Unit 7: Designing the Supply Chain Network

Topic Covered in Syllabus:

• Role of distribution in supply chain
• Factors influencing distribution network design
• Design options for a distribution network
• E-business and a distribution network
• Role of network design in supply chain
• Factors influencing network design decisions
• Framework for network design decisions
• Network optimization models
  • The capacitated plant location model
  • Gravity location model

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The Role of Distribution in the Supply Chain

Distribution refers to the steps taken to move and store a product from the supplier stage to a customer stage in the supply chain. Thus, distribution occurs between every pair of stages in a supply chain. Raw materials and components are moved from suppliers to manufacturers, whereas finished products are moved from the manufacturer to end customers. Distribution is an important driver of the overall profitability of a firm because it directly impacts both the supply chain cost and the customer experience.

For Wal-Mart and 7-Eleven Japan, the success of their entire business has been built around understanding distribution design and operations. Wal-Mart uses distribution to provide good availability of relatively common products at very low cost. 7-Eleven on the other hand, uses distribution to provide a very high level of customer responsiveness at a reasonable cost. Dell distributes its PCs directly to end consumers, whereas companies like HP distribute through resellers. Dell customers wait several days to get a PC while customers can walk away with an HP PC from a reseller. P&G has chosen to distribute directly to large supermarket chains while making the smaller players buy P&G products from distributors. The product moves faster from P&G to the larger chains while moving through an additional stage when going to the smaller supermarkets.

Factors Influencing Distribution Network Design

At the highest level, performance of a distribution network should be evaluated along two dimensions:

1. Customer needs that are met
2. Cost of meeting customer needs

The customer needs that are met influence the company’s revenues, which along with cost decide the profitability of the delivery network.

Although customer service consists of many components, we focus on those measures that are influenced by the structure of the distribution network. These include:

• Response time: the time between when a customer places an order and receives delivery
• Product variety: the number of different products/configurations that a customer desires from the distribution network
• Product availability: the probability of having a product in stock when a customer order arrives
• Customer experience: includes the ease with which the customer can place and receive their order
• Order visibility: the ability  of the customer  to track  their  order  from placement to delivery
• Returnability: the ease with which a customer can return unsatisfactory merchandise and the ability of the network to handle such returns

It may seem at first that a customer always wants the highest level of performance along all these dimensions. In practice, however, this is not the case. Firms that target customers who can tolerate a large time require few locations that may be far from the customer and can focus in increasing the capacity in each location. In contrast, firms that target customers who value short response time need to locate close to them and must have many facilities, with each location having a low capacity.

To summarize, a decrease in the response time customer desire increases the number of facilities required in the network which is shown in the figure below:

Changing the distribution network design affects the following supply chain costs:

• Inventories
• Transportation
• Facilities and handling
• Information

As the number of facilities in a supply chain increases, the inventory and resulting inventory costs also increases this is shown in the figure below. To decrease the inventory costs, firms try to consolidate and limit the number of facilities in their supply chain network.

Inbound transportation costs are the cost incurred in bringing material into facility. Outbound transportation costs are the cost incurred in sending material out of a facility. Outbound transportation costs per unit tend to be higher than inbound costs because inbound lot sizes are typically larger. As long as inbound transportation economies of scale are maintained, increasing the number of facilities decreases total transportation cost as shown in the figure below:

If the number of facilities is increased to a point where inbound lot sizes are also very small and result in a significant loss of economies of scale in inbound transportation, increasing the number of facilities increases the total transportation costs.

Facility cost decrease as the number of facilities is reduced as shown in the figure below. It is because a consolidation of facilities allows a firm to exploit economies of scale:

Total logistic costs  are the sum  of the  inventory, transportation  and  facility costs  for a  supply chain network. As the number of facilities increases, total logistic costs first decrease and then increase as shown in the figure below:

Each firm should have at least the number of facilities that minimize total logistic cost. In general, no distribution network will outperform others along all dimensions. Thus, it is important to ensure that the strength of the distribution network fit with the strategic position of the firm.

Design Options for a Distribution Network

There are two key decisions when designing a distribution network:

1. Will product be delivered to the customer location or picked up from a preordained site?
2. Will product flow through an intermediary (or intermediate location)?

