the supply chain network design

Cem Recai ÇIRAK

THE SUPPLY CHAIN

NETWORK DESIGN

INTRODUCTION

Why should an organization take a total network perspective?

What is involved in configuring a supply network?

Where should an operation be located?

How much capacity should an operation plan to have?

THE SUPPLY NETWORK PERSPECTIVE

• A supply network perspective means setting an operation in the context of all the other operations with

which it interacts, some of which are its suppliers and its customers. Materials, parts, other information,

ideas and sometimes people all flow through the network of customer–supplier relationships formed by all

these operations.

• On its supply side, an operation has its suppliers of parts, or information, or services. These suppliers

themselves have their own suppliers who in turn could also have suppliers, and so on.

• On the demand side, the operation has customers. These customers might not be the final consumers of

the operation’s products or services; they might have their own set of customers.


• On the supply side, is a group of operations that directly supply the operation; these are often called first-

tier suppliers. They are supplied by second-tier suppliers. However, some second-tier suppliers may also

supply an operation directly, thus missing out a link in the network.

• Similarly, on the demand side of the network, ‘first-tier’ customers are the main customer group for the

operation. These in turn supply ‘second-tier’ customers, although again the operation may at times supply

second-tier customers directly.

• The suppliers and customers who have direct contact with an operation are called its immediate supply

network, whereas all the operations which form the network of suppliers’ suppliers and customers’

customers, etc., are called the total supply network.


Upstream

Downstream

Operations network for a plastic homeware company and a shopping mall

Why consider the whole supply network?

It helps an understanding of competitiveness

• Immediate customers and immediate suppliers, quite understandably, are the main concern for

companies. Yet sometimes they need to look beyond these immediate contacts to understand why

customers and suppliers act as they do.

• Any operation has only two options if it wants to understand its ultimate customers’ needs at the end of

the network. It can rely on all the intermediate customers and customers’ customers, etc., which form

the links in the network between the company and its end customers. Alternatively, it can look beyond

its immediate customers and suppliers.

• Relying on one’s immediate network is seen as putting too much faith in someone else’s judgement of

things which are central to an organization’s own competitive health.


It helps identify significant links in the network

• Not everyone in a supply network has the same degree of influence over the performance of the

network as a whole. Some operations contribute more to the performance objectives that are valued by

end customers. So an analysis of networks needs to understand the downstream and the upstream

operations which contribute most to end customer service.

• For example, the important end customers for domestic plumbing parts and appliances are the

installers and service companies who deal directly with consumers. They are supplied by stock holders

who must have all parts in stock and deliver them fast. Suppliers of parts to the stock holders can best

contribute to their end customers’ competitiveness by offering a short delivery lead time but mainly

through dependable delivery. The best way of winning end customer business in this case is to give the

stock holder prompt delivery, which helps keep costs down while providing high availability of parts.


It helps focus on long-term issues

• There are times when circumstances render parts of a supply network weaker than its adjacent links.

• High street music stores, for example, have been largely displaced by music streaming and

downloading services. A long-term supply network view would involve constantly examining technology

and market changes to see how each operation in the supply networks might be affected.

The supply network view is useful because it prompts three particularly important design decisions:

How should the network be configured?

Where should each part of the network be located?

What physical capacity should each part of the network have?

Design decisions in supply networks

NETWORK CONFIGURATION

• Configuring a supply network means determining its overall pattern. This includes two main sets of

decisions.

• First, what should be the pattern, shape or arrangement of the various operations that make up the supply

network?

• Second, how much of the network should a specific operation own? This may be called the outsourcing,

vertical integration, or the do-or-buy decision.

Changing the shape of the supply network

• Even when an operation does not directly own or control other operations in its network, it may still change

the shape of the network by reconfiguring it so as to change the scope of the activities performed in each

operation and the nature of the relationships between them.

• Reconfiguring a supply network sometimes involves parts of the operation being merged. The most

common example of network reconfiguration has come through the many companies that have recently

reduced the number of direct suppliers. Due to the reason that the complexity of dealing with many

hundreds of suppliers may both be expensive for an operation and prevent the operation from developing a

close relationship with a supplier.

Disintermediation

• Another trend in some supply networks is that of companies within a network bypassing customers or

suppliers to make contact directly with customers’ customers or suppliers’ suppliers which is called

disintermediation.

