Tag Archives: supply chain management

Reverse Factoring, the Next Financial Bubble?

Some months ago, I read a piece praising Procter&Gamble for having finally adopted the “new standard” of paying suppliers in 90-100 days rather than the “old” 45 days [1]. This new standard comes from using “Reverse Factoring”, a financing approach that became popular in Spain in the 80’s and 90’s (oddly enough, the “Spanish” name for reverse factoring is “confirming”, a registered name by Banco Santander). The scheme has spread since 2008, to many other countries, especially in Northern Europe.

How reverse factoring (RF) works

Consider a strong buyer (say with rating AA) that buys on account from its weak suppliers (say with rating BBB), and pays them in 40 days. Suppliers in need of liquidity sell some of the buyer’s receivables to a financial institution at a high cost, say 15%. The cost is high because 1) the bank protects himself against the risk of the buyer not paying the supplier and 2) the supplier is weak so he may not be able to repay the bank if the buyer doesn’t pay him.

Now the buyer, in conjunction with her bank, proposes the supplier the following: “Whenever you need liquidity, you can sell my receivables to the new bank, which will charge you a mere 6% rather than 15%. In return, I will pay you in 80 days rather than 40.” The bank is willing to charge only 6% because it has the commitment from the buyer that she will pay at due date–recall the buyer is financially strong. The supplier is better off because, even if he is paid later, the lower cost of the factoring contract more than makes up for it. The buyer is better off as well because she pays 40 days later to the supplier, freeing up a nice pile of cash. Therefore, reverse factoring (the scheme just described) seems to be a win-win-win solution. That may be the reason why some European governments, such as Mr. Cameron’s in the UK last year, have seen in this scheme a potential solution for the liquidity problems of many private SME companies, thus they are encouraging firms and financial institutions to adopt RF programs. Others, as the Dutch government, might follow suit.


Where the problem stems from
The scheme works beautifully as long as the buyer pays on time, which is expected, since it is a relatively financially strong player. However, what if the buyer cannot duly pay for her invoices? Banks may immediately opt out of the corresponding RF program, which may well drag weak suppliers into bankruptcy. This may affect an entire industry, and even a major portion of an economy. In fact, if these RF practices generalize, they may well become the seed of the next financial crisis.

You may be right to think that odds are not high that a strong player cannot pay her suppliers on time. But it does not mean that it is impossible. For instance, Moody’s, Standard & Poor’s, and Fitch Ratings of Lehman Brothers was A or above when the latter went bankrupt in Sep 2008. Similarly, 75% of the analysts covering Parmalat had a buy or neutral rating on the stock a quarter before it collapsed in 2003. OF course these two corporations went bankrupt because of a financial scandal, but it is a fact that financial scandals do occur.

How to prevent RF from growing exponentially
Although RF programs may be beneficial under some circumstances, its generalised use may lead to serious situations. One way to prevent these programs from growing too much would be for factors (the financial institutions that provide liquidity) to put a risk premium on buyers, so as to compensate the negative outcome if they collapse. Additionally, suppliers should be aware of the risks of joining these RF programs before it is too late.

References
[1] http://www.scdigest.com/ONTARGET/13-05-02-1.PHP?cid=7006

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The challenge of invisibility

Why Supply Chain innovation is unlikely to be appreciated

Alejandro Serrano – . Jun 2012 | Spain

When faced with the question “What is the name of the most innovative company in the world?”, people will most likely answer “Apple, of course”. The answer seems undeniable, and there are good reasons for that: iPhone, iPad, and iWhatever are synonyms of great innovative products these days.

However, there is a bias there; when people think about innovation, the first idea that comes to mind is product innovation. However, a company can gain a huge competitive advantage trough process or supply chain innovation. I am referring to notorious cases of companies who have completely redefined the way of doing business in their industries. Some examples include Benetton, which changed the sequence of operations by delaying the time where pieces of garment were dyed (postponement), or Barilla, one of the first firms to adopt VMI (Vendor managed inventory) by managing its customers’ inventory so as to reduce order variability amplification. These changes had a large impact on the bottom line and gave these firms a clear competitive advantage in front of their competitors.