Based on the choices for the two decisions, there are six distinct distribution network designs that may be used to move products from factory to customer. These are classified as follows:

1. Manufacturer storage with direct shipping
2. Manufacturer storage with direct shipping and in-transit merge
3. Distributor storage with package carrier delivery
4. Distributor storage with last mile delivery
5. Manufacturer/distributor storage with consumer pickup
6. Retail storage with customer pickup

Manufacturer Storage with Direct Shipping

In this option, product is shipped directly from the manufacturer to the end customer, bypassing the retailer (who takes the order and initiates the delivery request). This option is also referred to as drop-shipping with product delivery directly from the manufacturer to the customer location.

The biggest advantage of drop- shipping is the ability to centralize inventories at the manufacturer and postpone product customization. A manufacturer can aggregate demand across all retailers that it supplies. The decision of Nordstrom to drop-ship low demand shoes.

The retailer, if they exist independent of the manufacturer, carries no inventory with all inventories stored at the manufacturer. Information flows from the customer, via retailer to the manufacturer, whereas product is shipped directly from the manufacturer to the customer as shown in the figure below:

Performance characteristics of Manufacturer storage with direct shipping network

Facilities and HandlingLower cost because of aggregation>

Cost Factor	Performance
Inventory	Lower cost because of aggregation
Transportation	Highest  transportation  cost  because  of  increased  distance  and disaggregate shipping
Information	Significant  investment  in  information  infrastructure  to  integrate manufacturer and retail

Service Factor	Performance
Response Time	Low response time of one to two weeks because of increased distance and two stages of order processing
Product variety	Easy to provide a very high level of variety
Product availability	Easy to provide  a  very  high  level of product availability because of aggregation at the manufacturer
Customer experience	Good in terms of home delivery
Time to market	Fast, with the product available as soon as the first unit is produced
Order visibility	More difficult but also more important from a customer service perspective
Returnability	Expensive and difficult to implement

Manufacturer storage with Direct Shipping and In-Transit Merge

Unlike pure drop-shipping where each product in the order is sent directly from its manufacturer to the end customer, in-transit merge combines pieces of the order coming from different locations so that the customer gets a single delivery. As with drop- shipping, the ability to centralize inventories at the manufacturer and postpone product customization is a significant advantage of in- transit merge. When a customer orders a PC from HP along with a Sony monitor, the package carrier picks up the PC from HP factory and the monitor from the Sony factory; it then merges the two together at a hub before making a single delivery to the customer. Information and product flows for the in-transit merge network as shown in the figure shown below:

Cost Factor	Performance
Inventory	Similar to drop-shipping
Transportation	Somewhat lower transportation cost than drop-shipping
Facilities and Handling	Handling  cost  higher  than drop-shipping  at carrier; receiving  cost lower at customer
Information	Investment is somewhat higher than for drop-shipping

Service Factor	Performance
Response Time	Similar to drop-shipping; may be marginally higher
Product variety	Similar to drop-shipping
Product availability	Similar to drop-shipping
Customer experience	Better than drop-shipping because a single delivery has to be received
Time to market	Similar to drop-shipping
Order visibility	Similar to drop-shipping
Returnability	Similar to drop-shipping

Distributor Storage with Carrier Delivery

Under this option, inventory is not held by manufacturers at the factories but is held by distributors/retailers in intermediate warehouses and package carriers are used to transport products from the intermediate location to the final customer. Relative to manufacturer storage distributor storage will require a higher level of inventory because the distributor/retailer warehouse aggregates demand uncertainty to a lower level than the manufacturer who is able to aggregate demand across all distributors/retailers. Transportation cost will be somewhat lower while facility costs will be somewhat higher than manufacturer storage. This option is followed by Amazon and W.W. Grainger.

Cost Factor	Performance
Inventory	Higher  than  manufacturer  storage.  Difference  is  not  large  for  fast moving items.
Transportation	Lower than manufacturer storage
Facilities and Handling	Somewhat higher than manufacturer storage
Information	Simpler infrastructure compared to manufacturer storage

Service Factor	Performance
Response Time	Faster than manufacturer storage
Product variety	Lower than manufacturer storage
Product availability	Higher cost to provide the same level of availability as manufacturer storage
Customer experience	Better than manufacturer storage with drop-shipping
Time to market	Higher than manufacturer storage
Order visibility	Easier than manufacturer storage
Returnability	Easier than manufacturer storage

Distributor Storage with Last Mile Delivery

Last mile delivery refers to the distributor/retailer delivering the product to the customer’s home instead of using a package carrier. (E.g. Webvan, Peapod and Albertson’s have a last mile delivery in the grocery industry). Unlike package carrier delivery, last mile delivery requires the distributor ware house to be much closer to the customer. High level of inventory with highest transportation, facility and processing cost but it is offset by the high level of responsiveness.