• An obvious example of this is the way the internet has allowed some suppliers to disintermediate traditional

retailers in supplying goods and services to consumers. For example, many services in the travel industry

that used to be sold through travel agents are now also available direct from the suppliers. The option of

purchasing the individual components of a vacation through the websites is now easier for consumers. So

the process of disintermediation has developed new linkages in the supply network.

Co-opetition

• One approach to thinking about supply networks sees any business as being surrounded by four types of

players: suppliers, customers, competitors and complementors.

• Complementors enable one’s products or services to be valued more by customers because they can also

have the complementor’s products or services, as opposed to having yours alone.

• Competitors are the opposite: they make customers value your product or service less when they can have

their product or service, rather than yours alone.

• Competitors can also be complementors and vice versa.

Co-opetition

• For example, adjacent restaurants may see themselves as competitors for customers’ business. A

customer standing outside and wanting a meal will choose between the two of them. Yet in another way

they are complementors. Restaurants, theatres, art galleries and tourist attractions generally, all cluster

together in a form of co-operation to increase the total size of their joint market.

• It is important to distinguish between the way companies co-operate in increasing the total size of a market

and the way in which they then compete for a share of that market. Customers and suppliers should have

symmetric roles.

• In the long term it creates value for the total network to find ways of increasing value for suppliers and well

as customers. All the players in the network, whether they are customers, suppliers, competitors or

complementors, can be both friends and enemies at different times. The term used to capture this idea is

co-opetition.

Outsourcing

• No single business does everything that is required to produce its products and services. It may contracts

out some of these works previously done within the operation to a supplier to do them better. This process

is called outsourcing (also known as the do-or-buy, or the vertical integration decision) and it has become

an important issue for most businesses.

• Although most companies have always outsourced some of their activities, a larger proportion of direct

activities are now being bought from suppliers. Also many indirect processes are now being outsourced.

This is often referred to as business process outsourcing (BPO).

• Financial service companies in particular are outsourcing some of their more routine back-office processes.

In a similar way, many processes within the human resource function, from simple payroll services through

to more complex training and development processes, are being outsourced to specialist companies. The

processes may still be physically located where they were before, but the staff and technology are

managed by the outsourcing service provider.

Outsourcing

• The reason for doing this is often primarily to reduce cost. However, there can sometimes also be

significant gains in the quality and flexibility of service offered.

• The outsourcing debate is just part of a far larger issue which will shape the fundamental nature of any

business. Namely, what should the scope of the business be? In other words, what should it do itself and

what should it buy in?

• This is often referred to as the do-or-buy decision when individual components or activities are being

considered, or vertical integration when it is the ownership of whole operations that are being decided.

Vertical integration is the extent to which an organization owns the network of which it is a part.

Outsourcing

• Company A is primarily a nacelle designer and manufacturer that also makes the parts. Company B is

primarily an installer that also makes the tower and blades (but buys in the nacelle itself). Company C is

primarily an operator that generates electricity and also designs and assembles the nacelles as well as

installing the whole tower.

Three companies operating in the wind power generation industry with different vertical integration positions

Making the outsourcing or vertical integration decision

How in-house and outsourced supply may affect an operation’s performance objectives

Outsourcing as a strategic design

• Although the effect of outsourcing on the operation’s performance objective is important, there are other

factors that companies take into account when deciding if outsourcing an activity is a sensible option. For

example, if an activity has long-term strategic importance to a company, it is unlikely to outsource it.

• Obviously if its operation’s performance is already superior to any potential supplier, it would unlikely to

outsource the activity. But also even if its performance was currently below that of potential suppliers, it

may not outsource the activity if it feels that it could significantly improve its performance.

The decision logic of outsourcing

• Two supply network strategies that are often confused are those of outsourcing and offshoring.

Outsourcing means deciding to buy in products or services rather than perform the activities in-house.

Offshoring means obtaining products and services from operations that are based outside one’s own

country.

• Offshoring is very closely related to outsourcing and the motives for each may be similar. Offshoring to a

lower cost region of the world is usually done to reduce an operation’s overall costs, as is outsourcing to a

supplier who has greater expertise or scale or both.

