Supply Chain

Management

Contents
1

A general perspective of logistics and supply chain ........................................................................ 4

1.1 Origins and definitions .............................................................................................................. 4
1.2 Importance of logistics .............................................................................................................. 9
1.3 Logistics systems ...................................................................................................................... 9
Supply chains ................................................................................................................................... 9
2.1 Structure of the supply chain and its performance drivers ...................................................... 11
2.2 Benefits of supply chains ........................................................................................................ 14
2.3 Organizing logistics in a company and its aims ...................................................................... 16
2.4 Effects on financial performance ............................................................................................ 17
2.5 Participants in supply chains ................................................................................................... 18
2.5.1 Producers ........................................................................................................................... 19
2.5.2 Distributors........................................................................................................................ 19
2.5.3 Retailers ............................................................................................................................ 19
2.5.4 Customers.......................................................................................................................... 19
2.5.5 Service providers............................................................................................................... 19
2.6 Activities in supply chains ...................................................................................................... 20
2.6.1 Order processing ............................................................................................................... 21
2.6.2 Inventory management ...................................................................................................... 22
2.6.3 Freight transportation ........................................................................................................ 24
2.7 Supply chain operations .......................................................................................................... 28
2.7.1 SCOR Model ..................................................................................................................... 28
2.7.2 Plan: demand forecasting .................................................................................................. 29
2.7.3 Plan: product pricing ......................................................................................................... 31
2.7.4 Plan: inventory management ............................................................................................. 32
2.7.5 Source: procurement ......................................................................................................... 33
Supply Chain Integration................................................................................................................ 34
3.1 Arguments for integration ....................................................................................................... 34
3.2 Integrating logistics ................................................................................................................. 35
3.2.1 Within an organization ...................................................................................................... 35
3.2.2 Along the supply chain ..................................................................................................... 37
3.2.3 Benefits of integration ....................................................................................................... 38
3.2.4 Achieving integration ........................................................................................................ 38
Managerial Issues and trends in Logistics ...................................................................................... 41
4.1 Logistics Managerial Issues .................................................................................................... 41
4.2 Trends in logistics ................................................................................................................... 41
4.2.1 Communication improvements ......................................................................................... 41
4.2.2 E-commerce ...................................................................................................................... 42
4.2.3 Customer service improvement ........................................................................................ 43
4.2.4 Other significant trends ..................................................................................................... 43
4.3 Logistics Decisions ................................................................................................................. 45
4.3.1 Decision support methods ................................................................................................. 45
Procurement or purchasing ............................................................................................................. 47
5.1 Procurement objectives ........................................................................................................... 47
5.2 Selecting suppliers .................................................................................................................. 48
5.3 Procurement cycle ................................................................................................................... 50
5.4 E-procurement ......................................................................................................................... 51
5.5 Types of purchase ................................................................................................................... 53
5.5.1 Different approaches for different products ...................................................................... 53
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5.5.2 Terms and conditions ........................................................................................................ 54

Inventory management and strategy............................................................................................... 57
6.1 Inventory Types and Characteristics ....................................................................................... 57
6.2 Inventory-related concepts ...................................................................................................... 58
6.3 Inventory carrying cost ........................................................................................................... 61
6.4 Planning inventory .................................................................................................................. 62
6.4.1 When to order.................................................................................................................... 62
6.4.2 How much to order ........................................................................................................... 62
6.5 Managing uncertainty ............................................................................................................. 66
6.5.1 Demand Uncertainty ......................................................................................................... 66
6.5.2 Performance cycle uncertainty .......................................................................................... 70
6.5.3 Combined demand and performance cycle uncertainty .................................................... 71
6.6 Inventory management policies .............................................................................................. 74
6.6.1 Inventory control ............................................................................................................... 74
7 Warehousing ................................................................................................................................... 76
7.1 Some historical aspects and evolution .................................................................................... 76
7.2 The function of warehousing .................................................................................................. 76
7.2.1 Economic benefits ............................................................................................................. 76
7.2.2 Service benefits ................................................................................................................. 79
7.3 Warehouse operations ............................................................................................................. 80
7.3.1 Handling ............................................................................................................................ 80
7.3.2 Storage .............................................................................................................................. 81
7.4 Warehouse planning ................................................................................................................ 82
7.4.1 Site selection ..................................................................................................................... 82
7.4.2 Design ............................................................................................................................... 85
7.5 Initiating warehouse operations .............................................................................................. 89
7.5.1 Stocking ............................................................................................................................ 89
7.5.2 Training ............................................................................................................................. 89
7.5.3 Warehouse management systems...................................................................................... 90
7.5.4 Security ............................................................................................................................. 90
7.5.5 Delivery............................................................................................................................. 91
7.5.6 Safety and maintenance .................................................................................................... 91
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1 A general perspective of logistics and supply chain

Manufacturers now compete less on product and quality which are often comparable and more on inventory turns and speed
to market.
John Kasarda, Forbes,October 18, 1999

Logistics and supply chains are the key to the modern economy. Almost every organization faces the
problem of getting the right materials to the right place at the right time. Increasingly competitive markets are
making it imperative to manage logistics systems more and more efficiently. We consider that logistics could
be the competitive advantage that brings an organization to the top.
Supply chains encompass the companies and the business activities needed to design, make, deliver,
and use a product or service.
Every business fits into one or more supply chains and has a role to play in each of them. Companies
are aware of the supply chains they participate in and they try to understand very well the roles that they play
inside markets which are changing and are becoming very dynamic and uncertain nowadays. Those
companies that learn how to build and participate in strong supply chains will have a substantial competitive
advantage in their markets.
Logistics is responsible for the physical movement of materials and, sometimes, people. It is a part of
the so called supply chain, which includes much more than logistics.
Logistics deals with the planning and control of material flows and related information in
organizations, both in the public and private sectors.
Its mission:
- to get the right materials to the right place at the right time, while optimizing a given performance
measure (e.g. minimizing total operating costs) and satisfying a given set of constraints (e.g. a budget
constraint)
The key issue is to decide how and when raw materials, semi-finished and finished goods should be
acquired, moved and stored. Logistics problems also arise in firms and public organizations producing
services. This is the case of garbage collection, mail delivery, public utilities and after-sales service.

1.1 Origins and definitions

Napoleon made the remark, An army marches on its stomach meaning that unless the soldiers are
fed, the army cannot move. In the same context there is another saying: Amateurs talk strategy and
professionals talk logistics (Alexander the Great) meaning that no strategy could be accomplished without
figuring out how to meet the need of providing an army with fuel, spare parts, food, shelter, and ammunition.
This remarks come from military area but they have many analogies in business.
Talking about the history of term supply chain management, first were logistics and operations
management and supply chain is much younger. There are a lot of debates in the literature whether there
are differences between these concepts or not. We are able to point out three different common views of the
supply chain:
1. Supply chain is just another term for logistics.
2. Supply chain includes other functions such as purchasing, engineering, production, finance,
marketing, and related control activities in the single company.
3. The supply chain is all the functions in definition #2 plus those in a companys suppliers suppliers
and a companys customers customers as well extending far outside the traditional enterprise.
Some definitions of a supply chain are offered below:
A supply chain is the alignment of firms that bring products or services to market.from
Lambert, Stock, and Ellram in their book Fundamentals of Logistics Management (Lambert,
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Douglas M., James R. Stock, and Lisa M. Ellram, 1998, Fundamentals of Logistics
Management, Boston, MA: Irwin/McGraw-Hill, Chapter 14).
A supply chain consists of all stages involved, directly or indirectly, in fulfilling a customer
request. The supply chain not only includes the manufacturer and suppliers, but also
transporters, warehouses, retailers, and customers themselves. from Chopra and Meindl in
their book Supply Chain Management: Strategy, Planning, and Operations (Chopra, Sunil, and
Peter Meindl, 2001, Supply Chain Management: Strategy, Planning, and Operations, Upper
Saddle River, NJ: Prentice-Hall, Inc. Chapter 1).
A supply chain is a network of facilities and distribution options that performs the functions
of procurement of materials, transformation of these materials into intermediate and finished
products, and the distribution of these finished products to customers.from Ganeshan and
Harrison at Penn State University in their article An Introduction to Supply Chain Management
Supply chain : Life cycle processes comprising physical, information, financial, and knowledge
flows whose purpose is to satisfy end-user requirements with products and services from
multiple linked suppliers

A SUPPLY CHAIN consists of the series of activities and organizations that move materials through
on their journey from initial suppliers to final customers, while LOGISTICS is the function responsible for
the flow of materials from suppliers into an organization, through operations within the organization, and
then out to customers. Sometimes, rarely we admit, logistics are also responsible for the movement of people
inside and outside the organization.
If this is what a supply chain is then we can define supply chain management as the things we do to
influence the behavior of the supply chain and get the results we want based on responsiveness and
efficiency. Supply chain management is the coordination of production, inventory, location, and
transportation among the participants in a supply chain to achieve the best mix of responsiveness and
efficiency for the market being served. (Essentials of Supply Chain Management, Michael Hugos).
There is a difference between the concept of supply chain management and the traditional concept of
logistics. Logistics typically refers to activities that occur within the boundaries of a single organization and
supply chains refer to networks of companies that work together and coordinate their actions to deliver a
product to market. Also traditional logistics focuses its attention on activities such as procurement,
distribution, maintenance, and inventory management. Supply chain management acknowledges all of
traditional logistics and also includes activities such as marketing, new product development, finance, and
customer service. Supply chain management views the supply chain and the organizations in it as a single
entity.
Here we have another approach:
Logistics is responsible for the flow of materials through a supply chain. This function is also called
supply chain management. Some people argue that logistics is somewhat narrower and concentrates on the
movement within a single organisation, while supply chain management takes a broader view of movement
through related organisations. This is, however, largely an argument over semantics rather than real
differences in practice. Here we will stick to the convention that the two terms refer to exactly the same
function. This view is supported by the Institute of Logistics and Transport the main professional body
within the UK.
In order to have a better view of the main concept of supply chain, its useful to clarify the meaning
and the role of some other related concepts and terms.
PRODUCTS: every organization delivers products to its customers. Products include: goods or
services and it is more and more actual that the products of today are a mixture of goods and services
(attached services) then the cases of pure goods or pure services.
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OPERATIONS: Is the core of any organization. They create and deliver the products. Operations
take a variety of inputs and convert them into desired outputs.

Operations are divided into parts or components, which designate quite often different departments or
offices inside organizations. These parts are interrelated and they are direct contributors to activities and
processes deployed within the boundaries of organizations and outside them. Going back to the definition of
logistics, we can say that logistics is also responsible for the movement of materials through different parts
(of operations) of an organization.

MATERIALS: are all the things that an organisation moves to create its products.These materials
can be both tangible (such as raw materials) and intangible (such as information).
Examples:
- a power station brings coal from a mine
- a farmer moves potatoes to a wholesaler
- a computer manufacturer delivers PCs to a warehouse
- a television company delivers entertainment to its viewers
- a telephone company provides a communications service
- research company creates new knowledge
- an university delivers education
Having clarified what materials means we do state that logistics are responsible for materials
movement. Moving materials into the organisation from suppliers is called inbound or inward logistics;
moving materials out to customers is outbound or outward logistics; moving materials within the
organisation is materials management.
Till this moment its clear that supply chain represents a series of activities and organizations
involved into materials transformation and product movement while logistics is strictly responsible with the
function of movement.
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People use different names for these chains of activities and organisations. When they emphasise the
operations, they refer to the process; when they emphasise marketing, they call it a logistics channel; when
they look at the value added, they call it a value chain, when they see how customer demands are satisfied,
they call it a demand chain. Here we are emphasising the movement of materials and will use the most
general term of supply chain.
Every product has its own unique supply chain, and these can be both long and complicated.
Examples:
- the supply chain of chocolate starts with cocoa beans growing on farms and ends with the delivery
of bars of chocolate to hungry customers
- The supply chain of jeans starts with cotton growing in a field and ends when you buy the jeans in
a shop.
Along this journey materials may move through raw materials suppliers, manufacturers, finishing
operations, logistics centres, warehouses, third party operators, transport companies, wholesalers,
retailers, and a whole range of other operations. Sometimes, the supply chain goes beyond the final customer
to add recycling and re-use of materials.

1.2 Importance of logistics

Logistics is one of the most important activities in modern societies and this is proved by a few
figures. Overall, in 2007 total logistics cost was 11% of GDP in USA and around 10% at the global level. In
the following table some results are available regarding logistics cost for EU firms:

1.3 Logistics systems

-

A logistics system is formed by two parts:

a set of facilities
transportation services

Facilities are linked by transportation services.

Facilities are sites where materials are processed, e.g. manufactured, stored, sorted, sold or
consumed. They include manufacturing and assembly centers, warehouses, distribution centers (DCs),
transportation terminals, retail outlets, mail sorting centers, garbage incinerators, dump sites, etc.
Transportation services move materials between facilities using vehicles and equipment such as
trucks, tractors, trailers, crews, pallets, containers, cars and trains.

2 Supply chains
A supply chain is a complex logistics system in which raw materials are converted into finished
products and then distributed to the final users (consumers or companies). It includes suppliers,
manufacturing centers, warehouses, DCs and retail outlets.

Figure 1.1 shows a typical supply chain in which the production and distribution systems are made up
of two stages each. In the production system, components and semi-finished parts are produced in two
manufacturing centers while finished goods are assembled at a different plant. The distribution system
consists of two central distribution centres (CDCs) supplied directly by the assembly centre, which in turn
replenish two regional distribution centres (RDCs) each. Of course, depending on product and demand
characteristics it may be more appropriate to design a supply chain without separate manufacturing and
assembly centres (or even without an assembly phase), without RDCs or with different kinds of facilities
(e.g. crossdocks). Each of the transportation links in Figure 1.1 could be a simple transportation line (e.g. a
truck line) or of a more complex transportation process involving additional facilities (e.g. port terminals)
and companies (e.g. truck carriers). Similarly, each facility in Figure 1.1 comprises several devices and
subsystems. Logistics is not normally associated with the detailed planning of material flows inside
manufacturing and assembly plants. Logistics area of interest is about the design and operations of DCs and
transportation terminals.
Push versus pull supply chains. Supply chains are often classified as push or pull systems. In a pull
(or make-to-order (MTO)) system, finished products are manufactured only when customers require them.
Hence, in principle, no inventories are needed at the manufacturer. In a push (or make-to-stock (MTS))
system, production and distribution decisions are based on forecasts. As a result, production anticipates
effective demand, and inventories are held in warehouses and at the retailers. Whether a push system is more
appropriate than a pull system depends on product features, manufacturing process characteristics, as well as
demand volume and variability. MTO systems are more suitable whenever lead times1 are short, products are
costly, and demand is low and highly variable.
In some cases, a mixed approach can be used. For example, in make-to-assembly (MTA) systems
components and semi-finished products are manufactured in a push-based manner while the final assembly
stage is pull-based.
Product and information flows in a supply chain. Products flow through the supply chain from raw
material sources to customers, except for obsolete, damaged and nonfunctioning products which have to be

A lead time is the period of time between the initiation of any process and the completion of it

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returned to their sources for repair or replacement (downstream). Information follows a reverse path. It
traverses the supply chain backward from customers to raw material suppliers (upstream).
In an MTO system, end-user orders are collected by salesmen and then transmitted to manufacturers
who in turn order the required components and semi-finished products from their suppliers. Similarly, in an
MTS system, past sales are used to forecast future product demand and associated material requirements.
Product and information flows cannot move instantaneously through the supply channel. First, freight
transportation between raw material sources, production plants and consumption sites is usually time
consuming. Second, manufacturing can take a long time, not only because of processing itself, but also
because of the limited plant capacity (not all products in demand can be manufactured at once). Finally,
information can flow slowly because order collection, transmission and processing take time, or because
retailers place their orders periodically (e.g. once a week), and distributors make their replenishment
decisions on a periodic basis (e.g. twice a week).
Degree of vertical integration and third-party logistics. According to a classical economic
concept, a supply chain is said to be vertically integrated if its components (raw material sources, plants,
transportation system, etc.) belong to a single firm. Fully vertically integrated systems are quite rare. More
frequently the supply chain is operated by several independent companies. This is the case of manufacturers
buying raw materials from outside suppliers, or using contractors to perform particular services, such as
container transportation and warehousing. The relationships between the companies of a supply chain may be
transaction based and function specific (as those illustrated in the previous example), or they can be strategic
alliances. Strategic alliances include third-party logistics (3PL) and vendor-managed resupply. 3PL is a
long-term commitment to use an outside company to perform all or part of a companys product distribution.
It allows the company to focus on its core business while leaving distribution to a logistics outsourcer. 3PL is
suitable whenever the company is not willing to invest much in transportation and warehousing
infrastructures, or whenever the company is unable to take advantage of economies of scale because of low
demand. On the other hand, 3PL causes the company to lose control of distribution and may possibly
generate higher logistics costs.
Retailer-managed versus vendor-managed resupply. Traditionally, customers (both retailers and
final consumers) have been in charge of monitoring their inventory levels and place purchase orders to
vendors (retailer-managed systems). In recent years, there has been a growth in vendor-managed systems, in
which vendors monitor customer sales (or consumption) and inventories through electronic data interchange
(EDI), and decide when and how to replenish their customers. Vendors are thus able to achieve cost savings
through a better coordination of customer deliveries while customers do not need to allocate costly resources
to inventory management. Vendor managed resupply is popular in the gas and soft drink industries, although
it is gaining in popularity in other sectors. In some vendor-managed systems, the retailer owns the goods
sitting on the shelves, while in others the inventory belongs to the vendor. In the first case, the retailer is
billed only at the time where it makes a sale to a customer.