Cost Factor	Performance
Inventory	Higher than distributor storage with package carrier delivery
Transportation	Very high cost given minimal scale economies
Facilities and Handling	Facility cost  higher  than  manufacturer  storage  or  distributor  storage with package carrier delivery but lower than chain of retail stores
Information	Similar to distributor storage with package carrier delivery
Service Factor	Performance
Response Time	Very quick.
Product variety	Somewhat less than distributor storage
Product availability	More expensive to provide availability than any other options except retail stores.
Customer experience	Very good, particularly for bulk items
Time to market	Slightly higher than distributor storage with package carrier delivery
Order visibility	Less of an issue and easier to implement than manufacturer storage
Returnability	Easier to implement than other options.

Manufacturer/distributor storage with consumer pickup

In this approach, inventory is stored at the manufacturer or distributor warehouse but customers place their order online or on the phone and then come to designated pickup points to collect their orders. Inventory costs using this approach can be kept low with either manufacturer or distributor storage to exploit aggregation. Transportation cost is lower but facility cost will be higher if new pickup sites have to be built.

Cost Factor	Performance
Inventory	Can match any other option, depending on the location of inventory
Transportation	Lower than the use of package carrier
Facilities and Handling	Can be very high if new facilities have to be built
Information	Significant investment in infrastructure required

Service Factor	Performance
Response Time	Similar to package carrier delivery
Product variety	Similar to other manufacturer or distributor storage
Product availability	Similar to other manufacturer or distributor storage
Customer experience	Lower than other options
Time to market	Similar to other manufacturer storage options
Order visibility	Difficult but essential
Returnability	Somewhat easier given that pickup location can handle returns

Retailer storage with customer pickup

In this option, inventory is stored locally at retail stores. Customers walk into the retail store or place an order online or on the phone and pick it up at the retail store. Local storage increase inventory cost because of a lack of aggregation. Transportation cost is much lower. The main advantage of a network with local storage is that it can lower the delivery cost and provide a faster response than other networks. The major disadvantage is the increased inventory and facility cost.

Selecting a Distribution Network Design

A network designer needs to consider product characteristics as well as network requirements when deciding on the appropriate deliver network. Only niche market will end up using a single distribution network. Most companies are best served by a combination of delivery network. The suitability of different delivery design from a supply chain perspective in various situations is shown in table below:

The Role of Network Design in the Supply Chain

Supply chain network design decisions include the location of manufacturing, storage or transportation-related facilities and the allocation of capacity and roles to each facility. Supply chain network design decisions are classified as follows:

1. Facility role: What role should each facility play? What processes are performed at each facility?
2. Facility location: Where should facilities be located?
3. Capacity allocation: How much capacity should be allocated to each facility?
4. Market and supply allocation: What markets should each facility serve? Which supply chain sources should feed each facility?

Decisions concerning the role of each facility are significant because they determine the amount of flexibility the supply chain has in changing the way it meets demand. Facility location decisions have a long-term impact on a supply chain’s performance because it is very expensive to shut down a facility or move it to a different location. Capacity location decisions also have a significant impact on supply chain performance. Whereas capacity allocation can be altered more easily than location, capacity decisions do tend to stay in place for several years. (Allocating too much capacity to a location results in a poor utilization and results in higher costs; while allocating too little results in poor responsiveness if demand is not satisfied or higher cost if demand is filled from a distant facility). The allocation of resources and markets to facilitate has a significant impact on performance because it affects total production, inventory and transportation costs incurred by the supply chain to satisfy customer demand. The decision should be reconsidered on a regular basis so that the allocation can be changed as market conditions or plant capacities change.

Network design decisions have a significant impact on performance because they determine the supply chain configuration and set constraints within which inventory, transportation and information can be used to either decrease supply chain cost or increase responsiveness. Network decision are also very important when two companies merge. Due to the redundancies and differences in markets served by either of the two separate firms, consolidating some facilities and changing the location and role of others can often help reduce cost and improve responsiveness.