Outsourcing and offshoring

Offshoring and outsourcing are related but different

LOCATION DECISION

• Get the location wrong and it can have a significant impact on profits, or service. In fact the same is true for

all types of operation.

• Location decisions will usually have an effect on an operation’s costs as well as its ability to serve its

customers and therefore its revenues.

• Also, location decisions, once taken, are difficult to undo. The costs of moving an operation can be hugely

expensive and the risks of inconveniencing customers very high. No operation wants to move very often.

Reasons for location decisions

Changes in demand

• A change in location may be prompted by customer demand shifting. For example, as garment

manufacture moved to Asia, suppliers of zips, threads, etc., started to follow them.

• Changes in the volume of demand can also prompt relocation. To meet higher demand, an operation

could expand its existing site, or choose a larger site in another location, or keep its existing location

and find a second location for an additional operation. These options will involve a location decision.

• High-visibility operations may not have the choice of expanding on the same site to meet rising

demand. A dry cleaning service may attract only marginally more business by expanding an existing site

because it offers a local service. Finding a new location for an additional operation is probably its only

option for expansion.

Reasons for location decisions

Changes in supply

• The other stimulus for relocation is changes in the cost, or availability, of the supply of inputs to the

operation.

• For example, a mining or oil company will need to relocate as the minerals it is extracting become

depleted. The reason why so many software companies are located in India is the availability of

talented, well-educated, but relatively cheap staff.

The objectives of the location decision

The aim of the location decision is to achieve an appropriate balance between three related objectives:

The variable costs of the operation that changes with geographical location

The service the operation is able to provide to its customers

The revenue potential of the operation

In for-profit organizations the last two objectives are related. The assumption is that the better the service the

operation can provide to its customers, the better will be its potential to attract custom and therefore generate

revenue. In not-for-profit organizations, revenue potential might not be a relevant objective and so cost and

customer service are often taken as the twin objectives of location.

The objectives of the location decision

• In making decisions about where to locate an operation, minimization of spatially variable costs and

maximization of revenue or customer service are concerned. Location affects both of these but not equally.

• For example, customers may not care very much where some products are made, so location is unlikely to

affect revenues significantly. However, the costs could be very greatly affected by location. Services, on the

other hand, often have both costs and revenues affected by location. The location decision for any

operation is determined by the relative strength of supply-side and demand-side factors.

Supply-side and demand-side factors in location decisions

Supply-side influences

Labour costs

• The costs of employing people with particular skills can vary between different areas in any country, but

are likely to be more significant when international comparisons are made.

• Labour costs can be expressed in two ways. The hourly cost is what firms have to pay workers on

average per hour. However, the unit cost is an indication of the labour cost per unit of production. This

includes the effects both of productivity differences between countries and of differing currency

exchange rates. Exchange rate variation can cause unit costs to change dramatically over time.

• Yet in spite of this, labour costs exert a major influence on the location decision, especially in some

industries such as clothing, where labour costs as a proportion of total costs are relatively high.


Land costs

• The cost of acquiring the site itself is sometimes a relevant factor in choosing a location. Land and

rental costs vary between countries, cities and districts. For example, a retail operation, when choosing

high street sites, will pay a particular level of rent only if it believes it can generate a certain level of

revenue from the site.

Energy costs

• Operations which use large amounts of energy, such as aluminium smelters, can be influenced in their

location decisions by the availability of relatively inexpensive energy. This may be direct, as in the

availability of hydroelectric generation in an area, or indirect, such as low-cost coal which can be used

to generate inexpensive electricity.


Transportation costs

• Transportation costs include both the cost of transporting inputs from their source to the site of the

operation, and the cost of transporting outputs to customers. Transportation should be considered as a

supply-side factor because as location changes, transportation costs also change.

• Proximity to sources of supply dominates the location decision where the cost of transporting input

materials is high or difficult. For example food processing and other agricultural-based activities are

often carried out close to growing areas.

• Conversely, transportation to customers dominates location decisions where this is expensive or

difficult. For example civil engineering projects are constructed mainly where they will be needed.


Community factors

• Community factors are those influences on an operation’s costs which derive from the social, political

and economic environment of its site.

• These include such things as local tax rates, government financial assistance and planning assistance,

political stability and corruption, language, local amenities (schools, theatres, shops, etc.), availability of

support and supply infrastructure, labour relations, environmental regulations and waste disposal,

planning procedures, etc.