2.1 Structure of the supply chain and its performance drivers

The simplest view of a supply chain has a single product moving through a series of organisations,
each of which somehow adds value to the product.
Taking one organisations point of view, activities in front of it moving materials inwards are
called upstream; those after the organisation moving materials outwards are called downstream.
The upstream activities are divided into tiers of suppliers. A supplier that sends materials directly to
the operations is a first tier supplier; one that send materials to a first tier supplier is a second tier supplier;
one that sends materials to a second tier supplier is a third tier supplier, and so on back to the original
sources. Customers are also divided into tiers. One that gets a product directly from the operations is a first
tier customer; one that gets a product from a first tier customer is a second tier customer; one that get a
product from a second tier customer is a third tier customer, and so on to final customers:
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A supply chain could be much more complicated in the real life as seen in the following image:

Each product has its own supply chain, and there are a huge number of different configurations.
Some are very short and simple such as a cook buying potatoes directly from a farmer. Others are
surprisingly long and complicated.
Supply chains diverge to meet demand from different types of customer. Supply chain divides into
separate strands with the same product following alternative routes. For example, companies producing
furniture might deliver completed assembled furniture to specialized retail shops but also could sell some
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parts to assembly plants, some to wholesalers, some to those doing repairs and service and others might be
sold through internet.
Some people say that is too simple to call such chains just supply chain and is more appropriate to
call them supply network or supply web.
Performance drivers
As we already know, companies in any supply chain have to take decisions individually and
collectively regarding their roles on that supply chain. There are 5 areas where companies can make
decisions that will define their supply chain performance: Production; Inventory; Location; Transportation;
and Information. They are also called performance drivers of the supply chain.
Production
Production refers to the capacity of a supply chain to make and store products. The facilities of
production are factories and warehouses. The fundamental decision that managers face when making
production decisions is how to resolve the trade-off between responsiveness and efficiency. If factories and
warehouses are built with a lot of excess capacity, they can be very flexible and respond quickly to wide
swings in product demand. Facilities where all or almost all capacity is being used are not capable of
responding easily to fluctuations in demand.On the other hand, capacity costs money and excess capacity is
idle capacity not in use and not generating revenue. So the more excess capacity that exists, the less efficient
the operation becomes.
Inventory
Inventory is spread throughout the supply chain and includes everything from raw material to work in
process to finished goods that are held by the manufacturers, distributors, and retailers in a supply chain.
Again, managers must decide where they want to position themselves in the trade-off between
responsiveness and efficiency. Holding large amounts of inventory allows a company or an entire supply
chain to be very responsive to fluctuations in customer demand. However, the creation and storage of
inventory is a cost and to achieve high levels of efficiency, the cost of inventory should be kept as low as
possible.
Location
Location refers to the geographical siting of supply chain facilities. It also includes the decisions
related to which activities should be performed in each facility. The responsiveness versus efficiency tradeoff here is the decision whether to centralize activities in fewer locations to gain economies of scale and
efficiency, or to decentralize activities in many locations close to customers and suppliers in order for
operations to be more responsive.
When making location decisions, managers need to consider a range of factors that relate to a given
location including the cost of facilities, the cost of labor, skills available in the workforce, infrastructure
conditions, taxes and tariffs, and proximity to suppliers and customers. Location decisions tend to be very
strategic decisions because they commit large amounts of money to long-term plans.
Transportation
This refers to the movement of everything from raw material to finished goods between different
facilities in a supply chain. In transportation the trade-off between responsiveness and efficiency is
manifested in the choice of transport mode. Fast modes of transport such as airplanes are very responsive but
also more costly. Slower modes such as ship and rail are very cost efficient but not as responsive. Since
transportation costs can be as much as a third of the operating cost of a supply chain, decisions made here are
very important.
There are six basic modes of transport that a company can choose from: ship, rail, pipelines, truck, air
and electronic transport (electric energy, data, and products composed of data such as music, pictures, and
text).
Information
Information is the basis upon which to make decisions regarding the other four supply chain drivers.
Information is used for two purposes in any supply chain:
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1. Coordinating daily activities related to the functioning of the other four supply chain drivers:
production; inventory; location; and transportation. The companies in a supply chain use available data on
product supply and demand to decide on weekly production schedules, inventory levels, transportation
routes, and stocking locations.
2. Forecasting and planning to anticipate and meet future demands. Available information is used to
make tactical forecasts to guide the setting of monthly and quarterly production schedules and timetables.
Information is also used for strategic forecasts to guide decisions about whether to build new facilities, enter
a new market, or exit an existing market.
Within an individual company the trade-off between responsiveness and efficiency involves weighing
the benefits that good information can provide against the cost of acquiring that information. Abundant,
accurate information can enable very efficient operating decisions and better forecasts but the cost of
building and installing systems to deliver this information can be very high.
Within the supply chain as a whole, the responsiveness versus efficiency trade-off that companies
make is one of deciding how much information to share with the other companies and how much information
to keep private. The more information about product supply, customer demand, market forecasts, and
production schedules that companies share with each other, the more responsive everyone can be.

2.2 Benefits of supply chains

Supply chains are so complicated that you might wonder if there is some way of avoiding them.
Sometimes this is possible, when we move products directly from initial producers to final customers but in
the most of the cases there are reasons in the favor of their existence.
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For example, farm shops could sell vegetables directly to consumers. Suppose the population of a
town decides to buy vegetables from a farm shop. This would have a minimal supply chain, but the whole
population would travel separately to the farm. It would make more sense to have a transport company
collect the vegetables and deliver them to a central location in the town like a supermarket. If the transport
company delivers to one town, it can easily deliver to other nearby towns, perhaps stopping at a depot to
organize local deliveries. As there is a depot, vegetables can be put into storage while the supply is plentiful,
and removed when there are shortages. If the vegetables need cleaning or preparation, the transport company
can divert to a processing plant. Continuing in this way, you can see why a long supply chain develops, and
what benefits it brings.
Supply chains exist to overcome the gaps created when suppliers are some distance away from
customers.
They allow for operations that are best done or can only be done at locations that are distant
from customers or sources of materials.
Supply chains allow for mismatches between supply and demand and they are able to balance demand
and supply. This is very important especially in the cases when production is done seasonally and demand is
more or less constant or production is constant and demand is so variable. When there is excess supply,
stocks are built-up in the supply chain.
Supply chains can also make movements a lot simpler. An example can be observed in the following
figure:

The figure presents the situation of 4 factories deriverying products to 8 customers. Using direct
distribution, which is the simplest supply chain configuration, logistics has to organise 32 different delivery
routes. In the second case, using a central wholesaler (or warehouse), which is a bit complicated supply chain
configuration, the number of routes is cut to 12.
Some other benefits of well-designed supply chains:
Producers locate operations in the best locations, regardless of the locations of their
customers.
Producers can get economies of scale, by concentrating operations in large facilities.
Producers do not keep large stocks of finished goods, as these are held further down the
supply chain nearer to customers.
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Wholesalers place large orders, and producers pass on lower unit costs in price discounts.
Wholesalers keep stocks from many suppliers, giving retailers a choice of goods.
Wholesalers are near to retailers and have short lead times.
Retailers carry less stock as wholesalers provide reliable deliveries.
Retailers can have small operations, giving a responsive service near to customers.
Transport is simpler, with fewer, larger deliveries reducing costs.
Organisations can develop expertise in specific types of operation.

2.3 Organizing logistics in a company and its aims

Logistics takes place in almost every organization taking many different forms. The most classical
view is that image with forklift trucks unloading pallets from lorries and moving them around warehouses.
But we also talk about logistics even when we have to decide for example, what kind of branch network to
have, where to locate offices, who to buy telephone and other services from, how to deliver information to
customers in an insurance company or bank.
The activities can be arranged in many ways within an organization, and there is certainly no single
best arrangement. A small organization might have one person looking after everything. A medium sized
organization might have one department with different sections for purchasing, transport, stock control,
distribution, and so on. A large organization might have a logistics division employing thousands of people
and running huge transport fleets.
Sometimes all the activities are organized in a single department reporting to a logistics director;
sometimes they are part of a larger department such as marketing or production; sometimes they are spread
out in small pockets throughout the organization; sometimes they are contracted out to third-party suppliers.
The current trend is towards an organization where logistics is a single integrated function, with a
logistics director or equivalent at its head. This follows a traditional functional structure, with the
logistics director working with directors in production, finance, sales, human resources, and so on.
There are many variations on this, with a common one found in companies organized around products
or projects. Then some logistics might exist in each division, with a matrix structure allowing co-ordination
of the overall function. The both forms, as an integrated function and product based organizing, are
represented in the following figure:

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The overall AIM OF LOGISTICS is to achieve high customer satisfaction. It must provide a high
quality service with low or acceptable costs.
Any organization can give outstanding customer service if it is prepared to allocate enough resources.
The problem, of course, is that more resources come with higher costs. There is a limit to the amount that
customers will pay for a product and, therefore, on the service that can be given. Then a realistic aim for
logistics balances the service given to customers with the cost of achieving it.
Logistics adds value by making products available in the right place and at the right time. If a product
is available at the place it is needed, logistics is said to have added place utility; if it is delivered at the right
time, logistics has added time utility.
People often summarize the aims of logistics as getting, the right materials, to the right place, at the
right time, from the right source, with the right quality, at the right price. This is broadly correct, but it
depends on how we define right.
Managers have to design logistics that are flexible enough to satisfy a variety of needs. There are two
aspects to this. The first is concerned with planning, when managers take a strategic view and design the best
possible supply chain for their circumstances. The second concern is about execution, when materials move
through this chain as efficiently as possible. Harrington summarizes this double role by saying that, logistics
is both the glue that holds the materials/product pipeline together and the grease that speeds product flow
along it.

2.4 Effects on financial performance

As an expensive function, logistics has an impact on an organisations overall financial performance.
We can give many illustrations of this, but will start with the effects on the return on assets (ROA).
The return on assets is defined as the pre-tax profit earned by an organisation divided by the value of
the assets employed.
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This gives a measure of how well available resources are used and, in general, the higher the value,
the better the organisations performance. Assets are usually described as current (cash, accounts receivable,
stocks, and so on) or fixed (property, plant, equipment, and so on). Improving the flow of materials reduces
the amount of stock. This clearly lowers current assets, but we can argue that it also reduces fixed assets and
increases profit (see the following figure)

Current assets. More efficient logistics reduces the current assets through lower stock levels.
Reducing the investment in stock can also free up cash for other more productive purposes and reduce the
need for borrowing.
Fixed assets. Fixed assets include property, plant and equipment. Logistics is a heavy user of these
resources, and the warehouses, transport fleets, materials handling equipment and other facilities needed to
move materials through the supply chain form a major part of fixed assets.
Sales. By making a more attractive product, or making it more readily available, logistics can increase
sales and give higher market share.
Profit margin. More efficient logistics gives lower operating costs, and this in turn leads to higher
profit margins.
Price. Logistics can improve the perceived value of products perhaps making them more easily
available, giving faster delivery or shortening lead times. More attractive products can get premium prices.

2.5 Participants in supply chains

In any given supply chain there is some combination of companies who perform different functions.
There are companies that are producers, distributors or wholesalers, retailers, and companies or individuals
who are the customers, the final consumers of a product. Supporting these companies there will be other
companies that are service providers that provide a range of needed services.
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2.5.1 Producers
Producers or manufacturers are organizations that make a product. This includes companies that are
producers of raw materials and companies that are producers of finished goods. Producers of raw materials
are organizations that mine for minerals, drill for oil and gas, and cut timber. It also includes organizations
that farm the land, raise animals, or catch seafood. Producers of finished goods use the raw materials and
subassemblies made by other producers to create their products.
Producers can create products that are intangible items such as music, entertainment, software, or
designs. A product can also be a service such as mowing a lawn, cleaning an office, performing surgery, or
teaching a skill. In many instances the producers of tangible, industrial products are moving to areas of the
world where labor is less costly. Producers in the developed world of North America, Europe, and parts of
Asia are increasingly producers of intangible items and services.

2.5.2 Distributors
Distributors are companies that take inventory in bulk from producers and deliver a bundle of related
product lines to customers. Distributors are also known as wholesalers. They typically sell to other businesses
and they sell products in larger quantities than an individual consumer would usually buy. Distributors buffer
the producers from fluctuations in product demand by stocking inventory and doing much of the sales work
to find and service customers. For the customer, distributors fulfill the Time and Place functionthey
deliver products when and where the customer wants them.
A distributor is typically an organization that takes ownership of significant inventories of products that
they buy from producers and sell to consumers. In addition to product promotion and sales, other functions
the distributor performs are inventory management, warehouse operations, and product transportation as well
as customer support and post-sales service. A distributor can also be an organization that only brokers a
product between the producer and the customer and never takes ownership of that product. This kind of
distributor performs mainly the functions of product promotion and sales. In both these cases, as the needs of
customers evolve and the range of available products changes, the distributor is the agent that continually
tracks customer needs and matches them with products available.

2.5.3 Retailers
Retailers stock inventory and sell in smaller quantities to the general public. This organization also
closely tracks the preferences and demands of the customers that it sells to. It advertises to its customers and
often uses some combination of price, product selection, service, and convenience as the primary draw to
attract customers for the products it sells. Discount department stores attract customers using price and wide
product selection. Upscale specialty stores offer a unique line of products and high levels of service. Fast
food restaurants use convenience and low prices as their draw.

2.5.4 Customers
Customers or consumers are any organization that purchases and uses a product. A customer
organization may purchase a product in order to incorporate it into another product that they in turn sell to
other customers. Or a customer may be the final end user of a product who buys the product in order to
consume it.

2.5.5 Service providers

These are organizations that provide services to producers, distributors, retailers, and customers.
Service providers have developed special expertise and skills that focus on a particular activity needed by a
supply chain. Because of this, they are able to perform these services more effectively and at a better price
than producers, distributors, retailers, or consumers could do on their own.
Some common service providers in any supply chain are providers of transportation services and
warehousing services. These are trucking companies and public warehouse companies and they are known as
19

logistics providers. Financial service providers deliver services such as making loans, doing credit analysis,
and collecting on past due invoices. These are banks, credit rating companies, and collection agencies. Some
service providers deliver market research and advertising, while others provide product design, engineering
services, legal services, and management advice. Still other service providers offer information technology
and data collection services. All these service providers are integrated to a greater or lesser degree into the
ongoing operations of the producers, distributors, retailers, and consumers in the supply chain.
Supply chains are composed of repeating sets of participants that fall into one or more of these
categories. Over time the needs of the supply chain as a whole remain fairly stable.What changes is the mix
of participants in the supply chain and the roles that each participant plays.

2.6 Activities in supply chains

Logistics is responsible for the movement and storage of materials as they move through the supply
chain. If you follow some materials moving through an organisation, you can see that the following activities
are normally included in logistics.
1. Procurement or purchasing. The flow of materials through an organisation is usually initiated when
procurement sends a purchase order to a supplier. This means that procurement:
finds suitable suppliers,
negotiates terms and conditions,
organises delivery,
arranges insurance and payment, and
does everything needed to get materials into the organisation.
2. Inward transport or traffic actually moves materials from suppliers to the organisations receiving area.
This has to choose:
the type of transport (road, rail, air, and so on),
find the best transport operator,
design a route,
make sure that all safety and legal requirements are met,
get deliveries on time and at reasonable cost, and so on.
3. Receiving makes sure that:
materials delivered correspond to the order,
acknowledges receipt,
unloads delivery vehicles,
inspects materials for damage, and
sorts them.
4. Warehousing or stores moves materials into storage, and takes care of them until they are needed. Many
materials need special care, such as frozen food, drugs, chemicals, animals, and dangerous goods. As well
as making sure that materials can be available quickly when needed, warehousing also makes sure that
they have the right conditions, treatment and packaging to keep them in good condition.
5. Stock control sets the policies for inventory. It considers the materials to store, overall investment,
customer service, stock levels, order sizes, order timing and so on.
6. Order picking finds and removes materials from stores. Typically materials for a customer order are:
located,
identified,
checked,
removed from racks,
consolidated into a single load,
wrapped and moved to a departure area for loading onto delivery vehicles

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7. Materials handling moves materials through the operations within an organisation. It moves materials
from one operation to the next, and also moves materials picked from stores to the point where they are
needed. The aim of materials handling is to give :
efficient movements,
with short journeys,
using appropriate equipment,
with little damage, and
using special packaging and handling where needed.
8. Outward transport takes materials from the departure area and delivers them to customers (with concerns
that are similar to inward transport).
9. Physical distribution management is a general term for the activities that deliver finished goods to
customers, including outward transport. It is often aligned with marketing and forms an important link
with downstream activities.
10. Recycling, returns and waste disposal. Even when products have been delivered to customers, the work
of logistics may not be finished. There might, for example, be problems with delivered materials
perhaps they were faulty, or too many were delivered, or they were the wrong type and they have to be
collected and brought back. Sometimes there are associated materials such as pallets, delivery boxes,
cable reels and containers (the standard 20 foot long metal boxes that are used to move goods) which are
returned to suppliers for reuse. Some materials are not reused, but are brought back for recycling, such as
metals, glass, paper, plastics and oils. Finally there are materials that cannot be used again, but are
brought back for safe disposal, such as dangerous chemicals. Activities that return materials back to an
organisation are called reverse logistics or reverse distribution.
11. Location. Some of the logistics activities can be done in different locations. Stocks of finished goods, for
example, can be held at the end of production, moved to nearby warehouses, put into stores nearer to
customers, passed on to be managed by other organisations, or a range of alternatives. Logistics has to
find the best locations for these activities or at least play a significant role in the decisions. It also
considers related questions about the size and number of facilities. These are important decisions that
affect the overall design of the supply chain.
12. Communication. Alongside the physical flow of materials is the associated flow of information. This
links all parts of the supply chain, passing information about products, customer demand, materials to be
moved, timing, stock levels, availability, problems, costs, service levels, and so on. Co-ordinating the
flow of information can be very difficult, and logistics managers often describe themselves as processing
information rather than moving goods.
Depending on the circumstances, many other activities can be included in logistics. The important
point is not to draw arbitrary boundaries between functions, but to recognise that they must all work together
to get an efficient flow of materials.
The above activities could be grouped so as to define the processes deployed by logistics activities.
Therefore, any logistics systems are made up of three main processes: order processing, inventory
management and freight transportation.

2.6.1 Order processing

Order processing is strictly related to information flows in the logistics system and includes a number
of operations. Customers may have to request the products by filling out an order form. These orders are
transmitted and checked. The availability of the requested items and customers credit status are then
verified. Later on, items are retrieved from the stock (or produced), packed and delivered along with their
shipping documentation. Finally, customers have to be kept informed about the status of their orders.
Traditionally, order processing has been a very time-consuming activity (up to 70% of the total ordercycle time). However, in recent years it has benefited greatly from advances in electronics and information
21

technology. Bar code scanning allows retailers to rapidly identify the required products and update inventory
level records. Laptop computers and modems allow salespeople to check in real time whether a product is
available in stock and to enter orders instantaneously. EDI allows companies to enter orders for industrial
goods directly in the sellers computer without any paperwork.

2.6.2 Inventory management

Inventory management is a key issue in logistics system planning and operations. Inventories are
stockpiles of goods waiting to be manufactured, transported or sold. Typical examples are
components and semi-finished products (work-in-process) waiting to be manufactured or assembled
in a plant;
merchandise (rawmaterial, components, finished products) transported through the supply chain (intransit inventory);
finished products stocked in a DC prior to being sold;
finished products stored by end-users (consumers or industrial users) to satisfy future needs.
There are several reasons why a logistician may wish to hold inventories in some facilities of the supply
chain.
Improving service level. Having a stock of finished goods in warehouses close to customers
determines shorter lead times.
Reducing overall logistics cost. Freight transportation is characterized by economies of scale
because of high fixed costs. As a result, rather than frequently delivering small orders over long distances, a
company may find it more convenient to satisfy customer demand from local warehouses (replenished at low
frequency).
Coping with randomness in customer demand and lead times. Inventories of finished goods
(safety stocks) help satisfy customer demand even if unexpected peaks of demand or delivery delays occur
(due, for example, to unfavorable weather or traffic conditions).
Making seasonal items available throughout the year. Seasonal products can be stored in
warehouses at production time and sold in subsequent months.
Speculating on price patterns. Merchandise whose price varies greatly during the year can be
purchased when prices are low, then stored and finally sold when prices go up.
Overcoming inefficiencies in managing the logistics system. Inventories may be used to overcome
inefficiencies in managing the logistics system (e.g. a distribution company may hold a stock because it is
unable to coordinate supply and demand).
Holding an inventory can, however, be very expensive for a number of reasons (see Table 1.1). First,
a company that keeps stocks incurs an opportunity (or capital) cost represented by the return on investment
the firm would have realized if money had been better invested. Second, warehousing costs must be incurred,
whether the warehouse is privately owned, leased or public..
The aim of inventory management is to determine stock levels in order to minimize total operating
cost while satisfying customer service requirements. In practice, a good inventory management policy should
take into account five issues: (1) the relative importance of customers; (2) the economic significance of the
different products; (3) transportation policies; (4) production process flexibility; (5) competitors policies.
Inventory and transportation strategies

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Inventory and transportation policies are inter-related. When distributing a product, three main
strategies can be used:
direct shipment,
warehousing,
crossdocking.
If a direct shipment strategy is used, goods are shipped directly from the manufacturer to the end-user
(the retailers in the case of retail goods) (see Figure 1.2a). Direct shipments eliminate the expenses of
operating a DC and reduce lead times. On the other hand, if a typical customer shipment size is small and
customers are dispersed over a wide geographic area, a large fleet of small trucks may be required. As a
result, direct shipment is common when fully loaded trucks are required by customers or when perishable
goods have to be delivered timely.
Warehousing is a traditional approach in which goods are received by warehouses and stored in tanks,
pallet racks or on shelves (see Figure 1.2b).When an order arrives, items are retrieved, packed and shipped to
the customer. Warehousing consists of four major functions: reception of the incoming goods, storage, order
picking and shipping. Out of these four functions, storage and order picking are the most expensive because
of inventory holding costs and labour costs, respectively.
Crossdocking (also referred to as just-in-time distribution) is a relatively new logistics technique that
has been successfully applied by several retail chains (see Figure 1.2c). A crossdock is a transshipment
facility in which incoming shipments (possibly originating from several manufacturers) are sorted,
consolidated with other products and transferred directly to outgoing trailers without intermediate storage or
order picking. As a result, shipments spend just a few hours at the facility. In predistribution crossdocking,
goods are assigned to a retail outlet before the shipment leaves the vendor. In post-distribution crossdocking,
the crossdock itself allocates goods to the retail outlets. In order to work properly, crossdocking requires high
volume and low variability of demand (otherwise it is difficult to match supply and demand) as well as easyto-handle products. Moreover, a suitable information system is needed to coordinate inbound and outbound
flows.
Centralized versus decentralized warehousing.
If a warehousing strategy is used, one has to decide whether to select a centralized or a decentralized
system. In centralized warehousing, a single warehouse serves the whole market, while in decentralized
warehousing the market is divided into different zones, each of which is served by a different (smaller)
warehouse. Decentralized warehousing leads to reduced lead times since warehouses are much closer to
customers. On the other hand, centralized warehousing is characterized by lower facility costs because of
23

larger economies of scale. In addition, if customers demands are uncorrelated, the aggregate safety stock
required by a centralized system is significantly smaller than the sum of the safety stocks in a decentralized
system. This phenomenon (known as risk pooling) can be explained qualitatively as follows: under the above
hypotheses, if the demand from a customer zone is higher than the average, then there will probably be a
customer zone whose demand is below average. Hence, demand originally allocated to a zone can be
reallocated to the other and, as a result, lower safety stocks are required. Finally, inbound transportation costs
(the costs of shipping the goods from manufacturing plants to warehouses) are lower in a centralized system
while outbound transportation costs (the costs of delivering the goods from the warehouses to the customers)
are lower in a decentralized system.