Factors Influencing Network Design Decisions

• Strategic Factors

A firm’s competitive strategy has a significant impact on network design decisions within the supply chain. Firms focusing on cost leadership tend to find the lowest cost location for their manufacturing facilities, even if that means locating very far from the markets they serve. A firm focusing on responsiveness tends to locate facilities closer to the market and may select a high- cost location if this choice allows the firm to quickly react to changing market needs.

It is important for a firm to identify the mission or strategic role of each facility when designing the global network. Kasra Ferdows (1997) suggests the following classification of possible strategic roles for various facilities in a global supply chain network.

• • Offshore facility: low-cost facility for export production:
  • Source facility: low-cost facility for global production
  • Server facility: regional production facility
  • Contributor facility: regional production facility and development skills
  • Outpost facility: regional production facility built to gain local skills
  • Lead facility: facility that leads in development and process technologies
• Technological Factors

Characteristics of available production technologies have a significant impact on network design decisions. If production technology displays significant economies of scale, few high-capacity locations are the most effective. In contrast, if facilities have lower fixed costs; many local facilities are preferred because this helps lower transportation costs. Flexibility of the production technology impacts the degree of consolidation that can be achieved in the network.

• Macroeconomic Factors

Macroeconomic factors include taxes, tariffs, exchange rates and other economic factors that are not internal to an individual firm. As trade has increased and marketing become more global, macroeconomic factors have had a significant influence on the success or failure of supply chain networks. Thus, it is imperative that firms take these factors into account when making decision decisions.

Tariffs and Tax Incentives: Tariffs refer to any duties that must be paid when products and/or equipment are moved across international, state or city boundaries. Tariffs have a strong influence on location decisions within a supply chain. If a country has a very high tariffs, companies either do not serve the local market or set up manufacturing plants within the country to save on duties. High tariffs lead to more production locations within a supply chain network, with each location havi9ng a lower allocated capacity.

Tax incentives are a reduction in tariffs or taxes that countries, states and cities often provide to encourage firms to locate their facilities in specific areas. Many countries vary incentives from city to city to encourage investments in areas with lower economic developments.

Exchange Rate and Demand Risk: Fluctuation in exchange rates has a significant impact on the profits of any supply chain serving global markets. Exchange rate risk may be handled using financial instruments that limit or hedge against the loss due to fluctuations. An effective way to do this is to build some over- capacity in the network and make the capacity flexible so that it can be used to supply different markets. When designing supply chain networks, companies must build appropriate flexibility to help counter fluctuations in exchange rates and demand across different countries.

• Political Factors

The political stability of the country under consideration plays a significant role in the location choice. Companies prefer to locate facilities in politically stable countries where the rules of commerce are well defined. Countries with independent and clear legal system allows firms to feel that they have recourse in the courts should they need it. This makes it easier for companies to invest in facilities in these countries. Political stability is hard to quantify, so a firm makes an essentially subjective evaluation when designing its supply chain network.

• Infrastructure Factors

The availability of good infrastructure is an important prerequisite to locating a facility in a given area. Poor infrastructure adds to the cost of doing business form a given location. Key infrastructure elements to be considered during network design include availability of sites, labor availability, proximity to transportation terminals, rail service, proximity to airports and seaports, high way access, congestion and local utilities.

• Competitive Factors

Companies must consider competitor’s strategy, size and location when designing their supply chain networks. A fundamental decision firms make is whether to locate their facilities close to competitors or far from them. How the firms compete and whether external factors such as raw material or labor availability force them to locate close to each other influence this decision. (Positive externalities and locating to split the market).

• Customer Response Time and Local Presence

Firms that target customers who value a short response time must locate close to them. In contrast, customers shop for large amounts at supermarkets and are willing to travel longer distance to get to one. If a firm is delivering its product to customers, use of rapid means of transportation allows it to build fewer facilities and still provide a short response time. This option however increases transportation cost.

• Logistics and Facility Costs

Logistics and facility costs incurred within a supply chain change as the number of facilities, their location and capacity allocation is changed. Companies must consider inventory, transportation and facility cost when designing their supply chain networks.

Inventory and facility costs increase as the number of facilities in a supply chain increase. Transportation cost decrease as the number of facilities is increased. The supply chain network design is also influenced by the transportation occurring at each facility. When there is a significant reduction in material weight or volume as a result of processing.

