The Objective of a Supply Chain

The objective of every supply chain should be to maximize the overall value generated. The value (also known as supply chain surplus) a supply chain generates is the difference between what the value of the final product is to the customer and the costs the entire supply chain incurs in filling the customer’s request.

Supply Chain Surplus = Customer Value – Supply Chain Cost

The value of the final product may vary for each customer and can be estimated by the maximum amount the customer is willing to pay for it. The difference between the value of the product and its price remains with the customer as consumer surplus. The rest of the supply chain surplus becomes supply chain profitability, the difference between the revenue generated from the customer and the overall cost across the supply chain. For example, a customer purchasing a wireless router from Best Buy pays $60, which represents the revenue the supply chain receives. Customers who purchase the router clearly value it at or above $60. Thus, part of the supply chain surplus is left with the customer as consumer surplus. The rest stays with the supply chain as profit. Best Buy and other stages of the supply chain incur costs to convey information, produce components, store them, transport them, transfer funds, and so on. The difference between the $60 that the customer paid and the sum of costs incurred across all stages by the supply chain to produce and distribute the router represents the supply chain profitability: the total profit to be shared across all supply chain stages and intermediaries. The higher the supply chain profitability, the more successful the supply chain. For most profit-making supply chains, the supply chain surplus will be strongly correlated with profits. Supply chain success should be measured in terms of supply chain surplus and not in terms of the profits at an individual stage. (In subsequent chapters, we see that a focus on profitability at individual stages may lead to a reduction in overall supply chain surplus.) A focus on growing the supply chain surplus pushes all members of the supply chain toward growing the size of the overall pie.

Having defined the success of a supply chain in terms of supply chain surplus, the next logical step is to look for sources of value, revenue, and cost. For any supply chain, there is only one source of revenue: the customer. The value obtained by a customer purchasing detergent at Walmart depends on several factors, including the functionality of the detergent, how far the customer must travel to Walmart, and the likelihood of finding the detergent in stock. The cus­tomer is the only one providing positive cash flow for the Walmart supply chain. All other cash flows are simply fund exchanges that occur within the supply chain, given that different stages have different owners. When Walmart pays its supplier, it is taking a portion of the funds the customer provides and passing that money on to the supplier. All flows of information, product, or funds generate costs within the supply chain. Thus, the appropriate management of these flows is a key to supply chain success. Effective supply chain management involves the manage­ment of supply chain assets and product, information, and fund flows to grow the total supply chain surplus. A growth in supply chain surplus increases the size of the total pie, allowing con­tributing members of the supply chain to benefit.

In this book, we have a strong focus on analyzing all supply chain decisions in terms of their impact on the supply chain surplus. These decisions and their impact can vary for a wide variety of reasons. For instance, consider the difference in the supply chain structure for fast- moving consumer goods that is observed in the United States and India. U.S. distributors play a much smaller role in this supply chain compared with their Indian counterparts. We argue that the difference in supply chain structure can be explained by the impact a distributor has on the supply chain surplus in the two countries.

Retailing in the United States is largely consolidated, with large chains buying consumer goods from most manufacturers. This consolidation gives retailers sufficient scale that the intro­duction of an intermediary such as a distributor does little to reduce costs—and may actually increase costs because of an additional transaction. In contrast, India has millions of small retail outlets. The small size of Indian retail outlets limits the amount of inventory they can hold, thus requiring frequent replenishment—an order can be compared with the weekly grocery shopping for a family in the United States. The only way for a manufacturer to keep transportation costs low is to bring full truckloads of product close to the market and then distribute locally using “milk runs” with smaller vehicles. The presence of an intermediary that can receive a full truck­load shipment, break bulk, and then make smaller deliveries to the retailers is crucial if trans­portation costs are to be kept low. Most Indian distributors are one-stop shops, stocking everything from cooking oil to soaps and detergents made by a variety of manufacturers. Besides the convenience provided by one-stop shopping, distributors in India are also able to reduce transportation costs for outbound delivery to the retailer by aggregating products across multiple manufacturers during the delivery runs. Distributors in India also handle collections, because their cost of collection is significantly lower than that of each manufacturer collecting from retailers on its own would be. Thus, the important role of distributors in India can be explained by the growth in supply chain surplus that results from their presence. The supply chain surplus argument implies that as retailing in India begins to consolidate, the role of dis­tributors will diminish.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.