The good thing about process innovation is that it may be hard for competitors to copy: there is no “product reverse engineering” to be performed. Competitors can and will try to emulate, but success is not by any means guaranteed. Think for instance about the well-known Toyota Production System (TPS). It has been around for about 40 years and still firms are trying to adopt it with bittersweet results. Why? It is simply that most of the changes cannot be seen, they are embedded in firms’ DNA, as pointed out by Spear and Bowen*, and followers just copy the visible part of it, such as Kanban systems in the case of TPS. A more recent example is Inditex, whose flagship Zara defined a new paradigm in a mature industry by betting on speed rather than cost. With more than 5,500 stores around the world, Inditex’s founder Amancio Ortega, is today the richest man in Europe, right before Ikea’s founder, Ingvar Kamprad, another visionary who also completely changed the rules of his industry.

This may not be the case for firms launching innovative products: Samsung’s Galaxy  Tab is closely following Apple’s iPad and even introducing features which go beyond what the Apple product offers. It is true that patents help sometimes, but the fact remains that a burden of expensive legal work is usually triggered as soon as competitors start copying or including almost identical products in their portfolios. The legal battle triggered when Windows 95 was launched by Microsoft or the generic drug business in India may be good examples of this.

All in all, supply chain innovation is likely not to be appreciated as much as product innovation, but its impact on the financials and the value of firms may be larger and last longer. Also, given the relatively small efforts exerted so far on supply chain innovation, there must be indeed great opportunities available to explore, low hanging fruit to be taken by those smart people who are able to identify those opportunities.

(*) Spear, Steven and H. Kent Bowen. Decoding the DNA of Toyota. Harvard Business Review

 To learn more about Supply Chain www.zlc.edu.es

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To centralize or not to centralize, that is the question

How much safety stock to hold? A ubiquitous question in supply chain network design

Alejandro Serrano –  Apr 2012 | Spain

When a firm designs from scratch its distribution network, a repetitive question arises sooner or later: should we have a centralized or a decentralized network? In a pure centralized network, a large, central distribution center (CDC) contains all the finished-good inventory of the company. In a pure decentralized setting, inventory for each SKU is splitted among several smaller regional distribution centers (RDC).

One of the key questions mangers usually struggle with when deciding about centralizing inventories or not is how many units of each SKU should be held in each case. It is a relevant question, because holding inventory usually entails significant holding costs, both financial and material.

Let us learn the basics of how to answer that question by means of a very simple example: Assume that the demand of a typical product in the portfolio in a stable market is normally distributed, with mean 400 units/period and standard deviation 80 units/period. The market is divided into four identical regions with independent demand. The firm service level target is 95%, thus in the (assumed current) CDC there should be 532 units to maximize expected profit:

(If it is not clear to you why this formula is used, please bear with me; it will be explained in a subsequent post)

Now consider that your company is planning to change its distribution strategy from centralized to decentralized, and so you consider having  four identical RDCs, one per region. The average demand in any region will be 1/4 of total demand, or 400 / 4 = 100 units. The regional variance will be 1/4 of total variance (assuming demand independence across regions), thus the standard deviation in any region will be

The quantity per RDC is

The total inventory is 166 x 4 = 633 units. The safety stock needed, i.e., the amount of inventory to hold above the average demand is 532 – 400 = 131.5 units in the centralized case and 633 – 400 = 263 units in the decentralized case. Interestingly, the latter quantity is exactly two times the former. It is not a coincidence that 2 is the squared root of 4. In fact, when switching from 1 to n DCs, overall safety stock is multiplied by √n. For instance, had we considered 9 RDCs, total inventory to hold would have been 400 + 3 x 131.5 = 795 units.

Of course there may be more involved scenarios (e.g. constraints or demand correlations across regions) that modify the optimal solution. However, keeping in mind this simple square-root formula as a rule of thumb for safety stock will help make back-of-the envelope calculations when quick business decisions have to be made.

To know more about Supply Chain www.zlc.edu.es

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Adidas to cut its assortment by 25%

How many SKUs should a firm offer?