2.6.3 Freight transportation

Freight transportation plays a key role in todays economies as it allows production and consumption
to take place at locations that are several hundreds or thousands of kilometres away from each other. As a
result, markets are wider, thus stimulating direct competition among manufacturers from different countries
and encouraging companies to exploit economies of scale. Moreover, companies in developed countries can
take advantage of lower manufacturing wages in developing countries. Finally, perishable goods can be made
available in the worldwide market.
Freight transportation often accounts for even two-thirds of the total logistics cost (see Table 1.1) and
has a major impact on the level of customer service. It is therefore not surprising that transportation planning
plays a key role in logistics system management.
A manufacturer or a distributor can choose among three alternatives to transport its materials. First,
the company may operate a private fleet of owned or rented vehicles (private transportation). Second, a
carrier may be in charge of transporting materials through direct shipments regulated by a contract (contract
transportation). Third, the company can resort to a carrier that uses common resources (vehicles, crews,
terminals) to fulfill several client transportation needs (common transportation).
In the remainder of this section, we will illustrate the main features of freight transportation from a
logisticians perspective.
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Distribution channels.

Bringing products to end-users or into retail stores may be a complex process. While a few
manufacturing firms sell their own products to end users directly, in most cases intermediaries participate in
product distribution. These can be sales agents or brokers, who act for the manufacturer, or wholesalers, who
purchase products from manufacturers and resell them to retailers, who in turn sell them to end-users.
Intermediaries add a markup to the cost of a product but on the whole they benefit consumers because they
provide lower transportation unit costs than manufacturers would be able to achieve. A distribution channel
is a path followed by a product from the manufacturer to the end-user. A relevant marketing decision is to
select an appropriate combination of distribution channels for each product. Figure 1.3 illustrates the main
distribution channels. Channels 14 correspond to consumer goods while channels 57 correspond to
industrial goods. In channel 1, there are no intermediaries. This approach is suitable for a restricted number
of products (cosmetics and encyclopedias sold door-to-door, handicraft sold at local flea markets, etc.). In
channel 2, producers distribute their products through retailers (e.g. in the tyre industry). Channel 3 is
popular whenever manufacturers distribute their products only in large quantities and retailers cannot afford
to purchase large quantities of goods (e.g. in the food industry). Channel 4 is similar to channel 3 except that
manufacturers are represented by sales agents or brokers (e.g. in the clothing industry). Channel 5 is used for
most industrial goods (raw material, equipment, etc.). Goods are sold in large quantities so that wholesalers
are useless. Channel 6 is the same as channel 5, except that manufacturers are represented by sales agents or
brokers. Finally, channel 7 is used for small accessories (paper clips, etc.).
Freight consolidation. A common way to achieve considerable logistics cost savings is to take
advantage of economies of scale in transportation by consolidating small shipments into larger ones.
Consolidation can be achieved in three ways. First, small shipments that have to be transported over long
distances may be consolidated so as to transport large shipments over long distances and small shipments
over short distances (facility consolidation). Second, less-than-truckload pick-up and deliveries associated
with different locations may be served by the same vehicle on a multi-stop route (multi-stop consolidation).
Third, shipment schedules may be adjusted forward or backward so as to make a single large shipment rather
than several small ones (temporal consolidation).
Modes of transportation. Transportation services come in a large number of variants. There are five
basic modes (ship, rail, truck, air and pipeline), which can be combined in several ways in order to obtain
25

door-to-door services such as those provided, for example, by intermodal carriers and small shipment
carriers.
Merchandise is often consolidated into pallets or containers in order to protect it and facilitate
handling at terminals. Common pallet sizes are 100120 cm2, 80100 cm2, 90110 cm2 and 120120 cm2.
Containers may be refrigerated, ventilated, closed or with upper openings, etc. Containers for transporting
liquids have capacities between 14000 and 20000 l.
When selecting a carrier, a shipper must take two fundamental parameters into account: price (or
cost) and transit time.
The cost of a shippers operated transportation service is the sum of all costs associated with
operating terminals and vehicles. The price of a transportation service is simply the rate charged by the
carrier to the shipper. A more detailed analysis of such costs is reported in Chapters 6 and 7. Air is the most
expensive mode of transportation, followed by truck, rail, pipeline and ship. According to recent surveys,
transportation by truck is approximately seven times more expensive than by train, which is four times more
costly than by ship.
Transit time is the time a shipment takes to move between its origin to its destination. It is a random
variable influenced by weather and traffic conditions. A comparison between the average transit times of the
five basic modes is provided in Figure 1.4. One must bear in mind that some modes (e.g. air) have to be used
jointly with other modes (e.g. truck) to provide door-to-door transportation. The standard deviation and the
coefficient of variation (standard deviation over average transit time) of the transit time are two measures of
the reliability of a transportation service (see Table 1.3).
Rail
Rail transportation is inexpensive (especially for long-distance movements), relatively slow and quite
unreliable. As a result, the railroad is a slow mover of raw materials (coal, chemicals, etc.) and of low-value
finished products (paper, tinned food, etc.). This is due mainly to three reasons:
convoys transporting freight have low priority compared to trains transporting passengers;
direct train connections are quite rare;
a convoy must include tens of cars in order to be worth operating.
Truck
Trucks are used mainly for moving semi-finished and finished products. Road transportation can be
truckload (TL) or less-than-truckload (LTL). A TL service moves a full load directly from its origin to its
destination in a single trip (see Figure 1.5). If shipments add up to much less than the vehicle capacity (LTL
loads), it is more convenient to resort to several trucking services in conjunction with consolidation terminals
rather than use direct shipments (see Figure 1.6). As a result, LTL trucking is slower than TL trucking.

26

Air
Air transportation is often used along with road transportation in order to provide door-to-door
services. While air transportation is in principle very fast, it is slowed down in practice by freight handling at
airports. Consequently, air transportation is not competitive for short and medium haul shipments. In
contrast, it is quite popular for the transportation of high-value products over long distances.
Intermodal transportation.
Using more than one mode of transportation can lead to transportation services having a reasonable
trade-off between cost and transit time.
Although there are in principle several combinations of the five basic modes of transportation, in
practice only a few of them turn out to be convenient. The most frequent intermodal services are airtruck
27

(birdyback) transportation, traintruck (piggyback) transportation, shiptruck (fishyback) transportation.

Containers are the most common load units in intermodal transportation and can be moved in two ways:
containers are loaded on a truck and the truck is then loaded onto a train, a ship or an airplane
(trailer on flatcar);
containers are loaded directly on a train, a ship or an airplane (container on flatcar).

2.7 Supply chain operations

2.7.1 SCOR Model
The five performance drivers discussed previously are the ones who define the policy decisions, the
framework of supply chain. Now its time to understand which are the operations regularly performed within
the framework created. a way to get a high level understanding of these operations and how they relate to
each other, we can use the supply chain operations research or SCOR model developed by the Supply-Chain
Council (Supply Chain Council Inc., 1150 Freeport Road, Pittsburgh, PA 15238, www.supply-chain.org). It
identifies a number of 4 categories of operations and the whole range of possible activities performed within
a supply chains, already described, belong to one these categories. The four categories are:
- Plan
- Source
- Make
- Deliver
Plan refers to all operations needed to plan and organize operations and activities in the other three
categories. Activities included here are at least the following:
- Demand forecasting
- Product pricing
- Inventory management
Source includes the activities necessary to acquire the inputs to manufacture products: procurement
of materials, main activity, and credit and collections, which can be seen as cash acquisition.
Make refers to those activities needed to develop the products the supply chain is delivering.
Activities discussed in this category are: product design, production management and facility management.
Deliver category encompass the activities related to receiving and processing of customer orders and
delivering products to customers.
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The four operation categories and their inter-relation is graphically illustrated in the next figure:

2.7.2 Plan: demand forecasting

Forecasting is necessary to determine which products will be required, which quantity, and when they
are needed.
The demand forecast becomes the basis for companies to plan their internal operations and to
cooperate among each other to meet market demand.
There are four variables the forecasts have to combine so as to determine the real market conditions:
Demand
Supply
Product characteristics
Competitive environment
Demand forecast answers questions like:
- Is the market growing or declining?
- What is the yearly or quarterly rate of growth or decline?
- Has the product a seasonality pattern?
Many products have a seasonal demand pattern. For example, snow skis and heating oil are more in
demand in the winter and tennis rackets and sun screen are more in demand in the summer.
Perhaps the market is a developing marketthe products or services are new and there is not much
historical data on demand or the demand varies widely because new customers are just being introduced to

29

the products. Markets where there is little historical data and lots of variability are the most difficult when it
comes to demand forecasting.
Supply is determined by the number of producers of a product and by the lead times that are
associated with a product.
The more producers there are of a product and the shorter the lead times, the more predictable this
variable is. When there are only a few suppliers or when lead times are longer, there is more potential
uncertainty in a market.
Like variability in demand, uncertainty in supply makes forecasting more difficult.Also, longer lead
times associated with a product require a longer time horizon over which forecasts must be done. Supply
chain forecasts must cover a time period that encompasses the combined lead times of all the components
that go into the creation of a final product.
Product characteristics include the features of a product that influence customer demand for the
product. Is the product new and developing quickly like many electronic products or is the product mature
and changing slowly or not at all, as is the case with many commodity products? Forecasts for mature
products can cover longer timeframes than forecasts for products that are developing quickly. It is also
important to know whether a product will steal demand away from another product. Can it be substituted for
another product? Or will the use of a product drive the complementary use of a related product? Products that
either compete with or complement each other should be forecasted together.
Competitive environment refers to the actions of a company and its competitors.What is the market
share of a company? Regardless of whether the total size of a market is growing or shrinking, what is the
trend in an individual companys market share? Is it growing or declining? What is the market share trend of
competitors? Market share trends can be influenced by product promotions and price wars, so forecasts
should take into account such events that are planned for the upcoming period. Forecasts should also account
for anticipated promotions and price wars that will be initiated by competitors.

2.7.2.1 Forecasting methods

There are four basic methods:
1. Qualitative
2. Casual
3. Time series
4. Simulation
Qualitative methods are based on a persons intuition or subjective opinions about a market. These
methods are most appropriate when there is little historical data to work with.When a new line of products is
introduced, people can make forecasts based on comparisons with other products or situations that they
consider similar.
Causal methods of forecasting assume that demand is strongly related to particular environmental or
market factors. For instance, a strong causal relationship exists between price and demand. If prices are
lowered, demand can be expected to increase and if prices are raised, demand can be expected to fall.
Time series methods are the most common form of forecasting. They are based on the assumption
that historical patterns of demand are a good indicator of future demand. These methods are best when there
is a reliable body of historical data and the markets being forecast are stable and have demand patterns that
do not vary much from one year to the next.
Simulation methods use combinations of causal and time series methods to imitate the behavior of
consumers under different circumstances. This method can be used to answer questions such as what will
happen to revenue if prices on a line of products are lowered or what will happen to market share if a
competitor introduces a competing product or opens a store nearby.
Few companies use only one of these methods to do forecasts. Most companies do several forecasts
using several methods and then combine the results of these different forecasts into the actual forecast that
they use to plan their business.
Some characteristics of forecasting to be kept in mind:
30

short-term forecasts are more accurate than long-term forecasts

aggregate forecasts are more accurate than forecasts for individual products or for small market
segments
forecasts are always wrong to a greater or lesser degree. An accurate forecast may have a degree of
error that is plus or minus 5 percent. It is important to know the degree of error.

2.7.2.2 Aggregate planning

A plan for the company to meet the expected (forecasted) demand has to be created once demand
forecasting has occurred. This is called aggregate planning and it has the purpose to satisfy demand in the
most possible profitable way. It sets the optimum levels of production and inventory that will be followed
over the next 3 to 18 months.
It becomes the framework within which decisions are made about production, inventory, and
distribution.
Production decisions refer to the following variables:
- rate of production
- amount of production capacity to use
- size of the workforce
- how much overtime and subcontracting to use
Inventory decisions refer to how much demand will be met immediately by inventory on hand and
how much demand can be satisfied late.
Distribution decisions define how and when product will be moved from the place of production to
the place where it will be used or purchased by customers.
There are three variables to be considered in creating the aggregate plan:
1. Increase/decrease production capacity: the objective here is to use 100 percent of capacity at all
times to fulfill the level of demand. This is achieved by adding or eliminating plant capacity as
needed and hiring and laying off employees as needed. This approach results in low levels of
inventory but it can be very expensive to implement if the cost of adding or reducing plant
capacity is high. It is also often disruptive and demoralizing to the workforce if people are
constantly being hired or fired as demand rises and falls. This approach works best when the cost
of carrying inventory is high and the cost of changing capacityplant and workforceis low.
2. Varying levels of total capacity to match demand: If existing plants are not used 24 hours a day
and 7 days a week then there is an opportunity to meet changing demand by increasing or
decreasing utilization of production capacity. The size of the workforce can be maintained at a
steady rate and overtime and flexible work scheduling used to match production rates. The
approach makes sense when the cost of carrying inventory is high and the cost of excess capacity
is relatively low.
3. Use inventory and backlogs to match demand: Production is not matched with demand. Instead
inventory is either built up during periods of low demand in anticipation of future demand or
inventory is allowed to run low and backlogs are built up in one period to be filled in a following
period. This approach results in higher capacity utilization and lower costs of changing capacity
but it does generate large inventories and backlogs over time as demand fluctuates. It should be
used when the cost of capacity and changing capacity is high and the cost of carrying inventory
and backlogs is relatively low.

2.7.3 Plan: product pricing

Companies and entire supply chains can influence demand over time by using price. Depending on
how price is used, it will tend to either maximize revenue or gross profit. Typically marketing and sales
people want to make pricing decisions that will stimulate demand during peak seasons. The aim here is to
maximize total revenue. Often financial or production people want to make pricing decisions that stimulate
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demand during low periods. Their aim is to maximize gross profit in peak demand periods and generate
revenue to cover costs during low demand periods.
Is it better to do price promotion during peak periods to increase revenue or during low periods to
cover costs? The answer depends on the companys cost structure.
If a company has flexibility to vary the size of its workforce and productive capacity and the cost of
carrying inventory is high, then it is best to create more demand in peak seasons. If there is less flexibility to
vary workforce and capacity and if cost to carry inventory is low, it is best to create demand in low periods.

2.7.4 Plan: inventory management

Inventory management is a set of techniques that are used to manage the inventory levels within
different companies in a supply chain. The aim is to reduce the cost of inventory as much as possible while
still maintaining the service levels that customers require, considering two variables: demand and price.
There are three kinds of inventory: 1) cycle inventory; 2) seasonal inventory; and 3) safety inventory.
Cycle inventory and seasonal inventory are both influenced by economy of scale considerations. The cost
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structure of the companies in any supply chain will suggest certain levels of inventory based on production
costs and inventory carrying cost. Safety inventory is influenced by the predictability of product demand. The
less predictable product demand is, the higher the level of safety inventory is required to cover unexpected
swings in demand.
Cycle inventory is the inventory required to meet product demand over the time period between
placing orders for the product. Cycle inventory exists because economies of scale make it desirable to make
fewer orders of large quantities of a product rather than continuous orders of small product quantity. The end
use customer of a product may actually use a product in continuous small amounts throughout the year. But
the distributor and the manufacturer of that product may find it more cost efficient to produce and stock the
product in large batches that do not match the usage pattern.
Cycle inventory is the buildup of inventory in the supply chain due to the fact that production and
stocking of inventory is done in lot sizes that are larger than the ongoing demand for the product.
Seasonal inventory happens when a company or a supply chain with a fixed amount of productive
capacity decides to produce and stockpile products in anticipation of future demand. If future demand is
going to exceed productive capacity, then the answer is to produce products in times of low demand that can
be put into inventory to meet the high demand in the future.
Managing seasonal inventory calls for demand forecasts to be accurate since large amounts of
inventory can be built up this way and it can become obsolete or holding costs can mount if the inventory is
not sold off as anticipated. Managing seasonal inventory also calls for manufacturers to offer price incentives
to persuade distributors to purchase it and put it in their warehouses well before demand for it occurs.
Safety inventory is necessary to compensate for the uncertainty that exists in a supply chain.
Retailers and distributors do not want to run out of inventory in the face of unexpected customer demand or
unexpected delay in receiving replenishment orders so they keep safety stock on hand. As a rule, the higher
the level of uncertainty, the higher the level of safety stock that is required.

