Sunday, September 15, 2013

Innovations and Variability: Bane or a Boon!

With the fast paced innovation that the world is experiencing today one of the greatest challenges faced by the companies is to re-establish their supply chain networks according to the new product design. The cost of re-designing the supply chain network for a product is really high. It has been noticed that 70% cost of producing the product is determined by design of the product whereas the production technology decisions account for merely 20% of the cost. Following are the key principles that need to be followed when designing a new product.

·         Reduce the number of parts
·         Develop modular design
·         Use of standard components
·         Multifunctional parts
·         Design parts for multiuse
·         Ease of fabrication
·         Minimize assemble instructions
·         Minimize compliance
·         Minimize handling

One of the key factors that the designers of a particular product need to take into account is the supply chain network that goes along with that. Determining the product life cycle is an important factor that needs to be considered when designing the product. For a product which has a high product life the company might want to use a highly engineered deign. This would increase the cost of production at this stage but in the longer run would prove to be profitable as the life of the product is higher and the production can reach economies of scale in that time period.

The main challenge faced by the firms is to find the right balance between the two points i.e. whether to create a higher unit manufacturing cost, but more responsive, supply chain versus a lower manufacturing cost, less responsive supply chain. Most of the firms have tried to solve this problem by minimizing the variability in the demand for their product. With the advanced predictive techniques like data-mining for big data, predictive modeling etc. in place the firms try to estimate the demand for their product. With this knowledge of understanding the demand for a particular product the supply chain networks can be established to meet those demands.

The profits that a firm can make are largely dependent on the per unit variable costs that are incurred in the production. This has widely encouraged the practice of outsourcing. The prime reason behind this is; outsourcing the production of a particular unit minimizes the risk and also minimizes the operational costs. There are times when a new product design demands a change in the equipment used for production. At these times having a higher fixed cost in investing in new equipment may leave the firm unprofitable. Thus the optimal strategy would be to outsource the production to a firm who can produce this product at a desired price range while operating in the economies of scale.  

Total cost of production is less for the supplier than the producing firms.

This practice has been widely adopted in the automobile industry. As the heart of the car is the engine the firms ensure to keep the production of certain parts in-house but decide to outsource the production of parts like dashboards etc. Two competitors could have the same supplier for their products as the supplier can produce the product needed at economies of scale but the firms ordering, cannot! An example of two competitors sharing a supplier would be Coke and Pepsi. The artificial sweetener that is a prime ingredient in both their products is provided by a common supplier.

Managing the demand and supply is a tricky business in itself. Variability is always bad for business. When the demand for a particular product increases the demand for supplier products increases as well. It is often noticed that the effect maximizes as we move from the consumer to the supplier.  

This is termed as bullwhip effect because even small increases in demand can cause a big snap in the need for parts and materials further down the supply chain. Caterpillar Inc. one of the largest producers of mining equipment told its suppliers that it would need double the supply of metal than they had already asked for even though there was no increase in their sales. This happened because they had exhausted their inventory and now needed a larger supply of material to fulfill the demand in the market. Therefore maintaining an optimal balance between the demand and the supply is essential for efficient functionality of the firm’s strategic policy.

Thinking from the supplier’s perspective there was an unconventional increase in demand which increased the variability for his business. This gives the supplier a strategic advantage which would allow him to charge a higher price for the extra units delivered. Should ‘the supplier’ be happy about this and as a precaution maintain an inventory for such a situation that allows him to stay profitable? Or should he be worried about the same strategy being adapted by his suppliers?

Prateek Arora

Microeconomics: By Robert S Pindyk

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