Alejandro Serrano – . Apr 2012 | Spain

Herbert Hainer, CEO of Adidas AG, announced last Saturday* that the company has plans to cut 25% of its 46,897 SKUs. An argument used by Mr. Hainer to justify their decision is that 20% of the current assortment generates 80% of sales.

If this roughly is the case–which should not be surprising, according to Pareto’s law, it means that 80% of the assortment accounts for 20% of sales. And most likely, within the remaining 80% SKUs, Pareto’s law still holds, i.e., 80% of that 80% account for 20% of the remaining 20% of sales, and so on and so for. Working in this fashion we can prepare the following table for how much the SKUs with the least sales sell.

How much SKUs with the least seales sell according to Pareto's Law

As the last row shows, cutting SKUs by 25% means removing those items that contribute to 0.006% of sales, or $1.2m, since Adidas sells roughly $18b. Remarkably, those 12,294 items  only sell $83 (roughly 1 unit) on average worldwide! Therefore, it makes a lot of sense to remove them from the assortment.

The natural question to ask at this point is why pruning 25% of the items and not more. Should Adidas also remove the second-to-last row items (15,367 SKUs!), which sell $400 on average worldwide? What about the third-to-last row?

These question nicely illustrates the usual trade-off between Marketing and Supply Chain departments in the retailing industry. A marketing-driven organization, like Adidas, argues that adding an SKU to the assortment increases sales. The more variety offered, the higher the chances that the customer likes whatever is on the shelf thus the probability of making one additional sale. The penalty to pay is in the form of, mainly, inventory holding cost and ordering cost. In good times (Adidas increased sales by 10% last year) this penalty tends to be underestimated.

Indeed there is no clear answer to the question posed above, but we can have a look at other industries to shed some light on the issue. For instance, in the telecommunication telephone manufacturing industry,  Apple sells only 2 SKUs (i-phone 4, either black or white), whilst Nokia sells at least one model for each market segment (for instance, it sells 37 different models only in Germany). Other successful companies have followed the same trend of reducing the number of SKUs to focus on reducing supply chain costs. Good examples include Lidl in Germany or Mercadona in Spain.

A holistic view of the company is necessary to make sound decisions when answering the question of ow many SKUs in the assortment are needed. Supply chain costs should be carefully pondered before blindly following the advice of marketing experts.

(*) Frankfurter Allgemeine Zeitung. The link to the piece of news is here  (in German)

 To know more about Supply Chain www.zlc.edu.es

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When too much is as bad as too little

Why your firm should not aim at achieving 99% service level for all products (most likely)

Alejandro Serrano – . Mar 2012 | Spain

Last week I attended a nice talk given by the head of logistics of an e-commerce retailer. His firm holds roughly 10,000 SKUs and serves daily demand to end users from a central distribution center. A characteristic of the industry in which this firm operates is that orders should be satisfied in less than 24 hours. Since suppliers’ lead-times are on the weeks or even months (some are based in Asia), the firm is forced to hold large amounts of inventory to cope with uncertain demand.

The firm has a customer service level goal as high as 99% for all products. This figure, 99%, may be judged as appropriate by some people, but rises at least two questions: 1) why 99% and not, for instance, 90% or 99.9%, and 2) why 99% for all 10,000 products.

The answer to the first question might have to do with the fact that achieving 100% service level is virtually impossible. Therefore (put yourself in the CEO’s shoes,) if you want to provide your customers with an excellent service level, a feasible, close-enough-to-100%, easy-to-remember, and popular figure is 99%. And why not, you want to keep that figure high for all 10,000 SKUs in your warehouse.

Picture: directindustry.com

A key point that is missed here is the fact that service level that maximizes expected profit should at least depend on the price and the cost of each particular item. In fact, inventory theory (or common sense) says that one should increase service level until the marginal benefit of adding an additional unit be exactly as high as the marginal cost of adding that additional unit. Note why this makes sense: given the cost of an specific item, if its market price goes up, the firm should increase the service level for that item. Why? a higher price implies a higher unit margin, and you want to capture that additional margin with higher probability, thus inventory should go up. Likewise, if given a price, the cost of an item increases, service level should be reduced to avoid a higher probability of holding too much inventory (as measured in moneys,) which is mainly driven by obsolescence, insurance, spoilage, and financial costs.