2.7.5 Source: procurement

The procurement function can be broken into five main activity categories:
1. Purchasing
2. Consumption Management
3. Vendor Selection
4. Contract Negotiation
5. Contract Management
Purchasing
These activities are the routine activities related to issuing purchase orders for needed products. There
are two types of products that a company buys;
1) direct or strategic materials that are needed to produce the products that the company sells to its
customers; and
2) indirect or MRO (maintenance, repair, and operations) products that a company consumes as part
of daily operations.
Purchasing decisions are made, purchase orders are issued, vendors are contacted, and orders are
placed. There is a lot of data communicated in this process between the buyer and the supplieritems and
quantities ordered, prices, delivery dates, delivery addresses, billing addresses, and payment terms.
Consumption management
How much of what categories of products are being bought across the entire company as well as by
each operating unit is the key issue of this activity. There must be an understanding of how much of what
kinds of products are bought from whom and at what prices. Expected levels of consumption for different
products at the various locations of a company should be set and then compared against actual consumption
on a regular basis. Consumption above expectations is either a problem to be corrected or it reflects
33

inaccurate expectations that need to be reset. Consumption below expectations may point to an opportunity
that should be exploited or it also may simply reflect inaccurate expectations to begin with.
Vendor selection
There must be an ongoing process to define the procurement capabilities needed to support the
companys business plan and its operating model.
The value of these capabilities have to be considered in addition to simply the price of a vendors
product.
Once there is an understanding of the current purchasing situation and an appreciation of what a
company needs to support its business plan and operating model, a search can be made for suppliers who
have both the products and the service capabilities needed. As a general rule, a company seeks to narrow
down the number of suppliers it does business with. This way it can leverage its purchasing power with a few
suppliers and get better prices in return for purchasing higher volumes of product.
Contract negotiation
The simplest negotiations
are for contracts to purchase indirect products where suppliers are selected on the basis of lowest
price. The most complex negotiations are for contracts to purchase direct materials that must meet exacting
quality requirements and where high service levels and technical support are needed.
Suppliers of both direct and indirect products need a common set of capabilities. Gaining greater
purchasing efficiencies requires that suppliers of these products have the capabilities to set up electronic
connections for purposes of receiving orders, sending delivery notifications, sending invoices, and receiving
payments. Better inventory management requires that inventory levels be reduced, which often means
suppliers need to make more frequent and smaller deliveries and orders must be filled accurately and
completely.
The negotiations must make tradeoffs between the unit price of a product and all the other value
added services that are required. Performance targets must be specified and penalties and other fees defined
when performance targets are not met.
Contract management
Once contracts are in place, vendor performance against these contracts must be measured and
managed.
A particular supplier may be the only source of a whole category of products that a company needs
and if it is not meeting its contractual obligations, the activities that depend on those products will suffer.
A company needs the ability to track the performance of its suppliers and hold them accountable to
meet the service levels they agreed to in their contract. Any supplier that consistently falls below
requirements should be made aware of their shortcomings and asked to correct them.
Often the supplier themselves should be given responsibility for tracking their own performance.They
should be able to proactively take action to keep their performance up to contracted levels. An example of
this is the concept of vendor managed inventory (VMI).VMI calls for the vendor to monitor the inventory
levels of its product within a customers business. The vendor proactively ships products to thecustomer
locations that need them and invoices the customer for those shipments under terms defined in the contract

3 Supply Chain Integration

3.1 Arguments for integration
Logistics has not always received its fair share of attention.
In the past, organizations put all their effort into making products and gave little importance to the
associated movement of materials. Managers recognized that transport and storage were needed. They
thought, they were simply the unavoidable costs of doing business. In 1962 Drucker described logistics as,
the economys dark continent and said that this formed the most sadly neglected, most promising area of
business. Since then there have been considerable changes.
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Perhaps the main reason for change was the recognition that logistics was expensive. In 70s and 80s
logistics had been identified as a high cost function, and the one where organizations can make significant
savings

3.2 Integrating logistics

3.2.1 Within an organization
In the following figure we can see the activities of logistics that are a series of related activities which
add value to the final product. These activities have traditionally been managed separately, so that an
organization might have a distinct purchasing department, transport department, warehouse, distribution
fleet, and so on. Unfortunately, organizing logistics in this way creates a number of problems because those
activities are not correlated and they have different purposes:
Purchasing might look for the most reliable suppliers
Inventory control might look for low unit costs
Warehousing might look for fast stock turnover
Materials management might look for easy handling
Transport might look for full vehicle loads
Etc
The problems will appear when the aims come into conflict. For instance, purchasing can reduce its
administrative costs by sending fewer, larger orders to suppliers but this increases stock levels and raises
the amount of money tied up in the warehouse. Using sea transport rather than airfreight reduces transport
costs but increases the amount of stock held in the supply chain.
If logistics is divided into separate functions, each part will move in a different direction, and there is
duplicated effort and wasted resources.

A fragmented supply chain also makes it difficult to co-ordinate the flow of information through
different systems. Suppose a production department knows that it is running short of a material and needs a
new delivery. This information should pass seamlessly to purchasing. If, however, it has to pass from one
35

system to another there is a greater chance of error, uncertainty, delay and inefficiency resulting in late
delivery, emergency orders, expediting and shortages.
Concluding, we can say that not integrated logistics has the disadvantages of:
giving different, often conflicting, objectives within an organization
duplicating effort and reducing productivity
giving worse communications and information flows between the parts
reducing co-ordination between the parts leading to lower efficiency, higher costs and
worse customer service
increasing uncertainty and delays along the supply chain
making planning more difficult
introducing unnecessary buffers between the parts, such as stocks of work in progress,
additional transport and administrative procedures
obscuring important information, such as the total cost of logistics
giving logistics a low status within an organization.
The solution of avoiding these problems is to consider logistics not as a series of distinct activities,
but as a single integrated function.
Sheehy, former Chairman of BAT, said, I believe that a well designed, integrated logistics system is
a vital prerequisite for commercial success2.
In practice, it is difficult to integrate all the logistics within an organization. The usual approach has
the integration developing over time. Some organizations are tempted to stop when they reach an
intermediary stage, and they work with two functions:
materials management, aligned with production and looking after the inwards flow of raw
materials and their movement through operations; and
physical distribution, aligned with marketing and looking at the outward flow of finished
goods.
However, this still keeps an artificial break in what is essentially a continuous function. The obvious
step is to combine the two into a single function responsible for all material movement into, through and out
of the organization. This completes the internal integration of an organizations logistics.
Another factor that encourages internal integration is the analysis of total logistics cost. We can
define this as:
Total logistics cost = transport cost + warehouse cost + stock holding cost + packaging cost +
information processing cost + other logistics overheads
In the 1960s organizations began to take a systems view of logistics, and analyze the interactions
between activities. It became clear that reducing the cost of one activity increased the cost of another and
the total logistics cost might be reduced by increasing the amount spent on certain activities.
One other important factor for integration is the availability of integrated information and control
systems. Managers need a system to collect, store, analyze, distribute and present information ranging from
the strategic aims of the organization down to details of each transaction. An information system might show
that stocks are running low, and a control system uses this information to place an order with suppliers.
Stages of integration
Stage 1: Separate logistics activities are not given much attention or considered important.
Stage 2: Recognizing that the separate activities of logistics are important for the success of
the organization.
Stage 3: Making improvements in the separate functions, making sure that each is as efficient
as possible.
Stage 4: Internal integration recognizing the benefits of internal co-operation and
combining the separate functions into one.
2

Sheehy P. (1988) Quality the springboard to success, Focus on Physical Distribution and Logistics Management, 7(8),

39.

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Stage 5: Developing a logistics strategy, to set the long-term direction of logistics.

Stage 6: Benchmarking comparing logistics performance with other organizations, learning
from their experiences, identifying areas that need improvement and finding ways of
achieving this.
Stage 7: Continuous improvement accepting that further changes are inevitable and always
searching for better ways of organizing logistics.

3.2.2 Along the supply chain

Benefits of integrating logistics within an organization can be extended for integrating logistics along
more of the supply chain. If each organization only looks at its own operations, there are unnecessary
boundaries between them, disrupting the flow of materials and increasing costs. External integration
removes these boundaries to improve the whole chain.
Concluding, we can talk about 3 levels of integration:
Level 0: logistics seen as separate activities within an organization
Level 1: internal integration to bring logistics activities together into a single function
Level 2: external integration, where organizations look ahead of their own operations and
integrate more inside the supply chain
Organizations within the same supply chain should CO-OPERATE to get final customer satisfaction.
They should not compete with each other, but with organizations in other supply chains.

A fragmented supply chain generates an interesting multiplying effect. Imagine a retailer who notices
that demand for a product rises by 5 units in a week. When it is time to place the next order, the retailer
37

assumes that demand is rising, and orders ten extra units to make sure it has enough. The local wholesaler
sees demand rise by ten units, so it orders an extra 15 units to meet the growth. The regional wholesaler sees
demand rise by 15 units, so it orders another 20 units. As this movement travels through the supply chain, a
relatively small change in final demand is amplified into a major variation for early suppliers. This effect is
also known the bullwhip effect.

3.2.3 Benefits of integration

Any uncertainty in the supply chain encourages organizations to hold higher stocks to give
themselves a margin of safety. These stocks increase costs and make the chain slow to react to changing
conditions.
Some benefits from external integration could be:
genuine co-operation between all parts of the supply chain, with shared information and
resources
lower costs due to balanced operations, lower stocks, less expediting, economies of scale,
elimination of activities that waste time or do not add value, and so on
improved performance due to more accurate forecasts, better planning, higher productivity
of resources, rational priorities, and so on
improved material flow, with co-ordination giving faster and more reliable movements
better customer service, with shorter lead times, faster deliveries and more customisation
more flexibility, with organisations reacting faster to changing conditions
standardised procedures, becoming routine and well-practiced with less duplication of effort,
information, planning, and so on
reliable quality and fewer inspections, with integrated quality management programmes
The benefits of external integration may be clear, but there are many practical difficulties of
achieving them. Many organisations simply do not trust other members of the supply chain, and they are
reluctant to share information. Even with sufficient trust, there can be problems with different priorities,
competition, data exchange, appropriate systems, skills, security, the complexity of systems, and so on.

3.2.4 Achieving integration

Co-operation vs. Conflict
Normally, a supply chain consists of distinct organisations, each working for their own benefit. So
why should they co-operate?
The first problem with external integration is overcoming the traditional view of organisations
as adversaries. When an organisation pays money to its suppliers, people assume that one can only benefit at
the expense of the other. If the organisation gets a good deal, it automatically means that the supplier is
losing out: if the supplier makes a good profit, it means that the organisation pays too much. This adversarial
attitude has major drawbacks. Suppliers set rigid conditions and, as they have no guarantee of repeat
business, they see no point in co-operation and try to make as much profit from each sale as possible. At the
same time, organisations have no loyalty, and they shop around to get the best deal and remind suppliers of
the competition. Each is concerned only with their own objectives and will when convenient to themselves
change specifications and conditions at short notice. The result is uncertainty about the number and size of
orders, constantly changing suppliers and customers, changing products and conditions, different times
between orders, no guarantee of repeat orders and changing costs.
To avoid these problems, organisations have to recognise that it is in their own long-term interest to
replace conflict by agreement. This often needs a major change of culture. The following table suggests some
specific adjustments.

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Types of co-operation
Mainly, there are two type of co-operation:
1. Informal co-operation
If an organisation has a good experience with a supplier, it will continue to use them and over some
period will develop a valuable working relationship. Sometimes the cooperation is more positive, such as
small companies making joint purchases to get the same quantity discounts as larger companies; EDI links to
share information; combining loads to reduce transport costs; agreed package sizes to ease material handling,
lists of preferred suppliers, and so on. The key point with these informal arrangements is that there is no
commitment. This is probably how you shop, as you have favourite shops but are not obliged to use them.
Japanese companies take this approach further forming Keiretsu which are groups of organisations that
work together without actually forming partnerships. An informal arrangement has the advantage of being
flexible and non-binding. On the other hand, it has the disadvantage that either party can end the co-operation
without warning, and at any time that suits them.
2. Formal co-operation
Many organisations prefer a more formal arrangement, with a written contract setting out the
obligations of each party. These are common when organisations see themselves as working together for
some time. An electricity company, for example, might agree to supply power at a fixed price for the next
three years, provided a customer buys some minimum quantity. More formal agreements have the advantage
of showing the details of the commitment, so that each side knows exactly what it has to do. On the other
hand, they have the disadvantage of losing flexibility and imposing rigid conditions.
Forming a partnership is only the first step, and it still needs a lot of effort to make it a success. There
are some key factors which initiate and influence a partnership:
drivers, which are the compelling reasons for forming partnerships, such as cost reduction,
better customer service, or security
facilitators, which are the supportive corporate factors that encourage partnerships, such as
compatibility of operations, similar management styles, common aims, and so on
components, which are the joint activities and operations used to build and sustain the
relationship, such as communication channels, joint planning, shared risk and rewards,
investment, and so on.
Vertical integration
If an organisation wants to go beyond partnerships, it has to own more of the supply chain. One
common arrangement has an organisation taking a minority share in another company. This gives it some say
in their operations, but it does not necessarily control them. A manufacturer, for example, might take a
minority share in a wholesaler, to get some influence in the way that its products are distributed.
39

Another option is for two organisations to start a joint venture, where they both put up funds to start
a third company with shared ownership. A manufacturer and supplier might together form a transport
company for moving materials between the two.
The most common arrangement has one organisation simply buying other organisations in the supply
chain. This increases its level of vertical integration.
VERTICAL INTEGRATION describes the amount of a supply chain that is owned by one
organisation.
If an organisation buys materials from outside suppliers and sells products to external customers, it
does not own much of the supply chain and has little vertical integration (as shown in Figure 2.5). If the
organisation owns initial suppliers, does most of the value adding.
Operations, and distributes products through to final customers, it owns a lot of the supply chain and
is highly vertically integrated. If the organisation owns a lot of the supply side it has backward or upstream
integration; if it owns a lot of the distribution network it has downstream or forward integration. In some
circumstances vertical integration is the best way of getting different parts of the supply chain to work
together.
More often, widespread vertical integration would be very expensive, leading to huge organisations
that spread their resources too thinly, needing specialised skills and experience that one organisation does not
have, reducing flexibility to respond to changing conditions, and so on. So vertical integration is not
necessarily desirable, and it is usually impossible for even the biggest organisation to own much of their
supply chains.

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4 Managerial Issues and trends in Logistics

4.1 Logistics Managerial Issues
When planning a logistics strategy, managers aim at achieving a suitable compromise between three
main objectives: capital reduction, cost reduction and service level improvement.
Capital reduction.
The first objective is to reduce as much as possible the level of investment in the logistics system
(which depends on owned equipment and inventories). This can be accomplished in a number of ways, for
example, by choosing public warehouses instead of privately owned warehouses, and by using common
carriers instead of privately owned vehicles. Of course, capital reduction usually comes at the expense of
higher operating costs.
Cost reduction.
The second objective is to minimize the total cost associated with transportation and storage. For
example, one can operate privately owned warehouses and vehicles (provided that sales volume is large
enough).
Service level improvement
The level of logistics service greatly influences customer satisfaction which in turn has a major
impact on revenues. Thus, improving the logistics service level may increase revenues, especially in markets
with homogeneous low-price products where competition is not based on product features.
The level of logistics service is often expressed through the order-cycle time, defined as the elapsed
time between the instant a purchase order (or a service request) is issued and the time goods are received by
the customer (or service is provided to the user).The order-cycle time is a random variable with a
multinomial probability distribution. When a retailer outlet issues an order, the following events may occur:
(a) if the goods required by the outlet are available at the associated RDC, the merchandise will be
delivered shortly;
(b) otherwise, the RDC has to resupply its stocks by placing an order to the CDC, in which case the
shipment to the retailer will be further delayed;
(c) if the goods are not available even at the CDC, the plants will be requested to produce them.
Let pa, pb and pc be the probabilities of events a, b and c, and let fa(t), fb(t), fc(t) be the functions of the
order-cycle time in case events a, b and c occur, respectively. The probability density function of the ordercycle time is then
f(t) = pa*fa(t) + pb*fb(t) + pc*fc(t)

4.2 Trends in logistics

In recent years, several strategic and technological changes have had a marked impact on logistics.
Among these, three are worthy of mention: globalization, new information technologies and e-commerce.

4.2.1 Communication improvements

Logistics continually meets new challenges, and is changing faster now than at any time in the past.
Perhaps the most obvious change is the increasing use of technology. Some of this appears directly in the
movement of goods such as electronic identification of packages, satellite tracking of lorries and automatic
guidance systems but the greatest impact has come with communications.
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When a company wants to buy something, it typically has to generate a description of the goods,
request for price, purchase order, order confirmation, contract terms, shipping papers, financial arrangements,
delivery details, special conditions, invoices, and so on. In the past, all of these had to be printed and posted
between organisations being complicated and time consuming.
In the past few years technology has revolutionised the communications. By the 1990s the apparition
of electronic data interchange (EDI) had been a major improvement. This allowed remote computers to
exchange data without going through any intermediaries. Early users were supermarkets, who linked their
stock control systems directly to suppliers order processing systems. The supermarket checkouts recorded
sales of each item, and when stocks got low the system automatically sent a message asking for another
delivery. This use of EPOS electronic point-of-sales data gave less paperwork, lower transaction costs,
faster communications, fewer errors, more integrated systems, and closer business relations.
By 1997 about 2000 companies in the UK used EDI for trade with suppliers. Over the next few years
electronic trading became more sophisticated and widespread. The efficient transfer of information has been
particularly useful for purchasing, which has developed into e-purchasing or e-procurement. This comes in
many forms, all based on the direct exchange of data between a suppliers computer and a customers. Two
main versions are B2B (business-to-business, where one business buys materials from another business) and
B2C (business-to-customer, where a final customer buys from a business). By 2002 around 83 per cent of
UK suppliers used B2B.
Two associated technologies have developed to support EDI. The first is item coding, which gives
every package of material moved an identifying tag. The tag is usually a bar code or magnetic stripe that can
be read automatically as the package moves through its journey. Then the logistics system knows where
every package is at any time, and automatic materials handling can move, sort, consolidate, pack and deliver
materials.
The second technology is electronic fund transfer (EFT). When the delivery of materials is
acknowledged, EFT automatically debits the customers bank account and credits the suppliers.

4.2.2 E-commerce
An increasing number of companies make commercial transactions through the internet. It is common
to distinguish between business-to-business (B2B) and business-to-consumers (B2C) transactions. The
growth of e-commerce parallels that of globalization and information technologies. As a result of ecommerce the volume of goods between producers and retailers should go down while more direct deliveries
should be expected between manufacturers and end-users.
E-commerce leads to a more complex organization of the entire logistics system (e-logistics), which
should be able to manage small- and medium-size shipments to a large number of customers, sometimes
scattered around the world. Furthermore, the return flow of defective (or rejected) goods becomes a major
issue (reverse logistics).
Table 1.4 reports the main differences between traditional logistics and e-logistics.

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In an e-logistics system different approaches for operating warehouses and distribution are generally
adopted. The virtual warehouse and the Points Of Presence In The Territory (POPITT) are just a few
examples. A virtual warehouse is a facility where suppliers and distributors keep their goods in stock in such
a way that the e-commerce company can fulfill its orders. A POPITT is a company-owned facility where
customers may go either for purchasing and fetching the ordered goods, or for returning defective products.
Unlike traditional shops, a POPITT only stores already sold goods waiting to be picked up by customers and
defective products waiting to be returned to the manufacturers. This solution simplifies distribution
management but reduces customer service level it doesnt include home deliveries (which is the most
convenient for the customer).

4.2.3 Customer service improvement

It is normally in everyones interests to make logistics costs as low as possible. Logistics managers
want low costs so that they remain competitive, and their users want to pay as little as possible. Many
organisations have reduced their logistics costs to levels that affect their whole operations.
While striving for lower costs, organisations obviously have to maintain their service levels.
Improved logistics means giving the service that customers want at the lowest possible cost. A problem, of
course, is finding the features that customers really want and the level of service they are willing to pay for.
These vary widely in different circumstances, but a key factor is the lead time. Again, it is normally in
everyones interest to make the delay between ordering materials and their final delivering as short as
possible. Ideally, the lead time should be as close to zero as possible, and one approach to this uses
synchronised material movement. This makes information available to all parts of the supply chain at the
same time, so that organisations can coordinate material movements, rather than wait for messages to move
up and down the chain.
Another key factor for customer satisfaction is personalised products. Instead of buying a standard
textbook, for example, you describe the contents you want and a publisher supplies a volume with exactly
these specifications. This is mass customisation, which combines the benefits of mass production with the
flexibility of customised products. It uses B2C to give direct communications between a final customer and a
manufacturer, and it needs supply chains that are flexible, that move materials very quickly, and respond to
varying conditions.
Dell Computers was one of the first companies to use mass customisation. They do not build standard
computers, but wait until a customer places an order on their website. Then they build a computer for the
specific order. Logistics makes sure that the necessary materials are always available for manufacturing, and
it delivers the finished machine quickly to the customer.
Dell work so closely with their suppliers that they have developed virtual integration, where they all
seem to be part of the same company. This works well with Dell, who have 50 main components, but would
it work with a car manufacturer and their three thousand components?

