Logistics 101: Back to Basics

Logistics can confound the newly initiated and veterans alike. So take out your notebook, sharpen your pencil, and take this Inbound Logistics short course on the fundamental concepts driving logistics theory and practice today.

Until recently, logistics activities had one primary focus—to minimize unit transportation costs for shipments to downstream customers.

“This focus worked well until the mid-1900s,” explains Theodore Stank, associate professor of logistics and supply chain management at Michigan State University, “when people started thinking about logistics in the context of systems theory. Systems theory espouses managing an enterprise or organization as an integrated whole for total optimal performance—lowest total costs and optimum service level, for example—as opposed to managing discrete functions individually for lowest costs.

“Say a company decides to sit on inventory in order to build a transportation load and thereby obtain a lower freight rate,” Stank offers by way of example. “This approach is fine if you’re not accounting for the cost of inventory. But if you ask, ‘What is it costing us to have the inventory sit on the warehouse floor for a few more days, you start to see the real cost of that decision.”

“Companies began to realize that effective logistics is all about managing tradeoffs,” notes Philip Evers, associate professor of logistics management at the University of Maryland’s R.H. Smith School of Business. “When you minimize cost in one area, they often go up somewhere else. If you ship by rail, you may reduce your transportation costs, but your inventory carrying and packaging costs go up.”

This kind of sub-optimization is a by-product of a functional orientation, explains Ed Marien, professor and program director, Executive Education, School of Business, University of Wisconsin.

Systems theory began to appear in logistics practice in the 1970s and 1980s. At the same time, a major shift in how organizations viewed customer service began to take hold. Companies started to compete on the basis of customer service, and logistics naturally played a vital role in making such service both possible and profitable. Businesses learned that by combining the two approaches effectively, they could offer competitive service at a lower total cost than their competitors, and thus gain an advantage.

“We still have a way to go in realizing this dream,” Stank says. “We still need more integration of internal functional activities so the purchasing manager who is buying something to support a downstream sale, for example, knows what needs to happen to that raw material, and is measured or incented to pursue performance objectives that benefit the total system.”

Six Degrees of Preparation

At the heart of this systems theory approach to logistics is a fundamental change in how companies view, capture, and manage costs.

According to Marien, six stages in enterprise costing today pertain to logistics. These stages reflect an increasing shift toward a systems approach to management and are evolving as follows:

Stage 1: Direct cost or price of purchased materials.

Stage 2: Net delivered cost of goods purchased. This includes Stage 1 costs plus order processing, transportation, and packaging costs.

Stage 3: Total cost of ownership (TCO). TCO includes Stages 1 and 2, as well as inventory carrying/holding costs and warehousing.

Stage 4: Total cost of sales. This includes the items in Stages 1 through 3, as well as other value-added costs such as overhead and administrative, marketing, R&D and manufacturing/operations, leading to before-tax gross margin.

Stage 5: Inter-enterprise oriented costing. This level includes all of the above, but also extends out to incorporate collaborative costs, shared among a manufacturer’s immediate Tier 1 supplier, customer, and intermediaries. Relationships are managed for mutual gain across channel partners.

Stage 6: End-user lowest delivered price. This final stage of cost management extends the aggregated supply chain value-add costs across all trading partners. All parties in the channel work to orchestrate their efforts toward the goal of delivering the best product, profitably, at the right cost for the end user.

Marien explains the concept behind Stage 6 as follows. “Suppose I have a 12-year-old Whirlpool dryer. At present, Whirlpool is insulated from me, the end user, by intermediaries such as the dealer or retailer. If Whirlpool was managing the end-user relationship, it would know that my dryer is nearing the end of its useful life. The only product performance metric that’s important to me is product up time.

“The manufacturer, therefore, could contact me and say, ‘We know you have a 12-year-old dryer; we know that certain major parts will go out before too long, so here’s a coupon to put toward replacing the dryer before it breaks down.’ Alternatively, the manufacturer could schedule maintenance on the dryer before it breaks down.

“As you start managing the end-user relationship more proactively,” Marien continues, “think about the impact on the supply chain. The manufacturer doesn’t have to carry a lot of spare parts that it may or may not use. Instead, all it needs to do is run a failure analysis of the product in the field, and work with dealers and end users to manage planned parts or unit replacements.

