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January 2005
Federal Reserve Bank of Dallas
Supply Chain Management: The Science
of Better, Faster, Cheaper
Supply
chain management is one of the most important strategic
aspects of any business enterprise. Decisions must be
made about how to coordinate the production of goods
and services, how and where to store inventory, whom
to buy materials from and how to distribute them in
the most cost-effective, timely manner.[1]
Figure 1
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Consider
a typical manufacturer. The supply chain is made up
of many interrelated firms (Figure 1). There
are parts suppliers, component suppliers and subassembly
suppliers. Further up the chain are the suppliers’
suppliers, finally reaching the raw materials suppliers
at the far end of the chain.
Going
downstream, back through the producing firm, the supply
chain continues through the warehousing and distribution
channels and then through the retail channels, ending
with the consumer.
The
supply chain encompasses all activities associated with
the flow and transformation of goods and services from
the raw materials stage (at one end of the supply chain)
through to the customer (at the other end of the chain),
including all associated information flows.
Overview
After defining and explaining
supply chain management, its evolution and transforming
effects on the design and structure of corporations
will be reviewed. Then, specific components within the
supply chain will be identified and several metrics
to gauge the level of supply chain improvements over
time will be examined. Of particular interest here is
the impact of new information technologies on supply
chain operations now and into the future. Finally, the
macroeconomic benefits of improved supply chain operations
will be explored.
Supply Chain Management: The
Science of Better, Faster, Cheaper
Figure 2
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Supply chain management is
getting the right things to the right places at the
right times, for profit (Figure 2). While supply
chain management is as old as trade itself, new information
and communications technologies have revolutionized
today’s supply chains, making them extraordinarily
better, faster, and cheaper.
For example, one way to buy a
computer today is to get on Dell’s web site and
configure and price a system exactly as you want it
(Figure 3). As soon as you click the mouse
and submit the online order to Dell, all of Dell’s
global suppliers—those supplying chips, monitors,
and so on—are immediately notified of the sale
and react as necessary so that you receive your computer
within a week.
Figure 3
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Contrast this direct sales model
with yesterday’s supply chain where you went to
a store in search of a product that the manufacturer
thought you wanted. Now, the middlemen between you and
the manufacturer can be eliminated, and Dell’s
upstream suppliers play a key real-time role in keeping
production and distribution flowing smoothly.
Better supply chain models don’t
just help manufacturers of physical goods, but also
service businesses, including those that require great
creativity, imagination, and specialized knowledge.
For example, using a virtual reality
system and ultrasound data sent through the Internet,
a medical specialist in Dallas can give an opinion to
a patient in Atlanta…or London…or Bombay.
A virtual reality system, worn around the hand and arm,
allows a physician to feel pressure sensations from
computer images and make an informed diagnosis in real-time,
half-way around the globe.
Using the Internet and associated
information technologies, bits of information—strings
of zeroes and ones—can be shipped anywhere in
the world in seconds at virtually no cost, opening up
a world of opportunity and rapid innovation. Moreover,
with digital products there are no time-to-manufacture
delays, no inventory shortages, and no delivery problems.
Supply Chain Evolution
Throughout history, new ideas
and technologies have revolutionized supply chains and
changed the way we work. Two hundred years ago, giant
mechanical machines replaced labor to complete tasks
in large factories. Railroads, electricity, and new
communications mediums expanded markets and also made
supply chains better, faster, and cheaper.
Then, in the early 1900s, Henry
Ford created the first moving assembly line, utilizing
scientific management methods. This reduced the time
required to build a Model T from 728 hours to 1.5 hours,
and ushered in the mass production era. Over the next
60 years or so, American manufacturers became adept
at mass production with the help of many operations
research techniques.
But in the 1970s, U.S. manufacturing’s
superiority was challenged by lower costs and higher
quality products from foreign firms in many industries.
Global competition forced U.S. manufacturers to concentrate
on improving quality by reducing defects in their supply
chains.
Starting in the early 1970s, Japanese
manufacturers like Toyota changed the rules of production
from mass to lean. Lean manufacturing focuses on flexibility
and quality more than on efficiency and quantity. Significant
lean manufacturing ideas include six-sigma quality control,
just-in-time inventory, and total quality management.
Today, businesses are improving
their supply chains through better information engineering.
Since about 1995—around the time of the commercial
application of the Internet—we have been in the
mass customization era. Now, manufacturers can mass-produce
customized products. It’s no longer “you
can have any color Model T as long as it’s black.”
Firms are effectively using new
information technologies like the Internet and wireless
telecommunications to improve service and delivery processes.
Through secure intranet systems and business-to-business
(B2B) e-commerce platforms, the focus is on improving
information management: integrating internal systems
with external partners—like Amazon’s practice
of giving customers the ability to track the delivery
location of their purchases through Amazon’s web
site. Or Wal-Mart’s routine practice of sharing
all sales data in real-time with its upstream suppliers
and manufacturers.