4.2.4 Other significant trends

Globalisation: Improved communications and better transport mean that physical distances are
becoming less significant. Organisations can become global in outlook, buying, storing, manufacturing,
moving and distributing materials in a single, worldwide market. As a result, international trade and
competition are continuing to rise. Organisations used to look for competitors in the same town, but now they
are just as likely to come from another continent.
Reduced number of suppliers: In the past, organisations have used a large number of suppliers. This
encouraged competition, ensured that they got the best deal and maintained secure deliveries if one supplier
ran into difficulties. The current trend, however, is to reduce the number of suppliers and develop long-term
relationships with the best. Working closely with a small number of organisations can bring considerable
benefits.
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Concentration of ownership: Large companies can get economies of scale, and they have come to
dominate many supply chains. There are, for example, many shops and transport companies but the biggest
ones continue to grow at the expense of small ones. The result is a continuing concentration of ownership,
which you can see in many logistics sectors ranging from food wholesalers to cruise lines.
Outsourcing: More organisations realise that they can benefit from using specialised companies to
take over part, or all, of their logistics. Using a third party for materials movement leaves an organisation free
to concentrate on its core activities.
Postponement: Traditionally, manufacturers move finished goods out of production and store them
in the distribution system until they are needed. When there are many variations on a basic product, this can
give high stocks of similar products. Postponement moves almost-finished products into the distribution
system, and delays final modifications or customisation until the last possible moment. You can imagine this
with package-to-order, where a company keeps a product in stock, but only puts it in a box written in the
appropriate language when it is about to ship an order. Manufacturers of electrical equipment, such as
Phillips and Hewlett-Packard, used to build into their products the transformers and plugs needed for
different markets. Then they had to keep separate stocks of products destined for each country. Now they
make the transformer and cables as separate, external units. They only keep stocks of the basic, standard
products, and customise them for different markets by adding the proper transformers and plugs at the last
minute. The result, of course, is much lower stocks. In the same way, Benetton used to dye yarn different
colours, knit sweaters and keep stocks of each colour to meet varying demand. Now they knit sweaters with
undyed yarn, keep much smaller stocks of these, and dye the finished sweaters to meet actual orders.
Cross-docking: Traditional warehouses move materials into storage, keep them until needed, and
then move them out to meet demand. Cross-docking co-ordinates the supply and delivery, so that goods
arrive at the receiving area and are transferred straight away to a loading area, where they are put onto
delivery vehicles. This dramatically reduces stock levels and associated administration. There are two basic
forms of cross-docking. In the first, packages are moved directly from arriving vehicles and onto departing
ones. This does not really need a warehouse and a simple transfer point is enough. In the second form there is
some additional work as materials arrive in larger packages which are opened, broken into smaller quantities,
sorted, consolidated into deliveries for different customers and transferred to vehicles. Cross-docking can
develop to the point where nothing actually moves through a warehouse. Any stock is kept within vehicles,
giving stock on wheels. A related arrangement uses drop-shipping, where wholesalers do not keep stock
themselves, but co-ordinate the movement of materials directly from upstream suppliers to downstream
customers. As warehousing is expensive and time-consuming, these methods can give much more efficient
flows, and allow methods such as quick response and efficient customer response.
Direct delivery: More customers are buying through the Web, or finding other ways of trading
earlier in the supply chain, such as mail order or buying directly from manufacturers. This has the benefits of
reducing lead times, reducing costs to customers, having manufacturers talking directly to their final
customers, allowing customers access to a wider range of products, and so on. It also means that logistics has
to move small deliveries quickly to final customers. This has encouraged the growth of couriers and express
parcel delivery services such as FedEx, UPS and DHL.
Other stock reduction methods: Keeping stock is expensive, so organisations continually look for
ways of reducing the amount stored in the supply chain. There are many ways of doing this. One approach
uses just-in-time operations to co-ordinate activities and minimise stock levels. Another approach has vendor
managed inventory, where suppliers manage both their own stocks and those held further down the supply
chain. Improved co-ordination reduces overall costs and can give economies of scale.
Increasing environmental concerns: There is growing concern about air pollution, water pollution,
energy consumption, urban development and waste disposal. Logistics does not have a good reputation for
environmental protection demonstrated by the emissions from heavy lorries, use of green field sites for
warehouses, calls for new road building, use of extensive packaging, ships illegally flushing their fuel tanks,
oil spillages from tanker accidents, and so on. On the positive side, logistics is moving towards greener
practices. Operators use more energy efficient vehicles, control exhaust emissions, reuse packaging, switch to
44

environmentally friendly modes of transport, increase recycling through reverse logistics, add safety features
to ships, develop brown-field sites, and so on. They increasingly recognise that careful management can
bring both environmental protection and lower costs. A fair assessment might be that logistics is making
progress on environmental issues, but it has some way to go.
More collaboration along the supply chain: Organisations in a supply chain increasingly recognise
that they have the same objectives which are satisfied final customers. They should not, therefore, compete
with each other, but should co-operate to get final customer satisfaction. Christopher3 summarises this by
saying that supply chains compete, not companies.

4.3 Logistics Decisions

When designing and operating a logistics system, one needs to address several fundamental issues.
For example, should new facilities (manufacturing and assembly centres, CDCs, RDCs, etc.) be opened?
What are their best configuration, size and location? Should any existing facility be divested, displaced or
sized down? Where should materials and components be acquired and stored? Where should manufacturing
and assembly take place? Where should finished goods be stored? Should warehouses be company-owned or
leased? Where should spare parts be stocked? How should production be planned? How should warehouses
operate? (Should goods be stored in racks or should they be stacked? Should goods be retrieved by a team of
human order pickers or by automated devices?) When and how should each stocking point be resupplied?
What mode of transportation should be used to transport products? Should vehicles be company-owned or
leased? What is the best fleet size? How should shipment be scheduled? How should vehicles be routed?
Should some transportation be carried out by common carriers?
Logistics decisions are traditionally classified as strategic, tactical and operational, according to the
planning horizon.
Strategic decisions.
Strategic decisions have long-lasting effects (usually over many years). They include logistics
systems design and the acquisition of costly resources (facility location, capacity sizing, plant and warehouse
layout, fleet sizing).
Because data are often incomplete and imprecise, strategic decisions generally use forecasts based on
aggregated data (obtained, for example, by grouping individual products into product families and
aggregating individual customers into customer zones).
Tactical decisions
Tactical decisions are made on a medium-term basis (e.g. monthly or quarterly) and include
production and distribution planning, as well as resource allocation (storage allocation, order picking
strategies, transportation mode selection, consolidation strategy). Tactical decisions often use forecasts based
on disaggregated data.
Operational decisions
Operational decisions are made on a daily basis or in realtime and have a narrow scope. They include
warehouse order picking as well as shipment and vehicle dispatching. Operational decisions are customarily
based on very detailed data.

4.3.1 Decision support methods

Quantitative analysis is essential for intelligent logistics decision-making. Operations research offers
a variety of planning tools. There are three basic situations in which quantitative analysis may be helpful.
If a logistics system already exists, one may wish to compare the current system
Design (or a current operating policy) to an industry standard.
3

Christopher M. (1996) Emerging Issues in Supply Chain Management, Proceedings of the Logistics Academic Network
Inaugural Workshop, Warwick

45

One may wish to evaluate specified alternatives. In particular, one may wish to answer a
number of what-if questions regarding specified alternatives to the existing system.
One may wish to generate a configuration (or a policy) which is optimal (or at least good)
with respect to a given performance measure.

Benchmarking
Benchmarking consists of comparing the performance of a logistics system to a best-practice
standard, i.e. the performance of an industry leader in logistics operations. The most popular logistics
benchmarking is based on the supply chain operations references (SCOR) model. The SCOR model makes
use of several performance parameters that range from highly aggregated indicators (named key performance
indicators (KPIs)) to indicators describing a specific operational issue.
Simulation
Simulation enables the evaluation of the behaviour of a particular configuration or policy by
considering the dynamics of the system. For instance, a simulation model can be used to estimate the average
order retrieval time in a given warehouse when a specific storage policy is used. Whenever a different
alternative has to be evaluated, a new simulation is run. For instance, if the number of order pickers is
increased by one, a new simulation is required. Simulation models can easily incorporate a large amount of
details, such as individual customer ordering patterns. However, detailed simulations are time consuming and
can be heavy when a large number of alternatives are considered.
Optimization
The decision-making process can sometimes be cast as a mathematical optimization problem.

46

5 Procurement or purchasing
The mechanism for initiating the flow of materials inside a supply chain is provided by purchasing
or procurement.
In a supply chain, each organisation buys materials from upstream suppliers, adds value, and sells
them to downstream customers. The trigger that initiates each move is a purchase. This is basically a
message that an organisation sends to a supplier, saying, we have agreed on terms, so send us materials and
we will pay you.
Purchasing is the function responsible for acquiring all the materials needed by an organisation. Many
of these transactions are not standard purchases, but include rental, leasing, contracting, exchange, gifts,
borrowing, and so on. This is why some people prefer to talk about the acquisition of materials or the more
common term of procurement. Procurement and purchasing are often taken to mean the same thing.
Procurement can include different types of acquisition, besides purchasing.
PROCUREMENT is responsible for acquiring all the materials needed by an organisation.
Procurement does not usually move materials itself. It is another function, such as transport, that actually
delivers them. So procurement is largely concerned with information processing. It collects data from various
sources, analyses it, and passes information to the supply chain.
Procurement is essential, and also responsible for a lot of expenditure. For a typical manufacturer,
60% of its spending goes on materials.
Example:
Suppose that a company buys raw materials for 60, spends 40 on operations and then sells the
product for 110. It clearly makes a profit of 110 (60 + 40) = 10 a unit. Now suppose that procurement
negotiates a 5% discount on materials. Materials now cost 60 0.95 = 57, and with the same selling price
the 3 saving goes straight to profit. The profit on each unit now jumps to 13, so a 5% decrease in materials
costs raises profit by 30%.

5.1 Procurement objectives

The overall aim of procurement is to guarantee that an organization has a reliable supply of
materials. Additionally, we can develop the following list of more immediate goals:
organizing a reliable and uninterrupted flow of materials into an organization
working closely with user departments, developing relationships and understanding their
needs
finding good suppliers, working closely with them and developing beneficial relationships
buying the right materials and making sure that they have acceptable quality, arrive at the time
and place needed, and meet any other requirements
negotiating good prices and conditions
keeping stocks low, considering inventory policies, investment, standard and readily available
materials, and so on
moving materials quickly through the supply chain, expediting deliveries when necessary
keeping abreast of conditions, including pending price increases, scarcities, new products, and
so on.
Usually procurement is organized as a single department to get the benefits of centralized
purchasing. These benefits include:
consolidation of all orders for the same, and similar, materials to get quantity discounts
co-ordinating associated activities to reduce costs of transport, stockholding and
administration
eliminating duplicated effort and chaotic practices
47

having a single point of contact for suppliers and giving them consistent information and
service
developing specialized skills and improving procurement operations
allowing other people to concentrate on their own work without diverting into purchasing
concentrating responsibility for procurement, making management control easier.
These benefits can be considerable, but centralized purchasing has its critics. Its the case of a
company having several subsidiaries widespread in the territory. It seems nonsensical to contact your
purchasing department which is placed kilometers away, at the headquarters. However, organisations that
work over a wide geographical area are aware of the problems of centralised purchasing, and may use local
purchasing. This can, of course, bring its own benefits. Local offices are likely to have better knowledge of
local conditions and culture, better relations with suppliers, more flexible operations, lower transport costs,
and so on.

5.2 Selecting suppliers

The most important part of procurement is finding the right supplier. There is no point in having a
well-designed product, if the supplier cannot actually deliver it. You will always look for two factors. First, a
product design that satisfies your needs. Second, a supplier who can guarantee to deliver the product as
designed. In other words, the supplier must be capable of doing the work, giving high quality, working to a
schedule, with acceptable costs, and so on.
Procurement starts by finding a qualified supplier. Organisations look for suppliers who:
are financially secure with good long-term prospects
have the ability and capacity to supply the necessary materials
accurately deliver the requested materials
send materials of guaranteed high quality
deliver reliably, on time with short lead times
quote acceptable prices and financing arrangements
are flexible to customers needs and changes
are experienced and have expertise in their products
have earned a good reputation
use convenient and easy procurement systems
have been used successfully in the past and can develop long-term relationships.
In different circumstances, many other factors might be important.
A useful approach for choosing the best supplier for a product has the following steps:
Look for alternative suppliers
Build a long list of qualified suppliers who can deliver the products
Compare organisations on this long list and eliminate those who are, for any reason, less
desirable
Continue eliminating organisations until you have a shortlist (usually four or five) of the most
promising suppliers
Prepare an enquiry, or request for quotation, and send it to the shortlist
Receive bids from the shortlist
Do a preliminary evaluation of bids and eliminate those with major problems
Do a technical evaluation to see if the products meet all specifications
Do a commercial evaluation to compare the costs and other conditions
Arrange a pre-award meeting to discuss bids with the remaining suppliers
Discuss condition bids, which are specific conditions that have to be agreed
Choose the supplier that is most likely to win the order
Arrange a pre-commitment meeting to sort out any last minute details
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 Award orders to the preferred supplier.

This is clearly a time-consuming procedure, but remember that a poor supplier can cause more
problems than poor materials. The whole procedure is only used for major purchases, and if you are
buying pencils the shop next door is probably as good as any other supplier. Normally, an organisation will
spend little time looking at alternative suppliers if:
it is buying low value materials
there is only one possible supplier
there is already a successful arrangement with a supplier
there is not enough time for extended negotiations
the organisation has a policy of selecting specific types of supplier.
Very often, we are talking about customers selecting suppliers and assume that suppliers are happy
to serve all the customers they can find. This is usually the case, but sometimes suppliers have more power
and effectively choose their customers. This might happen when a supplier has a monopoly, or near
monopoly, of some material. It might also happen when there is a temporary shortage of some commodity,
such as oil, and suppliers choose the customers they will supply, perhaps giving preference to larger
customers, those who pay more, or those who have long-term agreements.

One of the logistics trends of today is the one towards long-term alliances and partnerships. This
inevitably moves organisations towards single suppliers, either for each material, or for a range of different
materials. Some organisations say that this single sourcing leaves them vulnerable to the performance of an
individual company, and they have severe problems if something goes wrong. If the single supplier of a vital
component hits financial problems, an organisation may, through no fault of its own, have to stop production.
To avoid this, some organisations have a policy of buying the same materials from a number of competing
suppliers. They might use rules of thumb such as never let a manufacturer account for more than 20% of
total revenue; never let a customer absorb more than 50% of total resources.
Advantages of single sourcing:
a stronger relationship between customers and suppliers, often formalised in alliances or
partnerships
49

 commitment of all parties to the success of the relationship

economies of scale and price discounts with larger orders
easier communication, reduced administration and simpler procedures for regular orders
less variation in materials and their supply
easier to keep requirements, conditions and so on, confidential.
Advantages of multi-sourcing:
competition between suppliers reduces prices
there is less chance of disrupted supplies, as problems can be avoided by switching suppliers
can deal more easily with varying demands
involving more organisations can give access to wider knowledge and information
is more likely to encourage innovation and improvement
does not rely on trusting one external organisation.

5.3 Procurement cycle

Once it has chosen a supplier, an organisation has to follow some procedure for arranging purchases.
Your aim is to find the combination of products and suppliers that best satisfies your needs. The procurement
function in an organisation does exactly the same, and follows a specified procedure for each purchase. This
procedure is different in every organisation, and varies with the type of thing being purchased. Despite these
inevitable differences in detail, we can suggest a general approach to procurement. This has a series of
common steps, which start with a user identifying a need for materials and end when the materials are
delivered.

Description of the above scheme:

1. A user department:
50

2.

3.

4.

5.

6.

7.

8.

identifies a need for purchased materials

examines materials available and prepares specifications
checks departmental budgets and gets clearance to purchase
prepares and sends a purchase request to procurement.
Then procurement:
receive, verify and check the purchase request
examine the material requested, looking at current stocks, alternative products, production
options, and so on and after discussions with the user department confirm the decision to
purchase
make a shortlist of possible suppliers, from regular suppliers, lists of preferred suppliers, or
those known to meet requirements
send a request for quotations to this shortlist.
Then each supplier:
examines the request for quotations
checks the customers status, credit, and so on
sees how it could best satisfy the order
sends a quotation back to the organisation, giving details of products, prices andconditions.
Then procurement:
examine the quotations and do commercial evaluations
discuss technical aspects with the user department
check budget details and clearance to purchase
choose the best supplier, based on the details supplied
discuss, negotiate and finalize terms and conditions with the supplier
issue a purchase order for the materials (with terms and conditions attached).
Then the chosen supplier:
receives, acknowledges and processes the purchase order
organizes all operations needed to supply the materials
ships materials together with a shipping advice
sends an invoice.
Then procurement:
acknowledge receipt
do any necessary follow-up and expediting
receive, inspect and accept the materials
notify the user department of materials received.
Then the user department:
receives and checks the materials
authorizes transfer from budgets
updates inventory records
uses the materials as needed.
Then procurement:
arrange payment of the suppliers invoice.

5.4 E-procurement
Most organisations already use some form of e-procurement. Surveys7,8 suggest that over 60% of UK
companies used e-procurement by 2002, and 80% of European managers soon expect to use it extensively.
Some of the advantages this brings are:
allowing instant access to suppliers anywhere in the world
creating a transparent market where products and terms are readily available
51

automating procurement with standard procedures

greatly reducing the time needed for transactions
reducing costs, typically by 1215%
outsourcing some procurement activities to suppliers or third parties
integrating seamlessly with suppliers information systems.

There are basically two types of e-procurement which are described as B2B (where one business buys
materials from another business) and B2C (when a final customer buys from a business). Most of us are more
familiar with B2C transactions, where we buy books, music, software or travel from websites. Between 1999
and 2002 the number of Internet shoppers in the UK rose from 2 million to 6 million. 9 Nonetheless, many of
these sites have hit financial troubles with the bursting of the dot-com bubble, and there have been a
number of widely publicised bankruptcies. In 1996 Anderson Consulting predicted that on-line shopping
would soon account for 20% of UK groceries, but by 2002 the figure was still less than 1%. Verdict, a retail
research agency, then predicted that on-line sales would rise to 6% of all grocery sales by 2006. It is clearly
difficult to get reliable figures in this area, but there is a general feeling that B2C will continue to grow
strongly.
One problem, of course, is that people do not necessarily like e-procurement. If you want to buy a
book, you can use various websites, fill in the forms for your purchase, and get the book delivered within a
day. But if you go to your nearest bookshop, you might use less sophisticated technology, but pick up the
book immediately and without the delivery charge. B2C can hit difficulties because people actually like
going to look at things before they buy. Some evidence for this comes from the USA, where only 1% of car
purchases are made through the Web, but before buying 75% of people do on-line searches to compare prices
and specifications.
A more important factor is that most e-procurement is actually B2B. The Gartner Group have
produced the following estimates of B2B trade.

The attractions of e-procurement are so great that most organisations will continue to move in this
direction. One major software company estimated the following savings from e-procurement (values are in a
per transaction). The system gave a return on investment of 400% a year.

52

Many people are enthusiastic about the growth of e-procurement, but they often forget an important
point. If we organise e-procurement very efficiently, it gives much better communications but it does not
necessarily improve the physical flow of materials. This only happens when organisations in the supply chain
use the communications to find better ways of moving materials. Perhaps the main effects of e-procurement
are not the speed of purchasing but the effects it has on the supply chain. Customers can now buy from a
range of suppliers who might be geographically remote. They also have the option of buying directly from
manufacturers or primary suppliers, and can use the increasing number of specialised Web retailers. Merrill
Lynch suggest that the main changes that this will bring are:
growing use of the Internet for procurement will change patterns of logistics
e-commerce will change buying patterns, but will probably not generate much new business
organisations will have to improve customer service by, for example, home delivery services.

