What Has Not Changed in Supply Chains Because of E-Business?
Many articles have been written arguing that Supply Chain Management is - and will continue to be - very different because of the opportunities offered by Web-based information systems. Many speakers say that "everything is different" than it was two or three years ago. We agree wholeheartedly with the first statement, and disagree with the second. There are many eternal verities in managing supply chains, and the battlefield is littered with corporations who forgot or ignored them.
Sharing inventory status, sales data, forecasts and product information via the Internet provides opportunities to better manage assets and customer service. But the assets and customer service must still be managed. An abundance of evidence suggests that any company that deals with physical products needs to improve the physical flow of products, to provide what both customers and Wall Street want from them.
What Has Not Changed?
If we ask "what has not changed," we must also ask "since when?" We consider the last 20 years. The 1980s saw the quality revolution; now we are in the midst of an (another?) information revolution. The world of supply chains has been dramatically altered by both of these. But the topics below remain unchanged in principle; of course, the way in which a firm reacts to these does change as time is compressed. For companies that make, move, store or sell a physical product, we group our discussion into four categories. Firms that forget these verities do so at their peril, in both B2B and B2C markets.
Only "total cost" matters, and "companies do not compete, their supply chains do." Technology makes it possible to reshape a supply chain more easily, but firms still need a clear strategy with a focus on "total cost" from the customers' view. (Here, we could also use "total value," to include quality, delivery and other attributes.)
Tradeoffs are forever. Companies must select some performance attributes to favor at the expense of others. Didn't your mother tell you that you can't have everything? For what product and service attributes will the customer pay?
Uncertainty is certain. Web communication only removes some of the uncertainty. As long as some remains, countermeasures ("buffers") will be needed.
Old approaches to dealing with issues one to three, in both operations management and marketing, remain valid. The fundamental "laws" of inventory and manufacturing have not been repealed.
1. Only "Total Cost" Matters
Everyone knows this. Then why are people impressed that Dell makes its suppliers carry the inventory? If that was all Dell did, we would not know this company. The customer ultimately pays for the inventory wherever it is. Dell is successful, among other reasons, because: they have lower customer acquisition costs; they effectively share information within and manage their supply chain; they keep product complexity in check; they try to manage surges in demand; and they have some extra capacity to respond to surges.
Question: Why can Dell afford "excess" capacity in manufacturing?
Answer: Because inventory for a high-tech product costs between 60 and 100% per year of the item value, if properly analyzed (see Figure 1). Also, they need less capacity because they manage complexity well. Will their approach work in all situations? No.
Figure 1- Annual Inventory Costs, as a Percent of Value
Some dot-com companies offer "free" transportation, right? Of course not. The customer eventually pays, in normal circumstances. Up to now, shareholders have been willing to pay for us. We thank them, but we do not expect that to continue. When transportation cost is added, customers should only care what the total bill is, not who gets which part.
Question: Why did Amazon offer "free" delivery before December 10, 2000?
Answer: It allowed them to reduce cost sufficiently that they could "pay" customers for early orders. Both parties benefited; this does not contradict the above statements.
2. Tradeoffs are Forever
We cannot reduce inventory to zero and have fast response, unless we have a huge amount of excess capacity in the production-distribution system. (It may be more appropriate to have excess capacity if inventory is relatively expensive, as shown in Figure 1 for some high-tech products.) If it is possible to improve both inventory and service, e.g., then either you were managing poorly (off the "efficient frontier") or there is a new technology that shifts the efficient frontier (see Figure 2). In either case, once the improvement is made, the tradeoff is present again. Tradeoffs often are complicated, and involve several terms, not just two. Different parameters are important in different situations, but tradeoffs should consider at least the fixed cost of production, inventory, speed and reliability of service, and number of options offered.
Figure 2- The Inventory/Service Tradeoff
Consider transportation cost. The B2C explosion has made some home delivery companies successful, implying that transportation costs have increased while inventory (and other) costs have been reduced. This will not be appropriate for all products or all customers. Some of us will pay extra to save time; others will be pleased to move the product the "last mile" to save money.
Marketing and operations strategy still requires choices of what we will be and to whom. Not everyone can take over the world, and probably no one will. Tom Ehrenfeld in The Standard (thestandard.com, Spring, 2000) describes "The Old Rules That Rule the New Economy." He says "Profit Matters, People Matter, Character Counts, and Purpose Matters." We agree with all four. The fourth one, "Purpose Matters" fits this section. This implies having a strategic plan that specifies which services we will provide to whom. We must select some customers, understand their needs, and have an operational plan that serves those needs from initial contact to returns and/or service.
