the literature by Gereffi during the mid-1990s.
Gereffi’s contribution has enabled important advances to be made in the analytical and
normative usage of the value chain concept, particularly because of its focus on the power
relations which are imbedded in value chain analysis. By explicitly focusing on the
coordination of globally dispersed, but linked, production systems, Gereffi has shown that
many chains are characterized by a dominant party (or sometimes parties) who determine the
overall character of the chain, and as lead firm(s) becomes responsible for upgrading activities
within individual links and coordinating interaction between the links. This is a role of
‘governance’, and here a distinction is made between two types of governance: those cases
where the coordination is undertaken by buyers (‘buyer-driven commodity chains’) and those
in which producers play the key role (‘producer-driven commodity chains’).
11.2. Why Is Value Chain Analysis Important?
There are three main sets of reasons why value chain analysis is important in this era of rapid
globalization. They are:
• With the growing division of labor and the global dispersion of the production of
components, systemic competitiveness has become increasingly important
• Efficiency in production is only a necessary condition for successfully penetrating global
markets
• Entry into global markets which allows for sustained income growth – that is, making the
best of globalization - requires an understanding of dynamic factors within the whole
value chain.
11.2 The Growing Importance of Systemic Competitiveness

Adam Smith observed that the division of labor was determined by the extent of the market. By
this he meant that small scale markets allowed for little specialization –the entrepreneur
making a small number of chairs employed no-one and undertook all the different tasks that
were required in making the final product. But, as the market expanded, it became profitable to
employ workers, and to allow each of them to specialize. Smith argued that specialization of

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task meant that workers did not waste time picking up and putting down their work-in-
progress, and allowed them to concentrate on developing their specific skills. Moreover, it also
opened the way to the introduction of mechanization as simple, repetitive tasks were much
easier to mechanize than complex tasks. But, increasingly, the approach towards intra-plant
and inter-firm production organization shifted towards a more systemic focus.

A second reason promoting systemic thinking was that the use of electronics-based automation
technologies in different parts of the plant led to the possibility of coordinating the different
machines through EDI (electronic data interchange). And, finally, the need to get products to
the market more quickly meant that the historical division among development, design,
production and marketing had to be bridged. Rapid product innovation required that these
formerly distinct functions work together in a process of “parallel/concurrent” engineering.
This systemic approach towards intra-plant and intra-firm efficiency began to spill over into
thinking about inter-firm linkages during the 1980s. Here, two developments were particularly
important. First, Toyota in Japan had shown from the late 1970s that the development of just-
in-time, total quality management and continuous improvement procedures within the firm
might make no discernible difference towards its own competitiveness unless its various tiers
of component suppliers – accounting for 60-70 percent of total product costs.
Lean Production (also referred to as World Class Manufacturing) has its origins in three sets of
linked organizational innovations which were first developed in Japan. These are:
• Just in time production (JIT), which focuses on pulling rather than pushing inventories
through the enterprise, providing materials and products in just the right quantities, at
just the right time and in just the right place
• Total Quality Management (TQM) involves checking quality during the production
process rather than at the end of the production process
• Continuous Improvement (CI) involves the whole labor force participating in a focused
programme of incremental changes which adds up to significant and rapid change over
time.
Originally developed to further in-plant efficiency, it soon became apparent that their impact
would be limited unless in-plant changes were complimented by equivalent changes in the
relationship between different links in the value chain.

Value chain analysis therefore plays a key role in understanding the need and scope for
systemic competitiveness. The analysis and identification of core competences will lead the
firm to outsource those functions where it has no distinctive competence.

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11.3. Is The Value Chain A Heuristic Device Or An Analytical Tool?
The value chain is a descriptive construct, at most providing a heuristic framework for the
generation of data. However, recent developments in value chain theorization have begun to
provide an analytical structure.
There are three important components of value chains which need to be recognized and which
transform an heuristic device into an analytical tool:
♣ Value chains are repositories for rent, and these rents are dynamic
♣ Effectively functioning value chains involve some degree of ‘governance’
♣ There are different types of value chains

11.3.1. Three key elements of value chain analysis

a. Barriers to entry and rent
The value chain is an important construct for understanding the distribution of returns arising
from design, production, marketing, coordination and recycling. Essentially, the primary
returns accrue to those parties who are able to protect themselves from competition. This
ability to insulate activities can be encapsulated by the concept of rent, which arises from the
possession of scarce attributes and involves barriers to entry.
There are a variety of forms of rent. The focus of much of the literature, entrepreneurial
energies and government policies is on what is called economic rents.
The classical economists (such as Ricardo) argued that economic rent accrues on the basis of
unequal ownership/access or control over an existing scarce resource (eg. land). However as
Schumpeter showed, scarcity can be constructed through purposive action, and hence an
entrepreneurial surplus can accrue to those who create this scarcity.
Following the introduction of a ‘new combination’ the entrepreneur reaps a ‘surplus’ – what
we might term a producer rent. Then as this is copied – a process of diffusion – the producer
rent is whittled away, prices fall, and the innovation accrues in the form of consumer surplus.
In summary, economic rent:
♣ Arises in the case of differential productivity of factors (including entrepreneurship)
and barriers to entry (that is, scarcity)
♣ Takes various forms within the firm, including technological capabilities,
organizational capabilities, skills and marketing capabilities (such as brand names).
(These cluster of attributes are often discussed in relation to dynamic capabilities and
core competences in the literature).
♣ But they may also arise from purposeful activities taking place between groups of firms
– these are referred to as relational rents.
♣ Have become increasingly important since the rise of technological intensity in the
mid-nineteenth century (Freeman, 1976) and the growth of differentiated products after
the 1970s (Piore and Sabel, 1984).
♣ Is dynamic in nature, eroded by the forces of competition after which it is then
transferred into consumer surplus in the form of lower prices and/or higher quality