5.5 Types of purchase

5.5.1 Different approaches for different products
When we described a formal procedure for procurement, we said that it can be very complicated and
time consuming. It would be expensive and unnecessarily complicated to use this procedure for every
purchase, and nobody wants to spend six months buying a packet of envelopes. On the other hand, major
purchases need much more information and analysis. This is why organisations vary the details of their
procurement procedures, matching the methods to the types of materials. Generally speaking, the higher the
cost of materials and the more complicated the requirements, the more time and effort procurement needs.
Organisations often set rules for the effort put into procurement, perhaps using ad hoc procedures for
low-value routine supplies, a simple, automatic procedure for purchases up to 20,000, a more rigorous
procedure for purchases up to 150,000, and special, detailed analyses for bigger purchases. Van de Vliet
describes a variation on this at 3M, where the procurement effort depends on the importance of materials:
non-critical materials have low profits with little risk in supply, and need basic, simple
procedures for purchasing
bottleneck materials have low profits but have more risk in supply, and need long-term
contracts with alternative sources to avoid potential problems
strategic materials with higher profits need more formal relationships with suppliers over the
long term, possibly developing into alliances and partnerships.
Once such rules are established, a management control system can monitor purchases and make sure
they are done in the best way. It can see how purchases have been made, if the outcome is satisfactory, if the
effort is reasonable in relation to the costs and importance, and if the procedure can be improved for the
future.
53

An important point here is the difference between routine, repeat orders and new ones. If a supplier
has given good service over some extended time, an organisation might avoid almost all the procurement
cycle and put minimal effort into administering future orders. Ordering becomes routine and the organisation
effectively sends a message to say, send another order like the last one. With non-routine purchases, an
organisation has to be more careful and put more effort into the choice of supplier, and conditions of
purchase.
If an order is repeated often enough, an organisation might consider the make-or-buy decision. In
other words, it has to choose those materials that it can make itself, and those that are best met by outside
suppliers. In its simplest form, this asks whether an organisation can get materials more cheaply from a
supplier than it can make them. Efficient operations and economies of scale often mean that specialised
suppliers can deliver materials at lower prices than other organisations can produce them. There are,
however, many other factors to consider. Making parts internally can be more reliable, give greater control
over supply, tailor products, have shorter lead times, use spare resources, protect designs, keep value-adding
operations, increase the size of the company, and so on. On the other hand, buying them from suppliers can
get the benefits of specialisation, give access to greater expertise, get economies of scale, reduce stock levels,
transfer some risk, maintain flexibility, and so on.
The Department of Trade and Industry suggests that the three main criteria for such decisions are:
financial factors relating to the costs
operational factors relating to responsiveness, flexibility, reliability, and so on
strategic factors relating to the long-term implications of the decision for the organisation.
In practice, the perceived benefits of outsourcing are increasing and more organisations are happy to
concentrate on their core functions and use specialised suppliers for materials.

5.5.2 Terms and conditions

Although we have talked in general terms about placing an order, there are several different types of
order. Organisations typically talk about placing an order for goods, but signing a contract for services
and leasing equipment. To a large extent, these are different ways of saying the same things, but there may
be legal differences. For example, with hire purchase the materials remain the property of the supplier until
they are fully paid for, while credit financing gives ownership to the organisation which becomes responsible
for servicing a debt. We have already mentioned some specific types of order, with the following being most
common:
Purchase orders are used in the standard approach to procurement that we described above. It
is essentially a letter from one organisation to another, giving details of the materials it wants
to purchase and its conditions of purchase. This is usually a response to a quotation from a
qualified supplier, giving the materials it can supply and its conditions of trade.
Blanket orders give a simple system for cheap, standard items, such as stationery. An
organisation places a single order for all the materials that it will need over some period, such
as a year. Then the supplier delivers batches of materials when requested during the year.
e-Procurement uses EDI or the Internet to simplify purchases by replacing paper-based
procedures with electronic ones. This gives a fast and efficient method for repeat, or
straightforward, orders.
Contracts give detailed descriptions of an agreement between an organisation and a supplier;
they describe exactly the responsibilities, work and services for each, together with all
relevant terms and conditions. Many organisations use contracts instead of purchase orders for
extended services, so they sign a contract for a supply of electricity. In the same way,
organisations sign a contract for a specific piece of work, such as a construction company
building a length of road.
Sub-contracts: when a supplier signs a contract with an organisation, it may not do all the
work itself, but prefers to pass on some work to a sub-contractor. Then, there are two
agreements the contract between the organisation and the supplier, and the subcontract
54

between the supplier and sub-contractor. For big projects, there can be several more layers of
sub-contracting.
Leases and rental agreements again present the terms and conditions of acquiring materials.
They are generally used for buildings or equipment that is returned to the owner after some
period of use. You can rent or lease a car, for example, and when you have finished with it,
you return it to the owner.
The different types of purchase suggest another problem with procurement. There can be so many
different terms and conditions that it is surprisingly difficult to compare them. Suppose that you are buying
some standard commodity, such as electricity. Many competitors offer the same product so the best is the one
that offers the lowest price. Often, however, there are different conditions of purchase. If you want a
telephone service, all suppliers give essentially the same product, but the pricing structure, discounts and
offers can make significant differences. Then it is the conditions of purchase that show the best supplier.
In practice, there can be many factors other than cost to consider. Decisions about purchases are made
in two stages. In the first, available products are examined and those with qualifying factors get onto a
shortlist. Then order winning factors identify the best product from the shortlist. Cost is likely to be one of
the qualifying factors, but is only likely to be an order winning factor with commodities. Quality is
particularly important, which is the reason why total quality management says that the lowest price does not
necessarily give the best deal.
Pricing is a very complicated issue. It is certainly not in an organisations long-term interest to force
suppliers to give unrealistically low prices, or they will go out of business and not be there next time they are
needed. Supermarkets in parts of the European Union have followed consumer pressure to reduce food
prices. While this benefits their customers and presumably the broad population it means paying less to
farmers who grow the crops. If farmers go out of business, there is a major impact on rural communities and
the countryside, more reliance on imported food, an effect on the balance of trade, and so on. In general,
there are four ways of setting a price for materials:
1.
Price lists where suppliers quote fixed prices. Book publishers, for example, quote a selling
price that they expect retailers to use. They can give discounts for large or special
purchases, but one organisation essentially fixes the price.
2.
Special quotation where suppliers quote prices to each customer, particularly for
nonstandard materials. Customers submit a request for a quotation, and the supplier returns
a price and conditions that it is willing to offer.
3.
Negotiation when there is some flexibility in price and conditions. A supplier might give a
quote, but is willing to negotiate if it can get some benefit such as repeat orders. Similarly,
customers can negotiate if they want special conditions, such as fast delivery.
4.
Commodity pricing for commodities such as oil, coffee, gold and wheat, market forces set
the going rate that is used by all suppliers. You can see many such figures in, say, financial
futures markets.
Even when the basic price has been agreed there can be other difficulties with conditions. Who, for
example, pays for transportation to the final location and who accepts the risks for the journey? Several
standard conditions are used (shown in Figure 9.3) and for historical reasons they seem to be phrased in
terms of shipping:
Ex-works: The purchaser accepts materials at the factory gate and takes over all
responsibility for transport, documentation, customs clearance, insurance, risk and so on. This
type of contract is best when the supplier has little experience of moving materials through the
relevant area, or the purchaser has a lot of experience. If neither has the necessary experience,
they can sub-contract the actual movement to third party specialists.
Free alongside (FAS): Here the supplier moves materials to a specified port and delivers
them alongside a ship. The customer takes over the loading on a vessel and movement
onward.
55

Free on board (FOB): This is a variation of FAS, where the supplier also takes care of the
loading onto the vessel, and then the customer is responsible for onward transport. This might
seem like a small adjustment to FAS, but loading might involve heavy lifts, risk of damage, or
use of lighters (which are small vessels used to move materials out to a larger vessel moored
in deeper water).
Delivered ex-ship: Where the goods are available on the ship (or quayside) but the customer
has to arrange for customs clearance, duty, and so on.
Cost and freight (C&F): Here the supplier arranges transport to an agreed point, but the
customer accepts any risk and arranges insurance for the journey.
Cost, insurance and freight (CIF): Where the supplier delivers to an agreed point, and also
arranges insurance for the journey.
Delivered: Where the supplier is responsible for all aspects of the transport up to delivery to
the customer.

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6 Inventory management and strategy

To understand the importance of inventory decisions, consider the magnitude of assets committed by a
typical enterprise. Table 2-1 presents sales, net profit, and inventory investment for some consumer and
industrial goods manufacturers and merchandisers. The table illustrates the significance of inventory as
percent of assets.

Because inventory is a significant cost center, the reduction of a firm's inventory commitment by a few
percentage points can result in dramatic profit improvement.

6.1 Inventory Types and Characteristics

Inventory management is risky, and risk varies depending upon a firm's position in the distribution
channel. The typical measures of inventory commitment are time duration, depth, and width of
commitment.
For a manufacturer, inventory risk is long term. The manufacturer's inventory commitment starts with
raw material and component parts, includes work-in-process, and ends with finished goods. In addition,
finished goods are often positioned in warehouses in anticipation of customer demand. In some situations,
manufacturers are required to consign inventory to customer facilities. In effect, this practice shifts all
inventory risk to the manufacturer. Although a manufacturer typically has a narrower product line than a
retailer or wholesaler, the manufacturer's inventory commitment is deep and of long duration.
A wholesaler purchases large quantities from manufacturers and sells smaller quantities to retailers.
The economic justification of a wholesaler is the capability to provide retail customers with assorted
merchandise from different manufacturers in specific quantities. When products are seasonal, the wholesaler
may be required to take an inventory position far in advance of the selling season, thus increasing depth and
duration of risk.
For a retailer, inventory management is about buying and selling velocity. The retailer purchases a
wide variety of products. Retailer inventory risk can be viewed as wide but not deep. Due to the high cost of
store location, retailers place prime emphasis on inventory turnover and direct product profitability.
Inventory turnover is a measure of inventory velocity and is calculated as the ratio of annual sales divided by
average inventory.
Although retailers assume a position of risk on a variety of products, their position on any one product
is not deep. Specialty retailers, in contrast to mass merchandisers, normally experience less width of
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inventory risk as a result of handling narrower assortments; however, they must assume greater risk with
respect to depth and duration of inventory holding.
Examples:
A typical supermarket = 30000 SKUs (stockkeeping unit)
A discount store = 25000 SKUs
Holding inventory is necessary and has advantages despite of the great expenses engaged
Summarizing, the inventory has 4 main functions:

If a business plans to operate at more than one level of the distribution channel, it must be prepared to
assume related inventory risk. For the case an enterprise becomes vertically integrated, inventory must be
managed at all levels of the supply chain.

6.2 Inventory-related concepts

Inventory Policy
Inventory policy is about what to purchase or manufacture, when to take action, and in what
quantity. It also includes decisions regarding geographical inventory positioning. For example, some firms
may decide to postpone inventory positioning by maintaining stock at the plant. Other firms may use a more
speculative policy by electing to position more products in local markets or regional warehouses to have
product closer to the market. The development of sound inventory policy is the most difficult issue within
overall inventory management.
A second aspect of policy concerns inventory management practice. One approach is to independently
manage inventory at each stocking facility. At the other extreme is central inventory management of all
stocking locations. Centralized inventory management requires effective communication and coordination.
The increased availability of affordable information technology and integrated planning systems are allowing
more firms to move toward centralized inventory planning.
Service Level
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The service level is the performance target specified by management. It defines inventory performance
objectives. Service level is often measured in terms of an order cycle time, case fill rate, line fill rate, order
fill rate, or any combination of these. The performance cycle is the elapsed time between the release of a
purchase order by a buyer and the receipt of the corresponding shipment. A case fill rate defines the percent
of cases or units ordered that are shipped as requested. For example, a 95 percent case fill rate indicates that,
on average, 95 cases out of 100 are filled from available stock. The remaining 5 cases are backordered or
deleted. The line fill rate is the percent of order lines filled completely. Order fill is the percent of customer
orders filled completely.
While one strategy to achieve a high service level is to increase inventory, other alternative approaches
are the use of fast transportation and collaboration with customers and service providers to reduce
uncertainty.
Average Inventory
Average inventory consists of the materials, components, work-in-process, and finished product
typically stocked in the logistical system. From a policy viewpoint target inventory levels must be planned
for each facility. Figure 10-2 illustrates the performance cycles for one item at one warehouse location. At
the maximum, the facility has in stock and during the normal performance cycle $70,000 and a minimum of
$30,000. The difference between these two levels, $40,000 ($70,000 - $30,000), is the order quantity
resulting in a cycle inventory of $20,000. Cycle inventory or base stock (also called lot size stock) is the
portion of average inventory that results from replenishment.

At the beginning of a performance cycle, stock level is at a maximum. Customers consume inventory
until the stock level reaches its minimum. Prior to the stock level reaching the minimum, a replenishment
order is initiated so that inventory will arrive before an out-of-stock occurs. The replenishment order must be
initiated when the available inventory is less than or equal to forecasted demand during the performance
cycle time. The amount ordered for replenishment is termed the order quantity. Given this basic order
formulation, average cycle inventory or base stock equals onehalf order quantity. The majority of
inventory in the typical logistics system is typically safety stock. Safety stock is maintained in a logistical
system to protect against demand and performance cycle uncertainty. Safety stock inventory is used only at
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the end of replenishment cycles when uncertainty has caused higher than expected demand or longer than
expected performance cycle times. Thus, the average inventory focus of logistical management is one-half
order quantity plus safety stock.

Average Inventory Over Multiple Performance Cycles

In initial policy formulation, it is necessary to determine how much inventory to order at a specified
time. We take the following example: the replenishment performance cycle is a constant 10 days and daily
sales rate is 10 units per day. Also assume the replenishment order quantity is 200 units. Since complete
certainty exists with respect to usage and performance cycle, orders are scheduled to arrive just as the last
unit is sold. Thus, no safety stock is necessary. Since the rate of sale in the example is 10 units per day and it
takes 10 days to complete inventory replenishment, a sound reorder policy might be to order 200 units every
20 days. Given these conditions, terminology related to policy formulation can be identified. First, the
reorder point is specified as 100 units on hand. The reorder point defines when a replenishment order is
initiated. In this example, whenever the quantity on hand drops below 100, an additional order for 200 units
is placed. Second, average inventory is 100 units. Average inventory is equal to one-half the 200-unit order
quantity.
Third, assuming a work year of 240 days, 12 purchases will be required during the year.
Therefore, over a period of 1 year, 200 units will be purchased 12 times for a total of 2400 units.
Which are the alternatives of ordering policies? What if the replenishments are made more
frequently? Or rarely? These alternative ordering policies are illustrated in the following figure:

The figure illustrates that average inventory is a function of the reorder quantity. Smaller
replenishment order quantities do result in lower average inventory, but there are other factors such as
performance cycle uncertainty, purchasing discounts, and transportation economies that are important when
determining order quantity.
An exact order quantity policy can be determined by balancing the cost of ordering and the cost of
maintaining average inventory. The Economic Order Quantity(EOQ) model provides a specific quantity
balancing of these two critical cost components. By determining the EOQ and dividing it into annual
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demand, the frequency and size of replenishment orders minimizing the total cost of cycle inventory is
identified. Prior to reviewing EOQ, it is necessary to identify costs typically associated with ordering and
maintaining inventory.

6.3 Inventory carrying cost

Inventory carrying cost is the expense associated with maintaining inventory. Inventory expense is
calculated by multiplying annual inventory carrying cost percent by average inventory value. Standard
accounting practice is to value inventory at purchase or standard manufacturing cost rather than at selling
price.
Financial accounts relevant to inventory carrying cost percent are capital, insurance, obsolescence,
storage, and taxes.
Capital Cost
The appropriate charge to place on capital invested in inventory varies widely. Review of a variety of
enterprises indicates that assessments range from the prime interest rate.
Capital costs are based on expected or target return on investment for all funds available to an
enterprise. This target rate is often termed a hurdle rate. Any funds invested in inventory lose their earning
power, restrict capital availability, and limit other investment. For example, if a firm expects a 20 percent
before-tax return on invested capital, similar logic suggests that capital tied up in inventory should be
assessed or charged the same 20 percent.
Taxes
Taxing authorities typically assess inventory held in warehouses. The tax rate and means of assessment
vary by location. The tax expense is usually a direct levy based on inventory level on a specific day of the
year or average inventory level over a period of time.
Insurance
Insurance cost is an expense based upon estimated risk or loss over time. Loss risk depends on the
product and the facility storing the product. For example, high-value products that are easily stolen and
hazardous products result in high insurance cost. Insurance cost is also impacted by facility characteristics
such as security cameras and sprinkler systems that might help reduce risk.
Storage
Storage cost is facility expense related to product holding rather than product handling. Storage cost
must be allocated on the requirements of specific products since it is not related directly to inventory value.
In public or contract warehouses, storage charges are billed on an individual basis. With privately owned
facilities, the total annual depreciated expense of the warehouse must be calculated in terms of a standard
measure such as cost per day per square or cubic foot. The cost of total annual occupancy for a given product
can then be assigned by multiplying the average daily physical space occupied by the standard cost factor for
the year. This figure can then be divided by the total number of units of merchandise processed through the
facility to determine average storage cost per merchandise unit.
Table 10-3 illustrates the components of annual inventory carrying cost and typical range of component
costs. It should be clear that the final carrying cost percent used by a firm is determined by managerial
policy.

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6.4 Planning inventory

6.4.1 When to order
The reorder point defines when a replenishment shipment should be initiated. A reorder point can be
specified in terms of units or days' supply. This discussion focuses on determining reorder points under
conditions of demand and performance cycle certainty.
The basic reorder point formula is:

In this situation the reorder point is expressed in terms of units.

Reorder point in terms of days of supply equals T (performance cycle in days).
This is the situation when we are sure the replenishment shipment will arrive as scheduled and the
demand is constant (not variable).
When uncertainty exists in demand or performance cycle length, safety stock is required. When safety
stock is necessary to accommodate uncertainty, the reorder point formula is:

6.4.2 How much to order

Its very important to make a balance between inventory carrying cost and the cost of
ordering.
The greater the order quantity, the larger the average inventory and, consequently, the greater the
annual carrying cost is. However, the larger the order quantity, the fewer orders required per planning period
and, consequently, the lower the total ordering cost is.
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The point at which the sum of ordering and carrying cost is minimized represents the lowest total
cost. Simply stated, the objectives are to identify the ordering quantity that minimizes the total inventory
carrying and ordering cost.
Economic Order Quantity
The EOQ is the replenishment practice that minimizes the combined inventory carrying and ordering
cost. The most efficient method for calculating EOQ is mathematical.

To make the appropriate calculations, the standard formulation for EOQ is:

Where:
EOQ = Economic order quantity;
Co= Cost per order;
Ci = Annual inventory carrying cost;
D = Annual sales volume, units; and
U = Cost per unit.
Example:

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Total ordering cost would amount to $152 (2400/300 x $19.00).

Inventory carrying cost amounts to $150 [300/2 x (5 x 20%)].
The major assumptions of the simple EOQ model are (constraints of the model):
(1) all demand is satisfied;
(2) rate of demand is continuous, constant, and known;
(3) replenishment performance cycle time is constant and known;
(4) there is a constant price of product that is independent of order quantity or time;
(5) there is an infinite planning horizon;
(6) there is no interaction between multiple items of inventory;
(7) no inventory is in transit; and
(8) no limit is placed on capital availability.
The constraints imposed by some of these assumptions can be overcome through computational
extensions.
EOQ extensions
Because of some factors which typically affect the purchasing process, some adjustments are
necessary to be applied on EOQ computation. Three typical adjustments are volume transportation rates,
quantity discounts, and other EOQ adjustments.
Volume Transportation Rates

As a general rule, the greater the weight of an order, the lower the cost per weight unit of
transportation from any origin to destination is. A freight-rate discount for larger shipments is common for
both truck and rail. A firm naturally wants to purchase in quantities that offer maximum transportation
economies. Such quantities may be larger than the purchase quantity determined using the EOQ method.
Example:
Assume for purposes of illustration that the most desirable transportation rate is obtained when a
quantity of 480 is ordered as compared to the EOQ-recommended order of 300 calculated earlier.