3. Uncertainty Will Remain, So "Buffers" Will Still Be Needed
When information moves faster, the main benefit is that firms face a shorter period of uncertainty, no matter how long production and transportation take. POS data, inventory status and production schedules can be transmitted quickly. This is a major change due to e-biz. But there still is a period of uncertainty, and we need "buffers" to mitigate the effects of uncertainty. Only three buffers exist: inventory, "excess" capacity (above the amount needed on average), and customer waiting time.
Question: Which of the "three buffers" does McDonalds use?
Answer: All three, in small amounts.
Question: Why can Solectron (for example) respond quickly?
Answer: They have "surge" or "excess" capacity.
Even if all POS data were received instantaneously, production schedules often cannot be changed instantaneously. Some "frozen horizon" is needed to allow for planning, and some inventory is needed to protect against the difference between the plan and actual demand. Pharmaceutical factories, e.g., cannot change between products after every unit. The changeover cost and time are prohibitive. Even if changeover time is short, there are other reasons why maintaining total flexibility will be too expensive. Can the frozen horizon be reduced? It should be, up to a point selected based on costs.
Reducing information-processing time is crucial and effective. However, reducing physical flow time is more difficult, and there are variable as well as fixed costs associated with doing so. Many supply chains have been reducing total flow time (and therefore variability) since the early 80s. But, we have seen companies that have just started this journey, and others who believe much more reduction is possible, even after reductions of over 50%. Thus, companies must continue to improve the basic blocking and tackling of manufacturing and distribution. The Internet does not reduce changeover time or process variability or make manufacturing more flexible. It can reduce (but not eliminate) uncertainty about demand; customers will continue to want what they want, when they want it, and some information lag (or data inaccuracy) will always exist.
4. Some Old Responses to the Changing World Still Work
The concept of "mass customization" has been around for a long time. It is more important now. The "Dell Model," as the press sometimes calls it, involves complexity reduction and postponement of differentiation (for product and process design). These take dedication and time. The automobile industry has been talking about a "three-day car" for a long time, but the product is much more complex than a computer. If they have more common parts and fewer parts, then the B2B part of that supply chain, which constitutes most of the chain, will be cheaper to operate. Firms can then afford "excess" capacity at the finishing (assembly) stage. Finish (or assemble) to order is not new; it may apply to more industries than before, now that we can have better and faster information.
Another good, old idea is centralized inventory. If demand is unpredictable, holding inventory in one location (aggregating demand) can dramatically reduce total inventory. Of course, either service suffers and/or transportation cost goes up. Current information capability allows "virtual" centralization, in which inventory at all locations is visible, so any inventory can satisfy demand anywhere. Caterpillar maintains such a system.
Question: Why would Caterpillar want to have "virtual inventory centralization" instead of actual centralization?
Answer: If demand is very low, virtual centralization often involves transporting an item twice, which increases cost. But, the first shipment can go to a place that has higher probability of need than average, and the first transportation cost can be lower due to economies of scale or less need for speed. Considering total cost, "virtual" can be better.
Cadillac sells a "one-day car" by maintaining a centralized inventory of commonly-sold configurations. The "square-root rule" says that if we centralize N locations we need the square root of N times the old inventory compared to a decentralized system. This is not a "rule" for several reasons; it overstates actual savings. And, transportation costs may go up. Still, the savings can be dramatic, and total cost may be reduced.
In a supply chain (or any portion thereof) inventory is directly related to the flow time for material in the chain. If you want to be fast, reduce inventory; if you want to reduce inventory, be fast. Reducing information flow time helps. But the nature of the physical system makes it a mistake to simply reduce the inventory without making the other changes (changeover time, process uptime and reliability, first-pass yield, and so on) required to ensure that service level or some other aspect of performance does not suffer.
In operations management, with or without the Internet, firms must "buy, produce, store, deliver and provide after-sale service." Some pure "clicks" companies appear to be having more trouble with this than firms with "bricks." Of course the Internet provides better ways of managing operations. "M2M" (manufacturing to manufacturing transfer of information, where production schedules are really shared and even automated) is one example. Still, core business processes must continually be analyzed, tracked and improved; managing the reverse flow of products is one important example.