“The consumer benefits from greater up time, the manufacturer and dealer cement their relationship with the end user, and the manufacturer doesn’t need to have all this inventory sitting around in a warehouse somewhere waiting for the unknown service event to occur.”

Few companies have evolved beyond Stage 3 or 4 on Marien’s cost ladder. “On a scale of one to 100 where 100 is total integration, we’re at a five right now,” he suggests. “My estimate is the spread among corporations breaks down like this: 60 percent are in Stage 1, 20 percent are in Stage 2, 10 percent and five percent in Stages 3 and 4 respectively, and the remaining few are beginning to explore Stages 5 and 6.”

Stanley Fawcett of Brigham Young University’s Marriott School of Management and Gregory Magnan at the Albers School of Management, Seattle University, agree with Marien’s assessment.

In a paper entitled Achieving World Class Supply Chain Alignment: Benefits, Barriers and Bridges, they write, “While supply professionals can, and do quote the familiar mantra of ‘suppliers’ supplier to customers’ customer,’ few companies are engaged in such extensive supply chain integration. True integration beyond the first tier in either direction is rare.

“Few companies have adopted a formal definition of SCM,” the authors note. “Even fewer have carefully mapped out their supply chains so that they know who their suppliers’ suppliers or customers’ customers really are. Most supply chains simply compete as loose coalitions of companies that temporarily join forces to gain advantage through cooperation.”

The sheer complexity of major companies’ supply chains thwarts end-to-end supply chain management, Fawcett and Magnan acknowledge. Most companies participate in multiple supply chains. Defining the boundaries and intensity of specific relationships within these multiple relationships complicates supply chain design and management.

A Process Approach

To make these cost and supply chain integration theories work, leading companies are adopting a process approach to managing their logistics/supply chain activities.

Four core business processes comprise supply chain management. Marien describes them as follows:

Demand Management (Forecast) a collaborative, integrated process composed of these major tasks: corporate and financial planning, product/market planning, sales and operations planning, manufacturing planning, and supply planning, designed to provide forecasts and materials planning schedules to support the efficient flow of products and services throughout the supply chain.

Procurement (Source)— the process of developing strategic plans and forming alliances with suppliers to focus resources on minimizing total delivered costs, developing new products in support of the manufacturing “make” process while achieving simplified replenishment and transactional costs within the supply chain.

Manufacturing Flow Management (Make)— the process for obtaining maximum flexibility of production planning in using manufacturing capabilities and capacities to provide rapid response to changing market conditions and customer requirements.

Logistics Fulfillment Management (Deliver)— the supply chain process that plans, implements, and controls the efficient, effective flow and storage of goods, services, and related information from the point of origin to the point of consumption to meet customers’ requirements. This includes customer service ordering, shipment planning, transportation, warehousing, physical inventory control, packaging and unitization, and reverse logistics.

Managing these four core processes requires companies to adopt a cross-functional team or matrix organizational structure.

“Managers in a matrix organization,” explains Stank, “are not only responsible to a functional area within the company, but also to a horizontal process.

“A transportation manager, for instance, coordinates transportation activities within the organization as well as across the process for an entire product line or for a major customer. The transportation manager works with people in other areas of the company, and the flow is focused from upstream providers all the way down to the customer. But the individual’s ‘home’ department is still the transportation department.”

A classic example of this process approach in transportation is the management of inbound and outbound freight flows.

“Most companies still don’t understand what their inbound freight costs are because they are bundled into the cost of goods sold and managed FOB delivered,” Stank says. “What if a company viewed inbound and outbound as part of a continuous flow and managed it in its entirety? It could then take control of its inbound freight costs and negotiate with carriers to handle both the inbound and outbound legs of its transportation picture. By doing this, it could probably reap significant savings.”

Companies need to document and fully understand their current processes before undertaking any significant organizational change. This is especially critical when considering IT investments.

“Often,” says Stank, “companies bring the systems people in before they really understand their current processes and how they should be improved. The result? As much as 80 percent of new supply chain/corporate information solutions become shelfware.”