There are other factors that have an impact on service level above and beyond price and cost, such as the so-called salvage cost or goodwill cost. But as a conclusion,  and without entering into details on how to compute optimal service levels, it should be apparent that 1) There is an optimal service level that depends on the margin of the product, which may be below or above 99%; and 2) service level should be computed for each SKU, or type of SKUs, thus defining it for all items in a firm does not make by and large much economic sense.

 To know more about Supply Chain www.zlc.edu.es

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Conocimiento y experiencias logísticas innovadoras

Sesión organizada por el IAF y las Cámaras de comercio en Zaragoza

Alejandro Serrano – Mar 2012 | España

“Conocimiento y Experiencias logísticas innovadoras”

El 19 de marzo participo en esta sesión para hablar de la “Supply Chain and Finance Initiative“, puesta en marcha desde el Zaragoza Logistics Center. Haré una breve introducción de qué es ZLC y en qué consiste esta iniciativa. Después ilustraré con un ejemplo cómo cambia el comportamiento de un comprador cuando tiene que preocuparse por el impacto de sus decisiones no sólo en la cuenta de resultados, sino también en el balance de la empresa.

Más información e inscripciones en este enlace.


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Do not call it Logistics if you mean Supply Chain

The messy shift from Logistics to Supply Chain Management

Alejandro Serrano – . Feb 2012 | Spain

The word Logistics, initially borrowed from a military context, has had to do with the ability to move materials and personnel in an efficient way from one place to another. In a business context, according to the APICS dictionary, its meaning has changed to include additional activities, such as procurement and production. Sure enough, in this context, Logistics is defined as

“The art and science of obtaining, producing, and distributing material and product in the proper place and in proper quantities.” (APICS dictionary on line, accessed in Feb 2012)

However, the CSCMP dictionary does not include production activities, but specifically mentions storage and refers also to services and information:

“The process of planning, implementing, and controlling procedures for the […] transportation and storage of goods, including services, and related information from the point of origin to the point of consumption […] This definition includes inbound, outbound, internal, and external movements.” (CSCMP. Terms and Glossary. Feb 2010)

which is closer to its original meaning, i.e., “just” transportation and storage. it seems that, as the realm of the discipline was increasing an attempt was done to adjust the word logistics to the broader context of application, what explains the broader scope of logistics according to APICS.

Enter Supply Chain

In the early eighties, logistics was not enough to refer to all the increasing types of activities performed by  “logistics” managers, and a new term was coined: “Supply Chain Management”. A strategic flavor was added and the scope was enlarged both longitudinally (from “end to end,” or E2E) and transversely (not only material flows, but also information and cash was considered.) The two aforementioned dictionaries agree on this scope, except for the CSCMP dictionary, which does not mention cash.

“The global network used to deliver products and services from raw materials to end customers through an engineered flow of information, physical distribution, and cash.” (APICS dictionary on line, accessed in Feb 2012)

“The material and informational interchanges in the logistical process stretching from acquisition of raw materials to delivery of finished products to the end user. All vendors, service providers and customers are links in the supply chain.” (CSCMP. Terms and Glossary. Feb 2010)

Since then, the two terms have coexisted, but the evolution of the word Logistics towards Supply Chain (as it can be seen in the definition of Logistics according to APICS) still creates a lot of confusion in industry and academia. In my opinion, the relationship between the two could be defined as follows: “Logistics is the portion of Supply Chain that is concerned with the activities of transportation and storage of parts,” which is line with the CSCMP definition.

Supply Chain, however, is concerned not only with transportation and storage, but with many other key processes, such as demand forecasting, planning, purchasing, collaboration (contracts), outsourcing, facility location (network design), or inventory management (how much and where to hold inventory.)

To learn more about Supply Chain www.zlc.edu.es

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