Demand-side influences

Labour skills

• The abilities of a local labour force can have an effect on customer reaction to the products or services

which the operation produces. For example, techno-parks are usually located close to universities

because they hope to attract companies who are interested in using the skills available at the university.

The suitability of the site itself

• Different sites may have different intrinsic characteristics which can affect an operation’s ability to serve

customers and generate revenue. For example, locate a luxury resort hotel next to a beach, surrounded

by waving palm trees and overlooking a picturesque bay and the hotel is very attractive to its

customers. Move it a few kilometres away into the centre of an industrial estate and it rapidly loses its

attraction.

Demand-side influences

Image of the location

• Some locations are firmly associated in customers’ minds with a particular image. For example, the

product and fashion design houses of Milan and the financial services in London enjoy a reputation

shaped partly by that of their location.

Convenience for customers

• This is often the most important demand-side factor. For instance, locating a general hospital in the

middle of the countryside may have many advantages for its staff, and even perhaps for its costs, but it

clearly would be very inconvenient to its patients. So, hospitals are usually located close to centres of

demand. Similarly with other public services and restaurants, stores, banks, petrol filling stations, etc.,

location determines the effort to which customers have to go in order to use the operation.

Location techniques

• The procedure involves, first of all, identifying the criteria which will be used to evaluate the various

locations. Second, it involves establishing the relative importance of each criterion and giving weighting

factors to them. Third, it means rating each location according to each criterion. The scale of the score is

arbitrary.

Weighted-score method

• Although operations managers must exercise considerable judgement in the choice of alternative

locations, there are some systematic and quantitative techniques which can help the decision process.

Weighted-score method

The centre-of-gravity method

• The centre-of-gravity method is used to find a location which minimizes transportation costs. It is based on

the idea that all possible locations have a value which is the sum of all transportation costs to and from that

location.

• The best location, the one which minimizes costs, is represented by what in a physical analogy would be

the weighted centre of gravity of all points to and from which goods are transported.

The centre-of-gravity method

CAPACITY PLANNING

• Most organizations need to decide on the size of each of their facilities. For example, an air-conditioning

unit company might operate plants each of which has a capacity of 800 units per week. At activity levels

below this, the average cost of producing each unit will increase because the fixed costs of the factory are

being covered by fewer units produced.

• The total production costs of the factory have some elements which are fixed – they will be incurred

irrespective of how much, or little, the factory produces. Other costs are variable – they are the costs

incurred by the factory for each unit it produces.

The next set of supply network decisions concern the size or capacity of each part of the network.

The optimum capacity level


• Between them, the fixed and variable costs comprise the total cost at any output level. Dividing this cost by

the output level itself will give the theoretical average cost of producing units at that output rate.

• However, the actual average cost curve may be different from the theoretical unit cost curve for a number

of reasons:

All fixed costs are not incurred at one time as the factory starts to operate. Rather they occur at many

points called fixed cost breaks as volume increases. This makes the theoretically smooth average cost

curve more discontinuous.

Output levels may be increased above the theoretical capacity.

There may be less obvious cost penalties of operating at levels close to or above its nominal capacity.


• As the nominal capacity of the plants increases, the lowest cost points at first reduce. There are two main

reasons for this:

The fixed costs of an operation do not increase proportionately as its capacity increases. An 800-unit

plant has less than twice the fixed costs of a 400-unit plant.

Capital costs do not increase proportionately to capacity. An 800-unit plant costs less to build than twice

the cost of a 400-unit plant.

Unit cost curves for individual plants of varying capacities and the unit cost curve for this type of plant as its capacity varies


• These two factors, taken together, are often referred to as economies of scale. However, above a certain

size, the lowest cost point may increase. In the figure, this happens with plants above 800 units capacity

because of what are called diseconomies of scale, two of which are particularly important.

• First, transportation costs can be high for large operations. For example, if a manufacturer supplies its

global market from one major plant in Denmark, materials may have to be brought in to, and shipped from,

several countries.

• Second, complexity costs increase as size increases. The communications and coordination effort

necessary to manage an operation tends to increase faster than capacity. Although not seen as a direct

cost, it can nevertheless be very significant.