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As seen in the above example, if we consider EOQ=480, the inventory carrying cost increases
(from 150 to 240), the ordering cost decreases (because of less number of orders issued) and the
transportation cost also decreases because of the lower rate we benefit with large shipments. Taking into
consideration the potential transportation savings by purchasing in larger lot sizes, total annual cost by
purchasing 480 units 5 times per year rather than the EOQ solution of 300 units 8 times per year results in
approximately a $570 savings.
Quantity discounts
Some discounts on purchasing price could be acquired according to the volume of orders
issued. Bellow is an example which illustrates a sample schedule of discounts:

If the discount at any associated quantity is sufficient to make a tradeoff between increased
inventory carrying cost and the reduced cost of ordering, then the quantity discount offers a viable
alternative. It should be noted that quantity discounts and volume transportation rates each affect larger
purchase quantities. This does not necessarily mean that the lowest total cost purchase will always be a larger
quantity than the one suggested by the case of basic EOQ.
Other EOQ Adjustments
A variety of special situations may occur that will require adjustments to the basic EOQ.
Examples are:
(1) production lot size: refers to the most economical quantities from a manufacturing perspective.
(2) multiple-item purchase: Multiple-item purchase refers to situations when more than one product
is bought concurrently, so quantity and transportation discounts must consider the impact of product
combinations.
(3) limited capital: describes situations with budget limitations for total inventory investment.
(4) private trucking: influences order quantity since it represents a fixed cost. Once it is decided to
use a private fleet to transport replenishment product, the enterprise should fill the truck regardless of the
EOQ. It does not make sense to transport a half-empty truck simply so that a single item order quantity
represents the EOQ
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(5) unitization: many products are stored and moved in standard units such as cases or pallets. There
may be significant diseconomies when the EOQ is not a standard unit. As an example, suppose that a full
pallet quantity is 200 units of a specified product. Using an EOQ of 300 units would require shipments of 1.5
pallets. From a handling or transportation utilization perspective, it is probably more effective to order either
one or two pallets alternatively or permanently.

6.5 Managing uncertainty

Although it is useful to understand inventory relationships under conditions of certainty,
formulation of inventory policy must realistically consider uncertainty. One of the main functions of
inventory management is to plan safety stock to protect against out-of-stocks. Two types of uncertainty
have a direct impact upon inventory policy. Demand uncertainty is rate of sales during inventory
replenishment. Performance cycle uncertainty concerns inventory replenishment time variations.

6.5.1 Demand Uncertainty

Sales forecasting estimates unit demand during the inventory replenishment cycle. Even with good
forecasting, demand during replenishment cycle often exceeds or doesnt reach what is anticipated. To
protect against out of stock when demand exceeds forecast, safety stock is added to base inventory.
The below figure illustrates the inventory performance cycle under conditions of demand uncertainty:

Assume for purposes of illustration that the inventory performance cycle is 10 days. Historical
experience indicates that daily sales range from 0 to 10 units with average daily sales of 5 units. The
economic order is assumed to be 50, the reorder point is 50, the planned average inventory is 25, and sales
during the performance cycle are forecasted to be 50 units.
We have three different situations in the above figure. It presents three performance cycles.
The dashed line represents the forecast. The solid line illustrates inventory on hand from one performance
cycle to the next and also the evolution of real demand.
The history of real demand during the three consequent cycles is recorded in the below table.
During the first cycle, although daily demand experienced variation, the average of 5 units per day was
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maintained. Total demand during cycle 1 was 50 units, as expected. During cycle 2, demand totaled 50 units
in the first 8 days, resulting in a stockout; thus, no sales were possible on days 9 and 10. During cycle 3,
demand reached a total of 39 units. The third performance cycle ended with 11 units remaining in stock.
Over the 30-day period total sales were 139 units, for average daily sale of 4.6 units.
-

Other aspects observed:

stockouts occurred on 2 of 30 total days
Since sales never exceed 10 units per day, no possibility of stockout exists on the first 5 days of the
replenishment cycle
during the three performance cycles 10 units were sold on only one occasion

Considering all of these findings, we can create a table with all demand values which occurred and
their corresponding frequency:

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Given an expected average of 5 units per day, demand exceeded average on 11 days and was less than
average on 12 days
A chart is possible to be created based on frequency of demand:

Given the historical frequency of demand, it is possible to calculate the safety stock necessary to
provide a specified degree of stockout protection. The situation illustrated uses 28 days. In actual application,
a larger sample size would be desirable.
While a number of frequency distributions can be used in inventory control, the most basic is the
normal distribution. A normal distribution is characterized by a symmetrical bell-shaped curve, illustrated
below:

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The essential characteristic of a normal distribution is that the three measures of central
tendency have equal value. The mean (average) value, the median (middle) observation, and the mode (most
frequently observed) value are all the same. When these three measures are nearly identical, the frequency
distribution is normal.
The basis for predicting demand during a performance cycle using a normal distribution is the
standard deviation of observations around the measures of central tendency. The standard deviation is a
measure of dispersion of events within specified areas under the normal curve. For the inventory
management application, the event is unit sales per day and the dispersion is the variation in daily sales
levels. Within +1 standard deviation, 68.27 percent of all events occur. This means that 68.27 percent of the
days during a performance cycle will experience daily sales within +1 standard deviation of the average daily
sales. Within +2 standard deviations, 95.45 percent of all events occur. At +3 standard deviations, 99.73
percent of all events are included. In terms of inventory policy, the standard deviation provides a method of
estimating the safety stock required to offer a specified degree of protection above average demand.
The first step in setting safety stocks is to calculate the standard deviation. Most calculators
and spreadsheets calculate standard deviation, but if one of these aids is not available, another method to
compute the standard deviation is:

Continuing the example taken for illustration, the calculation of standard deviation is
presented in the following table:

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The standard deviation of the data in table is rounded to 3 units. When setting safety stocks, 2
standard deviations of protection, or 6 units, would protect against 95.45 percent of all events included in the
frequency distribution. Thus, 6 units represents the necessary safety stock to have a 95.45 % protection, in
the case when performance cycle time is constant.
The above example illustrates how statistical probability can assist with the quantification of demand
uncertainty, but demand conditions are not the only source of uncertainty. Performance cycles can also vary.

6.5.2 Performance cycle uncertainty

Performance cycle uncertainty appears when the company cannot assure constant delivery. It doesnt
have a constant value over multiple consequent cycles. The practice is to create safety stocks to cover the
uncertainty. If there is substantial variation in the performance cycle, a formal evaluation is desirable.
We take into consideration the following situation illustrated in the below table, which presents a
sample frequency distribution of performance cycles:

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In this situation the events are performance cycles expressed in days and the standard deviation is
calculated based on their dispersion. Eventually, the standard deviation is 2 days.
Although 10 days is the most frequent, replenishment experience ranges from 6 to 14 days. If the
performance cycle follows a normal bell-shaped distribution, an individual performance cycle would be
expected to fall between 8 and 12 days 68.27 percent of the time and between 6 and 14 days would protect
against the stockout 95.45 percent of the time. For + 2 standard deviation the necessary safety stock amounts
20 units in the case of constant daily sales of 5 units (4 days above the average 10 performance days, which
amounts 4x5=20 units of constant sales).
From a practical viewpoint, when cycle days drop below 10, no immediate problem exists with safety
stock. If the performance cycle were consistently below the planned performance cycle over a period of time,
then adjustment of performance cycle days is necessary.

6.5.3 Combined demand and performance cycle uncertainty

What if uncertainty exists in both demand and performance cycle in the same time? Such a situation
is illustrated in the below figure:

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The typical situation confronting the inventory planner is illustrated in above, where both demand and
performance cycle uncertainties exist. Treating both demand and performance cycle uncertainty requires
combining two independent variables. However, in setting safety stocks, the joint impact of the probability of
both demand and performance cycle variation must be determined.
The starting point is to put demand distribution and performance cycle distribution together, as
illustrated in the following:

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First, it is necessary to determine the standard deviation of both daily demand and performance cycle
uncertainty and then to approximate the combined standard deviation using the convolution formula4:

In probability theory, the probability distribution of the sum of two independent random variables is the convolution of
their individual distributions.

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This formulation estimates the convoluted or combined standard deviation of T days with an average
demand of D per day when the individual standard deviations are St and Ss respectively.
Thus, given a frequency distribution of daily sales from 0 to 10 units per day and a range in
replenishment cycle duration of 6 to 14 days, 13 units (1 standard deviation multiplied by 13 units) of safety
stock is required to protect 84.14 percent of all performance cycles (68.27 plus the percentage of situations
below 1st standard deviation). To protect at the 97.72 percent level, a 26-unit safety stock is necessary. These
levels of probability assume a one-tail distribution since it is not necessary to protect against lead time
demand below average. These percentages reflect the probability of a stockout during a given order cycle.
For example, with a 13-unit safety stock, stockouts would be expected to occur during 31.73 (100 - 68.27)
percent of the performance cycles.
The following table summarizes the possible alternatives already discussed regarding certainty and
uncertainty of inventory management:

One of the findings is that the safety stock for covering the performance cycle uncertainty is higher at
the same protection (2nd standard deviation from mean).

6.6 Inventory management policies

6.6.1 Inventory control
Inventory control measures units on hand at a specific location and tracks additions and deletions.
Accountability and tracking can be performed on a manual or computerized basis.
Inventory control defines how often inventory levels are reviewed to determine when and how much
to order. It is performed on either a perpetual or a periodic basis.
Perpetual review
Inventory control process reviews inventory status daily to determine inventory replenishment needs.
Accurate tracking of all SKUs is necessary.

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75

7 Warehousing
7.1 Some historical aspects and evolution
Storage has always been an important aspect of economic development.
Preindustrial era: storage was performed by individual households forced to function as self-sufficient
economic units
As transportation capability developed, product storage shifted from households to retailers,
wholesalers, and manufacturers (they didnt care about strategic storage), labor productivity, materials
handling efficiency, and inventory turnover were not major concerns during this early era, little consideration
was given to efficiency in space utilization, work methods, or materials handling, initial warehouses provided
a necessary bridge between production and marketing.
World War II: attention shifted toward strategic storage, reduction in warehousing was obtained as a
result of manufacturing improvements, seasonal production and consumption still required warehousing.
Warehousing became integral to Just-in-Time (JIT) and stockless production strategies. While the basic
notion of JIT is to reduce work-inprocess inventory, this requires strategically located warehouses. Utilizing
centralized parts inventory at a central warehouse reduces the need for inventory at each assembly plant.
Products can be purchased and shipped to the strategically located central warehouse, taking advantage of
consolidated transportation. At the warehouse, products are sorted, sequenced, and shipped to specific
manufacturing plants as needed. And thats the same for the outbound side of manufacturing.
An important charge in warehousing is maximum flexibility. Such flexibility can often be achieved
through information technology. Flexibility is an essential part of being able to respond to expanding
customer demand in terms of product assortments and the way shipments are delivered and presented.

7.2 The function of warehousing

7.2.1 Economic benefits
Economic benefits of warehousing occur when overall logistics costs are reduced at the end. For
example, if adding a warehouse in a logistical system reduces overall transportation cost by an amount
greater than required investment and operational cost, then total cost will be reduced. Warehouses are
efficient when they improve transportation efficiency.
Five basic economic benefits are:
1. consolidation and break-bulk,
2. assortment,
3. postponement,
4. stockpiling, and
5. reverse logistics.
Consolidation and break-bulk
The aim is to reduce transportation cost by using the warehouse capability to make consolidation or
break-bulk and consequently to profit from increased shipment economies of scale.
Consolidation, the warehouse receives materials from a number of sources, which are combined into a
large single shipment to a specific destination, such as a customer. Immediate benefits could be: quicker
delivery, lower transportation charges, even lower products purchasing prices.
A break-bulk operator receives a single large shipment and arranges for delivery to multiple
destinations. The break-bulk warehouse or terminal sorts or splits out individual orders and arranges local
delivery.
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Assortment
The basic benefit of assortment is to reconfigure freight as it flows from origin to destination. Three
types:
cross-docking,
mixing, and
assembly
Cross-docking is to combine inventory from multiple origins into an assortment for a specific
customer. The assortment is formed by different products combination, in different volumes accommodated
to each customer requirements.

Mixing achieves an end result similar to cross-docking. However, mixing is usually performed at an
intermediate location between shipment origin and destination. In a typical mixing operation, carloads or
truckloads of products are shipped from origin to mixing warehouses. During the mixing process, inbound
products can be combined with those regularly stored at the warehouse. Warehouses that perform in-transit
mixing have the net effect of reducing overall product storage in a logistical system while achieving
customer-specific assortments and minimizing transportation cost.
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Assembly supports manufacturing operations. Components are assembled by a warehouse located in

close proximity to the manufacturing plant. (Example: Personal Computers industry of today: manufacturers
are producing computer components and a third party entity is assembling the components on different
combinations according to customers specific requirements)

Processing/Postponement
Warehouses can also postpone commitment to final product configuration by completing final
packaging, labeling, and light manufacturing. For example, vegetables can be processed and canned in
brights at the processing plants. Brights are cans without labels. Once a specific customer order is received,
the warehouse can complete labeling and finalize packaging.
Postponement provides two economic benefits:
- risk is minimized because customized packaging is not performed in anticipation of customer orders or to
accommodate a forecast
- total inventory can be reduced by using inventory of the base product to support multiple customers'
labeling and package requirements
Stockpiling
The direct economic benefit of stockpiling is to accommodate seasonal production or demand.
Examples:
- lawn furniture and toys are typically produced all year long but are sold only during a very short
marketing period
- agricultural products are harvested at specific times, with subsequent consumption occurring
throughout the year.
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Reverse logistics
Warehousing plays a key role in performing reverse logistics. Activities managed at warehouse:
product recall, reclamation, and disposal of overstock and damaged inventory.
Reverse movement typically consists of nonuniform individual packages and cartons as contrasted to
outbound movement of cases and pallet loads. Packages are often broken, and product is not packaged
correctly. Return products typically require significant manual sorting and inspection to determine
appropriate disposal.

7.2.2 Service benefits

Warehouse service can provide benefits through enhanced revenue generation. It is typically difficult
to quantify service return-on-investment because it's difficult to measure. For example, establishing a
warehouse to service a specific market may increase cost but should also increase market sales, revenue,
potentially gross margin, and finally the customer satisfaction.
Services provided by a warehouse:
- spot stocking
- full line stocking
- production support
- market presence
Spot stocking
Manufacturers of highly seasonal products often spot stock. Responsiveness in peak selling periods
can be enhanced through temporary inventory positioning in strategic markets. Under this concept, select
inventory is positioned or spot stocked in a local market warehouse in anticipation of responding to customer
need during the critical sales period.
In this way inventories are placed closed to key customers just prior to a maximum period of seasonal
sales.
Example: agricultural fertilizer companies sometimes spot stock near farmers in anticipation of the
growing season. After the growing season, such spot stocking would likely be reduced.
Full line stocking
The difference between stock spotting and full line stocking is the degree and duration of warehouse
utilization. A firm following a spot stocking strategy would temporarily warehouse a narrow product
assortment in a large number of warehouses for a limited time period. The full line stocking warehouse is
more often restricted to a few strategic locations and operates year-round. Full line stocking warehouses
improve service by reducing the number of suppliers that a customer must deal with.
Production support
Its about the warehouses designated to stock specific parts and components. They support
manufacturing operations. stocks on items purchased from outside vendors may be justified because of long
lead times, potential supply discontinuity, and significant variations in usage rates. This service benefit of
warehousing could be easily related to assembly assortment discussed under economic benefits. The primary
difference between production support warehousing and assortment assembly is the size and purpose of the
warehouse.
Market presence
A local warehouse can respond faster to customer needs than can a more distant warehouse. It
sometimes creates a competitive advantage. It is anticipated that local warehouse presence will increase
market share and potentially profitability
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7.3 Warehouse operations

The objective of warehouse operations is to efficiently receive inventory, possibly store it until
required by the market, assemble it into complete orders, and initiate movement to customer.

7.3.1 Handling
Strategic approaches of handling:
- movement continuity
- scale economies
Movement continuity means that it is better for a material handler with a piece of handling equipment
to perform longer moves than to undertake a number of short handlings to accomplish the same overall
move. It is inefficient to exchange the product between handlers because it wastes time and increases the
potential for product damage. Thus, as a general rule, longer warehouse movements are preferred. Goods,
once in motion, should be continuously moved until arrival at their final destination.
Scale economies justify moving the largest quantities or loads possible. Instead of moving individual
cases, handling procedures should be designed to move cases grouped on pallets or containers.
Main activities of handling:
1. Receiving
Merchandise and materials typically arrive at warehouses in large quantity shipments. The first
handling activity is unloading. At most warehouses, unloading is performed mechanically, using a
combination of a lift truck and manual processes. When freight is floor stacked on the transport vehicle, the
typical procedure is to manually place products on pallets or to use a conveyor. When inbound product has
been unitized on pallets or containers, lift trucks can be used to facilitate receiving. A primary benefit of
receiving unitized loads is the ability to turn inbound transportation equipment more rapidly. Receiving is
usually the unloading of a relatively high volume of similar product.
2. In-Storage Handling
In-storage handling consists of movements within the warehouse (internal movements). Products
must be moved within the facility for storage or order selection. Finally, when an order is processed it is
necessary to select the required products and move them to a shipping area. These two types of in-storage
handling are typically referred to as transfer and selection.
Transfer movements:
- from the receiving area to a storage location: the merchandise, unitized on pallets, is handled by a
lift truck
- from storage to an order selection or picking area: when unit loads have to be broken down for
order selection
- from the selection area to the shipping staging area: the assembled customer order is transferred
to the area most adjacent to shipping docks.
Selection
The selection process requires that materials, parts, and products be grouped to facilitate order
assembly. It is typical for one area of a warehouse to be designated as a selection or picking area to assemble
orders. For each order, the combination of products must be selected and packaged to meet specific customer
order requirements. The typical selection process is coordinated by a warehouse management system.
3. Shipping

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Shipping consists of order verification and transportation materials loading. Similar to receiving,
firms may use conveyors or unit load materials handling equipment such as lift trucks to move products from
the staging area into the transportation vehicle.
Shipping unit loads is becoming increasingly popular because considerable time can be saved in
vehicle loading. A unit load consists of unitized or palletized product. To facilitate this loading and
subsequent unloading upon delivery, many customers are requesting that suppliers provide mixed
combinations of product within a unit.
The alternative is to floor stack cases in the transportation vehicle.
Shipment content verification is typically required when product changes ownership. Verification
may be limited to a simple carton count or a piece-by-piece check for proper brand, size, and in some cases
serial number to assure shipment accuracy.

7.3.2 Storage
The products should be positioned within a warehouse based upon individual characteristics. The
most important product variables to consider in a storage plan are:
- product volume
- weight
- and storage requirements.
Product volume is the major factor driving warehouse layout. High volume product should be
positioned in the warehouse to minimize movement distance. For example, high-velocity products should be
positioned near doors, primary aisles, and at lower levels in storage racks. Such positioning minimizes
warehouse handling and reduces the need for frequent lifting.

Product weight and special characteristics

Relatively heavy items should be assigned storage locations low to the ground to minimize lifting.
Bulky or low-density product requires cubic space. Floor space along outside walls is ideal for such items.
On the other hand, smaller items may require storage shelves, bins, or drawers. The integrated storage plan
must consider individual product characteristics.
Alternatives of storage: active vs. extended storage

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A typical warehouse is engaged in a combination of active and extended product storage alternatives.
Warehouses that directly serve customers typically focus on active short-term storage. In contrast,
warehouses use extended storage for speculative, seasonal, or obsolete inventory.
Active storage
Most goods must be stored for at least a short time. Active storage must provide sufficient inventory
to meet the periodic demands. The need for active storage is usually related to the capability to achieve
transportation or handling economies of scale.
The active storage concept includes flow-through distribution, which uses warehouses for
consolidation and assortment while maintaining minimal or no inventory in storage. Flow-through
distribution is most appropriate for high-volume, fast-moving products where quantities are reasonably
predictable. While flow-through distribution places minimal demands on storage requirements, it does
require that product be quickly unloaded, de-unitized, grouped and sequenced into customer assortments, and
reloaded into transportation equipment.
Extended storage
It refers to inventory in excess of that required for normal replenishment of customer stocks. In some
special situations, storage may be required for several months prior to customer shipment. Extended storage
focuses on maximum space utilization with minimal need for quick access.
A warehouse may be used for extended storage for several other reasons. Some products, such as
seasonal items, require storage to await demand or to spread supply across time. Other reasons for extended
storage include erratic demand items, product conditioning, speculative purchases, and discounts. Product
conditioning sometimes requires extended storage, such as to ripen bananas. Food warehouses typically have
ripening rooms to hold products until they reach peak quality.
Warehouses may also store goods on an extended basis when goods are purchased on a speculative
basis. For example, if a price increase for an item is expected, it is not uncommon for a firm to buy ahead at
the current price and warehouse the product for later use. In this case, the discount or savings has to be
traded off against extended storage and inventory carrying cost.
The warehouse may also be used to realize special discounts. The purchasing manager may be able to
realize a substantial price reduction during a specific period of the year.