Supply Chain Components
The supply chain has basically
four components:
- Production: where businesses focus on how much to
produce, where to produce it, and what suppliers to
use.
- Inventory: where businesses decide where to store
their products, and how much to store.
- Distribution: where businesses address questions
about how their products should be moved and stored.
- Payments: where businesses look for the best ways
to pay suppliers and get paid by customers.
The efficiency and effectiveness
of a supply chain is contingent on the ability to gather
and analyze important information through these components.
Information Distortions and
the Supply Chain
Figure 4
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Distorted information, or
the lack of information, is the main cause of the “bullwhip
effect,” named after the way the amplitude of
a whip increases down its length (Figure 4).
In essence, the bullwhip effect states that fluctuations
in orders become larger at every step up the supply
chain, from the customer through to the raw materials
suppliers.
Proctor and Gamble (P&G) executives
coined the term after studying the demand for disposable
diapers (Figure 5). As expected, babies use
diapers at a fairly steady and predictable rate, and
retail sales are quite uniform. But, P&G found that
each retailer bases his own orders on his own slightly
exaggerated forecast, thereby distorting the information
about real demand. Wholesalers' orders to the P&G
diaper factory fluctuated even more. And P&G’s
orders to 3M and other materials suppliers fluctuated
even more.
Figure 5
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The bullwhip effect phenomenon
has been observed in many different industries and occurs
whenever demand uncertainties and variability become
magnified when viewed by managers at each link in the
supply chain. It’s one of the most important causes
of inefficiency in a supply chain.
Figure 6
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Production. One
way to see how severe the bullwhip effect is in production
is to examine sales growth volatility at the customer
end of the supply chain and compare it with production
growth volatility at the opposite end of the supply
chain (Figure 6). Supply chains that use real-time
information effectively should have an information distortion
bullwhip that looks more like the shallower red line.
Figure 7 shows that for durable
goods, production growth volatility is now much closer
to sales growth volatility. The dramatic improvement
in production growth volatility occurred as improved
manufacturing and quality control processes combined
with new information technologies to bring significant
improvements to supply chain operations. For example,
JC Penney has implemented a revolutionary computer system
that directly captures sales data for each of its products
at the cash-register level. Rather than making forecasts
on what corporate managers think they will sell, forecasts
are now based on real-time point-of-sale data.
Figure 7
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For certain men’s dress
shirts, JC Penney has gone a step further and has outsourced
the sales forecasting and inventory management functions
to the shirt maker in Hong Kong. So now, a supplier
in Hong Kong decides how many shirts to make, and in
what styles, colors and sizes, and then sends the shirts
directly to each JC Penney store—bypassing JC
Penney’s corporate decision makers and its warehouses.
Inventory. Information
distortions and the bullwhip effect also unnecessarily
increase inventory at all points along the supply chain.
In many respects, inventory is insurance against supply
chain uncertainties. Unused and unsold inventory can
carry burdensome costs: holding costs, warehouse and
production-line storage costs, insurance costs, and
costs due to obsolescence and spoilage. At the same
time, however, sufficient inventory must be maintained
to meet demand and to keep production flowing as smoothly
as possible.
As shown in Figure 8, producers
have streamlined their operations to hold less inventory.
The inventory-to-shipments ratio dropped markedly during
the 1990s and is now near its all-time low. In essence,
new technologies have allowed firms to replace inventory
with information and then use that information more
productively.
Figure 8
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Indeed, Dell has turned traditional
manufacturing thinking on its head by saying that it
will not make anything until it receives an order from
a customer. In 1996, Dell held 31 days of inventory—today
they hold four days of inventory.
Distribution. Just
about everything that we consume is taken from the earth,
processed, and transported, often with many processing
and transportation steps before it is available to consumers.
Today, the transportation and distribution of goods
often involves greater distances and better coordination.
Yet, as Figure 9 shows, logistics
costs have trended downward—from about 16 percent
of GDP in 1981 to around 8.5 percent today. Transportation
costs have declined by nearly 25 percent, whereas inventory
carrying costs have declined by more than 65 percent.
Logistics costs have declined primarily because inventories
are managed more efficiently: warehousing expenses have
been reduced, and risks have been minimized as third-party
providers increasingly furnish specialized and customized
logistics solutions that are more efficient.
Figure 9
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Payments. Furthermore,
as technology costs have fallen and electronic connections
between companies increase, more firms are adopting
digital technologies and eliminating paper transactions
and human contact. Automatic order placement, billing,
and payment can all be triggered and performed by a
computer without requiring human intervention and a
trail of paperwork. And more and more companies have
developed B2B e-commerce systems to streamline payments
and create a sense of community for communicating with
suppliers. Such systems also guarantee faster payment
and result in fewer losses. Progressive Insurance uses
satellites, camera phones, software, and the Internet
to issue final settlement checks on the spot within
minutes of being called to an accident scene.