Scale of capacity and the demand–capacity balance

• Large units of capacity also have some disadvantages when the capacity of the operation is being changed

to match changing demand. Changing capacity using large units of capacity reduces the chance of

achieving demand–capacity balance. Over-capacity means low capacity utilization which means higher unit

costs. If smaller units of capacity is used, there will still be over-capacity but to a lesser extent, which

means higher capacity utilization and possibly lower costs.

The scale of capacity increments affects the utilization of capacity

Balancing capacity

• All operations are made up of separate processes, each of which will itself have its own capacity. So, for

example, the 800-unit air-conditioning plant may not only assemble the products but may also manufacture

the parts from which they are made, pack, store and load them in a warehouse and distribute them to

customers.

• If demand is 800 units per week, not only must the assembly process have a capacity sufficient for this

output, but the parts manufacturing processes, warehouse and distribution fleet of trucks must also have

sufficient capacity.

• For the network to operate efficiently, all its stages must have the same capacity. If not, the capacity of the

network as a whole will be limited to the capacity of its slowest link.

The timing of capacity change

• Changing the capacity of an operation is not just a matter of deciding on the best size of a capacity

increment. The operation also needs to decide when to bring on-stream new capacity.

• For example, according to the forecast demand for the new air-conditioning unit, the company has decided

to build 400-unit-per-week plants in order to meet the growth in demand for its new product. In deciding

when the new plants are to be introduced, the company must choose a position somewhere between two

extreme strategies:

capacity leads demand – timing the introduction of capacity in such a way that there is always sufficient

capacity to meet forecast demand;

capacity lags demand – timing the introduction of capacity so that demand is always equal to or greater

than capacity.


• These two extreme strategies are shown, although in practice the company is likely to choose a position

somewhere between the two.

(a) Capacity-leading and capacity-lagging strategies. (b) Smoothing with inventories means using

the excess capacity in one period to produce inventory that supplies the under-capacity period


• Each strategy has its own advantages and disadvantages. The actual approach taken by any company will

depend on how it views these advantages and disadvantages. For example, if the company’s access to

funds for capital expenditure is limited, it is likely to find the delayed capital expenditure requirement of the

capacity-lagging strategy relatively attractive.

The arguments for and against pure leading and pure lagging strategies of capacity timing

Smoothing with inventory

• The strategy on the continuum between pure leading and pure lagging strategies can be implemented so

that no inventories are accumulated. All demand in one period is satisfied (or not) by the activity of the

operation in the same period.

• Indeed, for customer-processing operations there is no alternative to this. A hotel cannot satisfy demand in

one year by using rooms which were vacant the previous year. However, for some operations output which

is not required in one period can be stored for use in the next.

Smoothing with inventory

• Using inventories can combine the advantages of both capacity leading and capacity lagging. Capacity is

introduced such that demand can always be met by a combination of production and inventories, and

capacity is, with the occasional exception, fully utilized.

• This may seem like an ideal state, but there is a price to pay – that is the cost of carrying the inventories.

Not only will these have to be funded but the risks of obsolescence and deterioration of stock are

introduced.

The advantages and disadvantages of a smoothing-with-inventory strategy

Break-even analysis of capacity expansion

• An alternative view of capacity expansion can be gained by examining the cost implications of adding

increments of capacity on a break-even basis.

• Each additional unit of capacity results in a fixed-cost break that is a further lump of expenditure which will

have to be incurred before any further activity can be undertaken in the operation.


• The operation is unlikely to be profitable at very low levels of output. Eventually, assuming that prices are

greater than marginal costs, revenue will exceed total costs. However, the level of profitability at the point

where the output level is equal to the capacity of the operation may not be sufficient to absorb all the extra

fixed costs of a further increment in capacity. This could make the operation unprofitable in some stages of

its expansion.

The advantages and disadvantages of a smoothing-with-inventory strategy

• Slack, N., Brandon-Jones, A., Johnston, R., ‘’Supply network design’’ in Operations management, 7th ed.,

Harlow, Essex, United Kingdom: Pearson, 2013, ch. 6, pp. 152-182.

• Chopra S., Meindl, P., ‘’Network design in the supply chain’’ in Supply chain management: strategy,

planning, and operation, 3rd ed., Upper Saddle River, New Jersey, United States of America: Pearson,

2007, ch.5, pp. 114-151.

REFERENCES

the supply chain network design

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