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The process of competition – the search for ‘new combinations’ to allow entrepreneurs to
escape the tyranny of the normal rate of profit, and the subsequent bidding away of this
economic rent by competitors – fuels the innovation process which drives capitalism forward.
As more and more countries have developed their capabilities in industrial activities, barriers to
entry in production have fallen and the competitive pressures have heightened.

b. Different Forms of Economic Rent

1. Economic rent arises in the case of differential productivity of factors and barriers to entry
2. There are a variety of forms of economic rent prevalent in the global economy;
Some are endogenous and are “constructed” by the firm and are classical Schumpeterian rents:
♣ Technology rents – having command over scarce technologies
♣ Human resource rents – having access to better skills than competitors
♣ Organizational rents – possessing superior forms of internal organization
♣ Marketing rents – possessing better marketing capabilities and/or valuable brand names
Other rents are endogenous to the chain, and are constructed by groups of firms:
♣ Relational rents – having superior quality relationships with suppliers and customers
3. But rents can also be exogenous to the chain and arise through the bounty of nature:
♣ Resource rents – access to scarce natural resources
4. Producers can also gain from the rents provided by parties external to the chain:
♣ Policy rents – operating in an environment of efficient government; constructing
barriers to the entry of competitors
♣ Infrastructural rents – access to high quality infrastructural inputs such as
telecommunications
♣ Financial rents – access to finance on better terms than competitors
5. Rents are dynamic – new rents will be added over time, and existing areas of rent will be
eroded through the forces of competition

Governance
A second consideration which helps to transform the value chain from an heuristic to an
analytical concept is that the various activities in the chain – within firms and in the division of
labour between firms – are subject to what Gereffi has usefully termed ‘governance’ (Gereffi,
1994). Value chains imply repetitiveness of linkage interactions. Governance ensures that
interactions between firms along a value chain exhibit some reflection of organization rather
than being simply random. Value chains are governed when parameters requiring product,
process, and logistic qualification are set which have consequences up or down the value chain
encompassing bundles of activities, actors, roles, and functions.
Value chains are coordinated at different places in the linkages in order to ensure these
consequences (intra firm, inter firm, regional) are managed in particular ways. Power
asymmetry is thus central to value chain governance. That is, there are key actors in the chain
who take responsibility for the inter-firm division of labor, and for the capacities of particular
participants to upgrade their activities.

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In trying to understand the role of governance in global value chains we can be informed by the
discussion of governance in civil society. Here, four elements are relevant:
♣ There is an important distinction among the three functions of government (the
“separation of powers”) - the legislature (making the laws), the executive
implementing the laws) and the judiciary (monitoring the conformance to laws)
♣ To be effective, the power to govern requires the capacity to make sanction on
behavior; these sanctions are generally negative and are directed against transgressions
(the “stick”), but they may also be positive and may reward conformance (the “carrot”)
♣ In the long run, sustained governance reflects the legitimacy of those in power.
♣ The remit of power may vary in intensity and in physical and economic space.
Beginning with the classical separation of powers, it is possible to distinguish three forms of
value chain governance. First, the basic rules which define the conditions for participation in
the chain need to be set. In the past, these rules were largely concerned with meeting basic cost
parameters and guaranteeing supply, but increasingly as Japanese management practices spread
during the 1990s, the critical success factors came to include what is known as “QPD” (that is
quality, price and delivery reliability). More recently, the “rules” of participation have
increasingly come to include conformance to international standards such as ISO9000 (on
quality), ISO14000 (on environment), SA8000 (labor standards) and other industry-specific
standards such as phyto-sanitary and HACCP (hazard analysis and critical control point) in the
food processing industry. The definition of these various sets of rules as defining the basis of
participation in value chains can be termed ‘legislative governance’, i.e. setting the parameters
governing the value chain.
But, it is also necessary to audit performance and to check compliance with these rules – this
can be seen as ‘judicial governance’, i.e. coordinating the conformance to the set parameters.
However, in order to meet these rules of participation, there needs to be some form of
proactive governance (which might be termed ‘executive governance’) which provides
assistance to value chain participants in meeting these operating rules, i.e. managing the
various subordinate links in the value chain.