All of these improvements—reduced
production volatility, lower inventory levels, less
expensive logistics, and streamlined payments systems—have
a common characteristic: they all use better methodologies
and better technologies to manage information more efficiently
and effectively. Successful businesses are reorganizing
to take advantage of IT and rethink the way work is
done. The end result, of course, is that consumers benefit
from lower prices, higher quality products, and a greater
variety and selection of goods.
Macroeconomic Benefits of Improved
Supply Chains
But have there also been
improvements to the macroeconomy as a result of better
supply chain operations? Figure 10 may look like an
ordinary bar code, but a closer scan reveals that it’s
actually a bar code of U.S. business cycle expansions
and contractions. Each black bar represents a recession;
the fatter the bar, the longer the recession. The time
line starts in 1855, the earliest year for such records
using NBER data. For perspective, the Great Depression
is shown here in red. The large white spaces on the
right side of the figure indicate that the U.S. economy
is in recession far less often today.
Figure 10
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Figure 11 takes a closer look
and shows GDP growth since 1948, and also shows the
economy becoming increasingly more stable. For perspective,
the time line is subdivided into the three supply chain
eras discussed earlier: mass production, lean manufacturing,
and mass customization. GDP growth has averaged 3.4
percent per year since 1995, but without all of the
big swings up and down.
Figure 11
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The pie charts in Figure 12 provide
more evidence that GDP growth has been less volatile
recently. The three pie charts correspond to the three
supply chain eras. The red areas show the percentage
of time when annual GDP growth was negative, which roughly
corresponds to recessionary periods. The yellow areas
show the percentage of time when annual GDP growth was
between 0 and 3.5 percent, and the green areas when
annual GDP growth exceeded 3.5 percent. During the mass
customization era, we see more green and little red.
Figure 12
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Better inventory management is
a key reason behind the economy’s increased stability.
Inventory investment is the largest contributor to reduced
GDP growth volatility across the three eras.
Productivity growth tells a similar
story: it has become less volatile and has been trending
upward for several years (Figure 13). Again,
we see more green in the mass customization era, where
productivity growth exceeds 2.5 percent, and little
red, where productivity growth was negative. As new
technologies help companies streamline supply chain
operations, it makes sense that productivity, measured
as output per hour, would improve.
Figure 13
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We live far better today than
did earlier generations because of the power of productivity.
Our ability to continuously innovate—to improve
production processes, to implement new technologies,
to better manage product and information flows, to engage
in more specialization and trade, and to further upgrade
our skills—allows us to get more for less.
Indeed, productivity growth has
accelerated in recent years, despite several negative
shocks to the economy (Figure 14). Strong productivity
growth and greater economic stability have helped make
the Fed’s job easier. Higher productivity growth
into the future is likely, as the primary drivers of
productivity gains—including continued rapid innovation,
the effective implementation of new information technologies,
and a more competitive and deregulated global economy—remain
firmly in place.
Figure 14
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Other new information technologies, like global positioning
system satellites and radio frequency identification
devices (RFIDs), will continue to greatly improve supply
chains. This is true not just for manufacturing, but
also in retail, insurance, health care, and so on. We
are likely just beginning to see the power of productivity
play out as firms effectively implement these new technologies.
For example, RFIDs can be embedded
into products to transmit information without it having
to be physically scanned in any way. In its simplest
form, an RFID tag allows an object to be tracked and
for it to carry a set of predetermined information about
the product it is embedded in.
The productivity gains from RFIDs
could be substantial. Imagine knowing the contents of
boxes and boxes of things, or truckloads of things,
without having to open them—or a grocery cart
filled with items wheeled through a checkout area with
an instant total.
As an aside, the Dallas area’s
infrastructure of distribution warehouses and supply-chain
experts is helping make RFID an economic catalyst for
the region. Wal-Mart recently used some of its area
stores for testing RFIDs, and the National RFID Center,
located in Richardson, is studying many uses for RFIDs,
with a big emphasis on homeland security.
Conclusion
Through better information
engineering, supply chain improvements have resulted
in a reduced bullwhip effect, lower inventory levels,
reduced logistics costs, and streamlined payments. These
improvements appear to have helped produce macroeconomic
benefits such as more stable economic output and higher
productivity growth.
| Note
- This presentation is based largely on
“The Impact of E-business Technologies
on Supply Chain Operations: A Macroeconomic
Perspective,” by Amit Basu and Thomas
F. Siems, Federal Reserve Bank of Dallas
Working Paper 0404, November 2004. See
http://www.dallasfed.org/research/papers/2004/wp0404.pdf.
About In Depth
This article is based
on a January 2005 presentation by Thomas
F. Siems, a senior economist and policy
advisor in the Research Department of the
Federal Reserve Bank of Dallas.
The views expressed
are those of the authors and do not necessarily
reflect the positions of the Federal Reserve
Bank of Dallas or the Federal Reserve System. |
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