To make this evolution toward process management work, companies must change the way they reward employee performance.

“People are often recognized and rewarded for their performance in trimming costs and reducing their budgets,” Marien says. “This actually works against a broader enterprise view of managing costs.”

As a growing number of organizations reap the benefits of a process orientation/cross-functional team structure, this approach has gained a lot of credence in recent years.

“There is a greater willingness to share information rather than hoard it,” adds Stank. “Managers want to do the right thing, and it has become obvious that the old silo approach does not produce the best results.”

Gaining Visibility

Supply chain collaboration, integration, or other similar endeavors rely heavily on information visibility to be successful. Information, shared across the supply chain, can eliminate uncertainty.

“Uncertainty costs money,” Evers says. “Most companies manage uncertainty through inventory—by carrying more ‘just-in-case’ inventory. At each stage in the supply chain, uncertainty causes businesses to add inventory, creating a bullwhip effect where inventory levels are progressively amplified across the channel. This bullwhip effect carries a high price tag.”

Companies, however, can take steps to break this amplification cycle.

“Through better relationships with customers and suppliers, better information flows, better understanding of customers’ and suppliers’ needs, capabilities, and constraints, companies can start to whittle away at the costly by-products of uncertainty,” Evers says.

Today’s information systems can help companies gain the visibility they need to manage inventory more effectively.

“Knowing where inventory is located and how much you have is critical,” Evers continues. “I always argue that every company within the same supply chain should work off the same forecast. We know with 100-percent certainty that forecasts will be wrong. If each player operates independently, the bullwhip effect comes into play at each successive node in the pipeline. By sharing the forecast across the supply chain, at least everyone is on the same page and the bullwhip effect is mitigated.”

Here again, such sharing is both rare and difficult. At the internal level, while they may claim to work off a single forecast, marketing, production, and logistics frequently all work off slightly different numbers.

“You compound the problem when you add other organizations to the mix,” Evers warns. When creating forecasts—whether intra- or inter-organizational—the best place to start is with the end customer. “If you try to work off a single forecast, you have to really understand customer demand,” Evers says. “Start with the end customer and work backward through the supply chain.”

Pursuing an integrated inter-enterprise supply chain is not easy. Fawcett and Magnan suggest that companies follow a six-stage framework to help them achieve competitive supply chain collaboration.

Stage 1: Develop an overall understanding of the supply chain. Managers need to recognize the major players in the supply chain. They need to understand the value proposition of the entire supply chain as well as what role companies at each tier play. Mapping critical processes, core technologies, and linkages to the end customer also helps managers make sound SCM decisions.

Stage 2: Position the organization within the supply chain. Managers must re-evaluate their organization’s value proposition from a supply chain perspective, defining the organization’s core competencies. They must then develop specific processes to support these core competencies.

Stage 3: Build the supply chain infrastructure needed for success. Extended enterprises must develop customer and supplier success infrastructures. This means classifying upstream and downstream partners based on their importance, and establishing appropriate relationships with different classes of customers/suppliers. Some relationships merit intense effort while others are best served by efficient and standardized processes and systems. The initial classification should take into account profitability and long-term growth.

Stage 4: Create and communicate a common supply chain vision. Alignment begins with the creation of a common vision which is then ‘sold’ internally and shared with key supply chain partners.

Stage 5: Cultivate integrative mechanisms. This involves identifying internal and external barriers to collaboration, defining improvement opportunities, and then prioritizing specific programs to address these areas.

Stage 6: Constantly re-evaluate and continuously improve. Supply chains must be dynamic and flexible. To promote this, companies must institutionalize environmental technology and industry scans. Use benchmarking efforts to keep the company at the cutting edge of supply chain practice. In addition, companies must institute continuous improvement initiatives that unleash the creativity and knowledge of their work force.

Logistics and SCM will continue to evolve. The ideas discussed here will continue to play out in the global business world, and new variations on these themes will no doubt emerge.

“The bottom line in all of this,” concludes Evers, “is that you need to understand the bigger view of your company’s current processes. Look at key metrics, core processes, and alternatives that you can strategically address, pick out a strategy of where you want to go, then go out and look at the system providers and channel partners that can help you pull this all together.”