Examples of legislative, judicial and executive value chain governance

Legislative governance-Setting standards for suppliers in relation to on-time deliveries,
frequency of deliveries and quality
Judicial governance-Monitoring the performance of suppliers in meeting these standards
Executive governance- Supply chain management assisting suppliers to meet these Standards
Producer associations assisting members to meet these standards.

The final characteristic of governance concerns its depth and pervasiveness that is its
“richness” and “reach” (Evans and Wurster, 2000). By depth we refer to the extent to which it
affects the core activities of individual parties in the chain.
c. Different types of value chains
Building on this concept of governance, Gereffi has made the very useful distinction between
two types of value chains. The first describes those chains where the critical governing role is

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played by a buyer at the apex of the chain. Buyer-driven chains are characteristic of labor
intensive industries (and therefore highly relevant to developing countries) such as footwear,
clothing, furniture and toys. The second describes a world where key producers in the chain,
generally commanding vital technologies, play the role of coordinating the various links –
producer-driven chains. Here, producers take responsibility for assisting the efficiency of both
their suppliers and their customers.

Buyer and Producer Driven Value Chains

“Producer-driven commodity chains are those in which large, usually transnational,
manufacturers play the central roles in coordinating production networks (including their
backward and forward linkages). This is characteristic of capital- and technology-intensive
industries such as automobiles, aircraft, computers, semiconductors, and heavy machinery.”
“Buyer-driven commodity chains refer to those industries in which large retailers, marketers,
and branded manufacturers play the pivotal roles in setting up decentralized production
networks in a variety of exporting countries, typically located in the third world. This pattern of
trade-led industrialization has become common in labor-intensive, consumer goods industries
such as garments, footwear, toys, house wares, consumer electronics, and a variety of
handicrafts. Production is generally carried out by tiered networks of third world contractors
that make finished goods for foreign buyers. The specifications are supplied by the large
retailers or marketers that order the goods” (Gereffi, 1999).

11.4. Value Chain Analysis Approach to Maximum Retail Price (MRP) in Ethiopia

The need for managing supply chain and adopting supply chain management practice through
integration with partners is inevitable for Ethiopian firms, because it is not only a source of
competitive advantage for these firms but also a question of survival even as followers as the
firms are already in the global market competing with global companies(Matiwos:2009).

However, the practices in every sector (manufacturing, agriculture, construction, service, etc)
of Ethiopia, have arms length relationship and have rivalry relationship and compete among
each other instead of cooperation. As a result, market is distorted and price is unreasonably sky
rocketed, even if other factors were attributed to the cause. The increase in the price of goods
and services in the market is because of lack of cooperation among players in the market and
motivation of some players in the market (especially, importers, wholesalers, distributors,
retailers and commission agents who try to speculate on the future prices of goods and hoard
and hold goods by creating artificial shortage in the market.) Because of information
asymmetry by some players the bullwhip effect has been created- the distortion in information
with regard to goods availability (stock out/shortage) in the market which is magnified as one
goes from market (buyer side-the downstream) to supplier (upstream side). This forced the
government to set price cap on commodities and some imported goods before two years. In

190
effect, it seems the action taken by the government worked especially in the short term and, at
least, from the buyers’ point of view. The price cap solution approach to price increase in
essential commodities in Ethiopia can be said it was not an effective solution. Because, the
government failed to realize the unintended consequences of the price cap on the whole supply
chain from source to end which actually brought general price increase, unavailability of
certain essential items like oil, sugar, hoarding of some items by traders, shortage of imported
goods in the market are among the problems encountered.

After reasonable period of time the problem exacerbated and forced the government to lift the
price cap on certain items and maintain price cap on essential items. This action again brought
a chain effect of going for re registration by the traders for trade license and the logistics part
of essential goods to be delivered via government agencies and the like. As a result, stock
out/unavailability of goods is common in the market of Addis Ababa and even severe in the
regional towns of Ethiopia. These raise the question of the effectiveness of price capping
strategy taken by the government in Ethiopia and under what conditions such strategy works.

The effective strategy of price capping or maximum retail price of goods(MRP) works only by
looking in to the market structure in the flow of goods from source to end(suppliers’ of
suppliers to customers’ of customers)-the essence of value chain analysis.

Therefore, sustained solution to inflationary pressure and price speculation by intermediary

traders between farmers (suppliers) and consumers in Ethiopia is through effective value chain
analysis of all commodities and tagging price at each stage of the value chain to the point of
retail shop using maximum retail price setting and allowing commodity tracking at every stage
of commodity movement from farmer/supplier to consumer via intermediaries.
11.5 Self-Assessment Questions
1. Differentiate between value chain and value chain analysis
2. What are the reasons promoting systemic thinking?
3. Describe the three key elements of value chain analysis
4. How do you explain the way supply chain is managed in Ethiopia? What are the
consequences of such management?
11.6 Chapter Summary
The value chain describes the full range of activities which are required to bring a product or
service from conception through the different phases of production, delivery to final

191
consumers, and disposal after use. The primary activities are: inbound logistics, operations,
outbound logistics, marketing and sales and services. Value chain analysis is an instrument for
identifying the value of each step in the production and delivery process.

192
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