7.4 Warehouse planning

7.4.1 Site selection
The first task is to identify both the general and then the specific warehouse location. It means to
identify the location where an active warehouse makes sense from a service, economic, and strategic
perspective.
Typical areas in a community for locating warehouses:
- commercial zone,
- outlying areas served primarily by motor truck only,
- the central or downtown area.
Drivers in site selection:
- land cost
- warehouses can exist among industrial plants and in areas zoned for light or heavy industry
- rail sidings
- utility hookups
- taxes
- insurance rates
- highway access
- adequate room for expansion
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- necessary utilities must be available

- soil must be capable of supporting the structure
Best positioning of the warehouse in the territory
The location of a warehouse in a certain geographical area has a big impact on the overall distribution
costs. It influences the operating and inventory management costs, which are inside costs of the warehouse,
but it has a bigger impact on the related transportation costs from the suppliers to the warehouse and from the
warehouse to the customers. In a very simple logic, the best situation is when the warehouse is in the close
proximity of the customers but also adjacent to the suppliers. This is just a desirable case but it is not easy to
accomplish. The very starting point is to set criteria to help the decider to find the optimum location of a
warehouse so as to carry out efficiency goals such as: minimum distribution costs, fast delivery time, high
customer satisfaction, reliable reverse logistics, quality customer service etc.
A good way to find the best location for a warehouse could be:
A. Why is necessary to have a new location (warehouse)?
Possible answers:
Market expansion
Operational needs
Increased stocks
Safer transportation
Etc.
B. Which are my needs?
Possible answers:
Service to customers
Transportation costs
Stock level
Labor cost
Who is my consultant?: Real Estate Agencies, Local government etc.
The role of real estate agencies on warehouse positioning
In many cases, in the developed countries, such companies have built warehouses for rent or for sale. Large
companies, in the most of the cases, have the tendency to expand themselves very quickly and they take
action very easy in order to benefit, for instance, from the advantage of being the first one in that market,
before any competitor. One of the solutions is to check with real estate agencies if there are warehouses
available because they are willing to rent or even to buy one or more existing warehouses in the target zone.
This is a faster way than to build a brand new warehouse, which, on the other hand, could assure better
conditions for their specificity.
Another important aspect is that real estate agencies have relevant information about spaces and lands
available and suitable for developing this type of investments. Therefore, databases of the real estate agencies
are truly goldmines for those companies having access to them.
Support from local government on warehouse development
In the most of the cases local governments can influence the development or stagnation of a business (or
industry) by taking and applying different resolutions and decisions. Regarding the warehouse development,
local governments could have the following influence:
a) The promptness of the following activities: release of the property documents, analysis of the files
regarding building and designing activities, responds given for various requirements of the local
investors
b) The existence and availability of some facilities such as: proper access routes, other utilities (in the
case these local utility services are managed by government institutions)
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There are cases when local government doesnt get involved at all, although these depots bring a lot of
advantages: revenues coming from encashed taxes, jobs for local inhabitants etc. On the other hand we can
find also some disadvantages: it is not so profitable comparing to other industries, it highly uses access ways
and it damages them, negative ecological effects etc.
The whole problem is reduced to how adaptive the local governments are for the new economic requirements
C. Macro analysis
Position of the country
Essential constrains: clime, geographical zone, the proximity of the available transportation modes,
number of warehouses already owned by the company in the zone.
Characteristics of the country regarding consumption, labor offer etc.
The best warehouse positioning is a concession between the cost of the field or building and the cost of
transportation.
Transportation cost might be identified by the proximity of the major transportation modes: ports, highways,
railway and the price is determined by the market.
The vast majority of the companies dont own the property of their warehouses (WalMart) but there are also
exceptions (Toyota, Kmart). Anyway, the majority of them prefer to invest in their products rather then brick
and concrete walls.
The influence of worldwide labor cost differentiation
A very important thing having a big impact on the warehouse positioning is the availability and price of the
production factors.
The warehouses are located nearby raw materials sources but the most important factor in this case remains
the labor force. There are areas with no production because of the high labor cost. You might pay high
transport prices when you can save a lot from the labor force.
D. Micro analysis
Local factors: laws, regulations, taxes with local impact
Population density might be a problem
E. Models
Math models
Software models
Gravity point method
Multicriterial analysis
Electre
Etc.

Gravity point method

It has the purpose to find out the best location for a warehouse by minimizing the transportation costs. It is a
mathematical method. The method hypotheses are:
the method purpose is to find out the location of a warehouse serving N customers.
customer demand is Dci. Demand is expressed in volume or kilos, or other unit measures.
the customers a located using a coordinates system (Xci,Yci). Coordinates measure the real distance
between them.
Transport activity is measured using ton*km or cubic meters*km. Transport costs are: cost per kilometer or
per cubic meter.
The supplier: for simplicity, we have just one single supplier which is located in the same system in point
(Xs, Ys). Delivered quantity by the supplier is S.
The warehouse is placed in (X, Y) point.
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S Di

i 1
The relation between supplied quantity and customers demand is:
The optimum location, which minimizes transport distances, has the following coordinates:

Xs S Xci Dci

i 1
N

S Dci

Ys S Yci Dci
i 1
N

S Dci
i 1
and
These formulations dont incorporate the transportation costs. In the following, we pay attention also to
transportation costs.
i 1

We have the same situation: one supplier which delivers S quantity has Xs and Ys coordinates, with
transportation cost Ts, one single warehouse with unknown X, Y coordinates and several positioned
customers (Xci, Yci) with different transportation cost for each Tti, having Di demand.
N

S Di

i 1
In this case we have:
X and Y coordinates are calculated with the formula:

Xs Ts S Xci Tti Dci

i 1
N

Ts S Dci Tti
i 1

Ys Ts S Yci Tti Dci

i 1
N

Ts S Dci Tti
i 1

7.4.2 Design
Warehouse design must consider product movement characteristics.
Three factors to be determined during the design process:
- number of floors
- cube utilization plan
- product flow
Number of floors
The ideal warehouse design is a one-floor building that eliminates the need to move product
vertically. The use of vertical handling devices, such as elevators and conveyors, to move product from one
floor to the next requires time, energy, and typically creates handling bottlenecks.
Cubic utilization
Warehouse design should maximize cubic utilization. Maximum effective warehouse height is limited
by the safe lifting capabilities of materials handling equipment, such as lift trucks, rack design, and fire safety
regulations imposed by sprinkler systems.
Product flow
Warehouse design should facilitate continuous straight product flow through the building. This is true
whether the product is moving into storage or is being crossdocked. In general, this means that product
should be received at one end of a building, stored as necessary in the middle, and shipped from the other
end. Straight line product flow facilitates velocity while minimizing congestion and redundant handling.

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Product-Mix Analysis
Each product should be analyzed in terms of annual sales, demand, weight, cube, and packaging. It is
also desirable to determine the total size, cube, and weight of the average order to be processed through the
warehouse. These data provide necessary information for determining warehouse space, design and layout,
materials handling equipment, operating procedures, and controls.
Future expansion
Future expansion should be considered during the initial planning phase. Well-managed organizations
often establish 5- to 10-year expansion plans. Potential expansion may justify purchase or option of a site
three to five times larger than required to support initial construction.
Material handling considerations
A materials handling system is the basic driver of warehouse design. As noted previously, product
movement and assortment are the main functions of a warehouse. Consequently, the warehouse is viewed as
a structure designed to facilitate efficient product flow. It is important to stress that the materials handling
system must be selected early in the warehouse development process.
Layout
The layout or storage plan of a warehouse should be planned to facilitate product flow. The layout
and the material handling system are integral. In addition, special attention must be given to location,
number, and design of receiving and loading docks.
It is difficult to generalize warehouse layouts since they are usually customized to accommodate
specific handling requirements. The general idea is to start from standard size of unit loads. The most
common handling element used throughout a warehouse is pallet. In general, the larger the pallet load, the
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lower the movement cost per pound or package over a given distance. One lift truck operator can move a
large load in the same time and with the same effort required to move a smaller load. Regardless of the size
finally selected, management should adopt one pallet size for the overall warehouse.
The second step in planning warehouse layout involves pallet positioning. The most common practice
in positioning pallets is 90 degree, or square, placement. Square placement means that the pallet is positioned
perpendicular to the aisle.

Finally, the handling equipment must be integrated to finalize layout. The path and tempo of product
flow depend upon the materials handling system. To illustrate the relationship between materials handling
and layout, two systems and their respective layouts are illustrated.

Layout A:
- lift trucks for inbound and inventory transfer movements and tow tractors with trailer for order
selection
- is approximately square
- special area for selection or order picking
- it minimizes the distance order pickers must travel when assembling an order
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- when products are received they are palletized and moved to the storage area
- The selection area is replenished from storage as required
- Within the selection area, products are positioned according to weight, bulk, and replenishment
velocity to minimize outbound movement
- Customer orders are assembled by an order selector using a tow tractor pulling trailers through
the selection area
Layout B:
- handling system utilizing lift trucks to move product inbound and for transfer movements
- A continuous towline is used for order selection
- Products are moved from receiving areas into storage positions adjacent to the towline
- The orders are then selected directly from storage and loaded onto carts, which are propelled
around the warehouse by the towline
The weakness of the fixed towline is that it facilitates selection of all products at an equal speed and
frequency and does not consider special needs of high-velocity products

Sizing
Several techniques are available to help estimate warehouse size. Each method begins with a
projection of the total volume expected to move through the warehouse during a given period. The projection
is used to estimate base and safety stocks for each product to be stocked in the warehouse. Some techniques
consider both normal and peak utilization rates. Failure to consider utilization rates can result in
overbuilding, with corresponding increase in cost. It is important to note, however, that a major complaint of
warehouse managers is underestimation of warehouse size requirements. A good rule of thumb is to allow 10
percent additional space to account for increased volume, new products, and new business opportunities.

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7.5 Initiating warehouse operations

To initiate warehouse operations, management must plan and perform initial stocking, personnel
staffing, and work procedures, as well as implement a Warehouse Management System (WMS) and
outbound distribution operation. Although this focuses on the warehouse start-up process, many of these
activities are relevant for ongoing warehouse operations as well.

7.5.1 Stocking
The ideal initial stocking procedure is to receive and stock all inventory items prior to initiating
operations. Individual products to be distributed through the warehouse and the quantities of each inventory
SKU are determined during warehouse planning. The challenge in initial stocking is to schedule and
sequence product arrival. Time required to initially stock a warehouse depends upon the number and quantity
of products. In most situations the initial stocking process will require 2 to 4 weeks for completion.
In a storage area, full pallet loads of product are assigned to predetermined positions. Two common
methods of slot assignment are variable and fixed. A variable-slot placement system, also called dynamic
slotting, allows the warehouse location to be changed each time a new shipment arrives. The goal of variable
slotting is efficient utilization of warehouse space. A fixed-slot system assigns product to a permanent
location in the warehouse. The product is stocked at this location as long as it sustains volume. As volume
increases or decreases, the product location may be reassigned. The advantage of fixed slotting is that
warehouse operations personnel become familiar with the location of specific product, making them more
efficient. However, newer WMS and RF capabilities have substantially increased location recording
accuracy. Regardless of which slotting system is employed, each inbound product must be assigned an initial
location.

7.5.2 Training
A major concern in logistical operations over the past several decades has been labor productivity.
The basic nature of raw materials, parts, and finished goods flowing through and between a vast network of
facilities makes logistics labor-intensive. In fact, warehousing is the single largest consumer of logistics
labor.
Hiring and training qualified personnel to operate a warehouse is a challenge. Regardless of how
efficient the proposed warehouse system is in theory, in practice it will only be as good as its operating
personnel. Part of the challenge is to attract competent, productive workers to a warehouse environment.
Because warehousing is demanding physical work completed at times and in locations that are less than
ideal, it becomes particularly difficult to attract workers in periods of relatively full employment.
Compounding this challenge in warehouse start-up as well as ongoing operations is the need to find operating
personnel who can pass necessary aptitude and drug tests. Newer materials handling equipment requires the
ability to interface with computers and the discipline to follow specific directions. The drug tests are required
to reduce the liability for personal injury or damage while operating materials handling equipment.
Once hired, personnel then must be properly trained to ensure desired system results. The full
workforce should be available for test operations prior to the arrival of merchandise. Personnel hired for
specific assignments should be fully trained to perform job requirements and to understand the role of their
contribution to total system performance. After orientation, all employees should be given specific training.
Personnel hired to operate a warehouse may be grouped in the following categories: administrators,
supervisors, selectors, equipment operators, laborers, material handlers, and support workers such as
maintenance.
Prior to actual operations it is desirable to simulate the work that each group performs. Such
simulation provides hands-on experience doing work without the risk of creating operational problems.
When initial warehouse stocking begins, the workforce receives actual experience in merchandise handling.
Normally, the manufacturer supplying the basic materials handling system and equipment provides
instruction regarding operations under both simulated and initial stocking conditions. Once the initial
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inventory is on hand, it is good practice to simulate fulfilling customer orders. Simulated orders can be
selected and loaded into delivery trucks, and the merchandise may then be treated as a new arrival and
transferred back into stock.

7.5.3 Warehouse management systems

The development of work procedures goes hard in hand with training warehouse personnel. Most
firms implement a WMS to standardize work procedure and encourage best practice. It is management's
responsibility to see that all personnel understand and use these procedures.
In a mechanized warehouse, approximately 65 percent of personnel are employed in some facet of
order selection. The two basic methods of order picking are individual and area selection, also known as
batch selection. Using individual selection, one employee completes a customer's total order. This system is
not widely used. Its primary application occurs when a large number of small orders is selected for repack or
consolidated shipment, such as e-commerce fulfillment. Under the more commonly used area selection
system each employee is assigned responsibility for a specific portion of the warehouse. To complete a
customer's order, several different selectors are required. Because each employee has a thorough knowledge
of a specific selection area, less time is required to locate items.
Work procedures are also important for receiving and shipping. Established procedures for receiving
and ensuring product entry into inventory records are critical. If pallets are used, the merchandise must be
stacked in appropriate patterns to ensure maximum load stability and consistent case counts. Personnel
working in shipping must have knowledge of trailer loading practices. In specific types of operations,
particularly when merchandise changes ownership, items must be checked during loading.
Work procedures are not restricted to floor personnel. Procedures must be established for
administration and maintenance. Replenishment of warehouse inventory can cause operational problems if
proper ordering procedures are lacking. Normally, there is limited interaction between buyers and warehouse
personnel although such communication is improving with integrated supply chain management
organizations. Buyers tend to purchase in quantities that afford the best price, and little attention is given to
pallet compatible quantities or available warehouse space.
Ideally buyers should coordinate with warehouse personnel before commissioning large orders or
introducing new products. The experience of some companies has forced management to require buyers to
predetermine warehouse space assignment prior to ordering. Another potential problem is the quantity of
cases ordered. The goal is to purchase in pallet-multiple quantities. For example, if a product is ideally
stacked on pallets in a 50-case pattern, the buyer should order in multiples of 50. If an order is placed for 120
cases, upon arrival the cases will fill two pallets plus 20 on a third pallet. The extra 20 cases will require the
warehouse cubic space typically used for a pallet of 50 and will require the same amount of materials
handling capacity to move.

7.5.4 Security
In a broad sense, security in a warehouse involves protection against merchandise pilferage and
deterioration. Each form of security requires management attention.
Pilferage Protection
In warehouse operations it is necessary to protect against theft by employees and thieves as well as
from riots and civil disturbances. Typical security procedures used throughout a business should be strictly
enforced at each warehouse. Security begins at the fence. As standard procedure, only authorized personnel
should be permitted into the facility and surrounding grounds. Entry to the warehouse yard should be
controlled through a single gate. Without exception, no private automobile, regardless of management rank
or customer status, should be allowed to enter the yard or park adjacent to the warehouse.
To illustrate the importance of security guidelines, the following experience may be helpful. A firm
adopted the rule that no private vehicles would be permitted in the warehouse yard. Exceptions were made
for two office employees with special needs. One night after work, one of these employees discovered a
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bundle taped under one fender of his car. Subsequent checking revealed that the car was literally a loaded
delivery truck. The matter was promptly reported to security, who informed the employee not to alter any
packages taped to the car and to continue parking inside the yard. Over the next several days, the situation
was fully uncovered, with the ultimate arrest and conviction of seven warehouse employees who confessed to
stealing thousands of dollars worth of company merchandise. The firm would have been far better off had it
provided transportation for the two special-needs employees from the regular parking lots to their work
locations.
Shortages are always a major concern in warehouse operations. Many are honest mistakes that occur
during order selection and shipment, but the purpose of security is to restrict theft from all angles. The
majority of thefts occur during normal working hours.
Inventory control and order processing systems help protect merchandise from being carried out of
the warehouse unless accompanied by a computer release document. If samples are authorized for
salesperson use, such merchandise should be maintained in a separate inventory. Not all pilferage occurs on
an individual basis. Organized efforts between warehouse personnel and carrier truck drivers can result in
deliberate overpicking, or high-for-low-value product substitution occurring in order to move unauthorized
merchandise out of the warehouse. Employee work assignment rotation, total case counts, and occasional
complete line-item checks can reduce vulnerability to such collaboration.
A final concern is the increased incidence of hijacking over-the-road trailer loads from yards or while
in transit. Hijacking is a major logistical concern. Over-the-road hijack prevention is primarily a lawenforcement matter, but in-yard theft can be eliminated by tight security provisions. Such over-the-road theft
is a significant problem in developing countries. One beverage company manager reported that he budgeted
to lose one truck a week due to theft for his South American operation. He instructed his drivers to simply
turn over the keys and walk away rather than risk their life.
Product Deterioration
Within the warehouse, a number of factors can reduce a product or material to non-saleable status.
The most obvious form of product deterioration is damage from careless materials handling. For example,
when pallets of merchandise are stacked in great heights, a marked change in humidity or temperature can
cause packages supporting the stack to collapse. The warehouse environment must be carefully controlled
and measured to provide proper product protection. Of major concern is warehouse employee carelessness.
In this respect, the lift truck may well be management's worst enemy. Regardless of how often lift truck
operators are warned against carrying overloads, some still attempt such shortcuts when not properly
supervised. In one situation, a stack of four pallets was dropped off a lift truck at the receiving dock of a food
warehouse. Standard procedure was to move two pallets per load. The dollar cost of the damaged
merchandise exceeded the average daily profit of two retail supermarkets. Product deterioration from careless
handling within the warehouse is a form of loss that cannot be insured against or offset with compensating
revenue.
Another major form of deterioration is incompatibility of products stored or transported together. For
example, care must be taken when storing or shipping chocolate to make sure that it doesn't absorb odors
from products it is being transported with, such as household chemicals.

7.5.5 Delivery
Most shipments from distribution warehouses to customers are completed by truck. When private
trucking is utilized, a managerial concern is to schedule shipments to achieve efficient transportation.
Computer-assisted load planning and equipment routing techniques are very useful for organizing
transportation requirements.

7.5.6 Safety and maintenance

Accident prevention is a concern of warehouse management. A comprehensive safety program
requires constant examination of work procedures and equipment to locate and take corrective action to
eliminate unsafe conditions before accidents result. Accidents occur when workers become careless or are
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exposed to mechanical or physical hazards. The floors of a warehouse may cause accidents if not properly
cleaned. During normal operation, rubber and glass deposits collect on aisles and, from time to time, broken
cases will result in product seepage onto the floor. Proper cleaning procedures can reduce the accident risk of
such hazards. Environmental safety has become a major concern of government, such as OSHA, and cannot
be neglected by management.
A preventive maintenance program is necessary for materials handling equipment. Unlike production
machines, movement equipment is not stationary, so it is more difficult to properly maintain. A preventive
maintenance program scheduling periodic checks of all handling equipment should be applied in every
warehouse.

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