Total logistic costs are a sum of the inventory, transportation and facility costs. The facilities in a supply chain network must at least equal the number that minimizes total logistics cost.

A Framework for Network Design Decisions

When faced with a network design decision, the goal of a manager is to design a network that maximizes the firm’s profits while satisfying customer needs in terms of demand and responsiveness. To design an effective network a manager must consider all the factors described in the figure below. Global network design decisions are made in four phases:

Phase I: Define a Supply Chain Strategy

The objective of the first phase of network design is to define a firm’s supply chain strategy. The supply chain strategy specifies what capabilities the supply chain network must have to support a firm’s competitive strategy. Next, the manager must forecast the likely evolution of global competition and whether competitors in each market will be local or global players. Managers must also identify constraints on available capital and whether growth will be accomplished by acquiring existing facilities, building new facilities or partnering.

Phase II: Define the Regional Facility Configuration

The objective of the second phase of network design is to identify regions where facilities will be located, their potential roles and their approximate capacity. An analysis of Phase II is started with a forecast of the demand by country. The next step is for managers to identify whether economies of scale or scope can play a significant role in reducing cost given available production technologies. Next managers must identify demand risk, exchange rate risk and political risk associated with different regional markets. They must be identify regional tariffs, any requirements for local production, tax incentives and any export or import restrictions for each market. managers must also identify competitors in each region and make a case for whether a facility needs to be located close to or far from a competitor’s facility. Along with that managers must also identify the factor and logistics costs at an aggregate level in each region. Based on all these information, manager will identify the regional facility configuration for the supply chain network using network design models. (The regional configuration defines the approximate number of facilities in the network, regions where facilities will be set up and whether a facility will produce all products for a given market or few product for all markets in the network).

Phase III: Select Desirable Sites

The objective of Phase III is to select a set of desirable sites within each region where facilities are to be located. The set of desirable sites should be larger than the desired number of facilities to be set up so that a precise selection may be made in Phase IV.

Sites should be selected based on an analysis of infrastructure availability to support the desired production methodologies: Hard infrastructure (requirements include the availability of suppliers, transportation services, communication, utilities and warehousing infrastructure) and soft infrastructure (requirements include the availability of skilled workforce, workforce turnover, and the community receptivity to business and industry).

Phase IV: Location Choices

The objective of this Phase is to select a precise location and capacity allocation for each facility. Attention is restricted to the desirable sites selected in Phase III. The network is designed to maximize total profits taking into account the expected margins and demand in each market, various logistics and facility costs and the taxes and tariffs at each location.

Network Optimization Models

During Phase II of the network design framework, a manager must consider regional demand, tariffs, economies of scale and aggregate factor cost to decide the regions in which facilities are to be located. Network optimization models are useful for managers considering regional configuration during Phase II. The model that we use in this Phase is The Capacitated Plant Location Model.

The capacitated plant location network optimization model requires the following inputs:

n = number of potential plant locations/capacity

m = number of markets or demand points

D_j = annual demand for market j

K_i = potential capacity of plant i

f_i = annualized fixed cost of keeping factory i open

c_ij = cost of producing and shipping one unit from factory I to market j

The supply chain’s goal is to decide on a network design that maximizes profits after taxes. The model thus focuses on minimizing the cost of meeting global demand. Define the following decision variables:

yi = 1 if plant is open, 0 otherwise

xij = quantity shipped from plant i to market j

The problem is then formulated as the following integer program:

Min           ∑              +          ∑

During Phase III, a manager must identify potential locations in each region where the company has decided to locate a plant. As a preliminary step, the manager needs to identify the geographical location where potential sites may be considered. Gravity Location Models can be useful when identifying suitable geographical locations within a region. Gravity models are used to find locations that minimize the cost of transporting raw material from supplier and finished goods to the market served.

Gravity models assume that both the markets and the supply sources can be located as grid points on a plane. All distances are calculated as a geometric distance between two points on a plane. The basic inputs to the models are as follows:

x_n,y_n = coordinate location of either market or supply source n

F_n = cost of shipping one unit for one mile between the facility and either market or supply source n

D_n = quantity to be shipped between facility and market or supply source n

If (x,y)  is the location  selected  for the  facility, the distance d_n between the facility at  location (x,y) and the supply source of market ni is given by:

d_n = -2+-2

The total transportation cost is given by:

TC= dnDnfn