New Ideas or Phrases We Would Like to Banish
It is frequently said that "information has replaced inventory." What does this mean? (It does not mean that people want the information about their refrigerator instead of the refrigerator!) Inventory formulas in many commercial-software products compute inventories using a variety of factors including the variability of demand per day and the length and variability of lead-time. Information speed reduces the period of uncertainty and, therefore, the lead-time and the inventory. But the approach is unchanged. One caveat is that the models built into software are imperfect. As time is compressed, the error due to these imperfections may increase. This phenomenon is analogous to the discrepancies inherent in using Newtonian physics to describe bodies moving near the speed of light. In order to understand this new, faster business world, we may need to replace our "Newtonian" inventory theory with a new, more comprehensive theory. And it has always been true that more accurate information is more important than the "model" one uses.
Business 2.0 ("The 10 Driving Principles of the New Economy," March, 2000) said:
"'Matter' matters less; processing information is more cost-effective than moving physical products. Distance has vanished, and time is compressed."
Item one is correct only in that we may be able to move the refrigerator to the right time and place better than in the past, but the customer still wants a refrigerator, not information. Items two and three apply only to the information part of the exchange. Distance does matter. Locating production in Asia implies long and variable delivery time and/or expensive delivery to North America. This may be appropriate, but the laws above apply to the analysis.
We're Not Really Curmudgeons
Some important changes are occurring. (OK, so we are curmudgeons, but we understand the importance of the Internet.)
There have always been both costs and benefits associated with cultivating and maintaining long-term relationships. Internet based procurement (auctions, exchanges, online catalogs, etc.) dramatically reduces the relationship costs. Total cost of procurement is reduced in several ways: cost of managing procurement, purchase price and inventory reduction (due to speed of processing). When long-term relationships remain, the vendor must be part of product or supply chain design.
The trend toward focus is continuing. We do what we do well, and we buy everything else. Can this go too far? Of course. How do we insure that our core competence will be useful tomorrow? By understanding that power can shift in the supply chain more quickly because of the Internet. Contract manufacturing is growing, but the contract manufacturer can be tomorrow's competitor, especially as we contract out more of the process (including some design work). Maybe retaining some "non-core" competencies is a smart hedge against an uncertain future.
Operations research models are back in fashion. The information is available to do more optimization than ever before, including optimization across organizational barriers. Of course, the software does not really "optimize." Rather it tries to find a reasonably good solution. But that can be a major step forward. Competing successfully is not about being optimal, but about being better than your competitor.
New infomediaries, fewer barriers to entry, and global competition, will continue to put pressure on firms to segment their markets (so as to extract a premium) and reduce operating costs (so as to keep more of their revenue). Strategic advantage will be short lived.
Some Intriguing Questions
"Logistics" costs have come down in many parts of the world for 20 years, to nearly half the old values as a per cent of GDP (see Fig. 3). Will that continue? Internet companies use small shipments and individualized products. Transportation cost, the largest part of logistics cost, is likely to increase. "Drop shipping" is an expensive way to ship most items, and the customer will pay, eventually.
Figure 3 - Logistics costs in Europe, through time, as a percent of revenues
(Source: ELA, Insight to Impact, 1999)
Will bricks and clicks companies win because they have everything? It depends on what the consumer wants to pay for. If you like picking out gourmet items for dinner, your local store has an advantage over Webvan. You could perform the part of the service you think is fun, while an attached, automated warehouse packs the rest of your order, for example. The Internet does not eliminate the need for strategic planning that connects marketing and operations.
Auctions and spot markets cannot replace all long-term contracts, of course. It is still true that choosing the supplier with the lowest unit cost is not necessarily the best idea. Logistics, quality and reliability issues still rear their heads. Buyers seek the supplier offering the highest value. Will Internet auction markets really be able to accommodate such complicated, multiple attribute problems efficiently?
We heard a 3PL company official say "Our cost of capital is lower than that of our customers, so we can make money holding their inventory." This is "wrong think" financially, but it still may occur. Will financial settlement via the Internet mean the end of "2% -10, net 30?"
One way to postpone commitments is to buy capacity rather than products. A contract manufacturer's capacity can be purchased, delaying the precise product mix decision. This is a form of demand aggregation, similar to inventory centralization.
So...tradeoffs are forever. Information does not replace inventory, but fast information allows you to have less. Access to information can provide the benefit that previously required physical centralization. Only total cost matters and we are in danger of increasing transportation cost. A strategic plan for the business and a functional plan for marketing and operations are still necessary. And, if you have one, the Internet can allow you to reduce costs and acquire and serve customers better than before. But again, the Internet is only a tool that enables new ways of attaining goals. The only problem is it also allows new and old competitors to do so. It is a good time to be a consumer.
