Supply Chain Management (3rd Edition)

Chapter 5 Network Design in the Supply Chain

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Outline
A strategic framework for facility location Multi-echelon networks Gravity methods for location Plant location models

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Network Design Decisions

Facility role: function and processes in each facility Facility location: where Capacity allocation; capacity of each one Market and supply allocation: what markets will
serve, and which supply sources should feed.

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Factors Influencing Network Design Decisions

Strategic factors Technological factors Macroeconomic factors Political factors Infrastructure factors Competitive factors Logistics and facility costs factors
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Strategic factors
It is important for a firm to identify the mission or strategic role of each facility when designing its global network. Kasra Ferdows (1997) suggests the following classification of possible strategic roles for various facilities in a global supply chain network.1 1. Offshore Facility: Low-cost facility for export production. An offshore facility serves the role of being a low-cost supply source for markets located outside the country where the facility is located. The location selected for an offshore facility should have low labor and other costs to facilitate low-cost production. Given that many Asian developing countries waive import tariffs if all the output from a factory is exported, they are preferred sites for offshore manufacturing facilities.

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2. Source Facility: Low-cost facility for global production. A source facility also has low cost as its primary objective, but its strategic role is broader than that of an offshore facility. A source facility is often a primary source of product for the entire global network. Source facilities tend to be located in places where production costs are relatively low, infrastructure is well developed, and a skilled workforce is available. Good offshore facilities migrate over time into source facilities. A good example is Nike's plant network in Korea and Taiwan. Plants in both countries started out as offshore facilities because of low labor costs. Over time, however, these plants have become more involved with new product development and manufacture some products for sale all over the world. 3. Server Facility: Regional production facility. A server facility's objective is to supply the market where it is located. A server facility is built because of tax incentives, local content requirement, tariff barriers, or high logistics cost to supply the region from elsewhere. In the late 1970s, Suzuki partnered with the Indian government to set up Maruti Udyog. Initially, Maruti was set up as a server facility and only produced cars for the Indian market. The Maruti facility allowed Suzuki to overcome the high tariffs for imported cars in India.
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4. Contributor Facility: Regional production facility with development skills. A contributor facility serves the market where it is located but also assumes responsibility for product customization, process improvements, product modifications, or product development. Most well-managed server facilities become contributor facilities over time. The Maruti facility in India today develops many new products for both the Indian and the overseas markets and has moved from being a server to a contributor facility in the Suzuki network. IKasra Ferdo\Vs. 1997. "Making the Most of Your Foreign Factories," Harvard Business Review (March-April), 5. Outpost Facility: Regional production facility built to gain local skills. An outpost facility is located primarily to obtain access to knowledge or skills that may exist within a certain region. Given its location, it also plays the role of a server facility. The primary objective remains one of being a source of knowledge and skills for the entire network. Many global firms have production facilities located in Japan in spite of the high operating costs. Most of these serve as outpost facilities. 6. Lead Facility: Facility that leads in development and process technologies. A lead facility creates new products, processes, and technologies for the entire network. Lead facilities are located in areas with good access to a skilled workforce and technological resources.

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Technological Factors Characteristics of available production technologies have a significant impact on network design decisions. If production technology displays significant economies of scale, few high-capacity locations are the most effective. This is the case in the manufacture of computer chips where factories require a very large investment. As a result, most companies build few chip production facilities, and each one they build has a very large capacity. In contrast, if facilities have lower fixed costs; many local facilities are preferred because this helps lower transportation costs. For example, bottling plants for Coca Cola do not have a very high fixed cost. To reduce transportation costs, Coca-Cola sets up many bottling plants all over the world, each serving its local market. Flexibility of the production technology impacts the degree of consolidation that can be achieved in the network. If the production technology is very inflexible and product requirements vary from one country to another, a firm has to set up local facilities to serve the market in each country. Conversely, if the technology is flexible, it becomes easier to consolidate manufacturing in a few large facilities. .
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Macroeconomic Factors Macroeconomic factors include taxes, tariffs, exchange rates, and other economic factors that are not internal to an individual firm. As trade has increased and markets have become more global, macroeconomic factors have had a significant influence on the success or failure of supply chain networks. Thus, it is imperative that firms take these factors into account when making network design decisions
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Tariffs and Tax Incentives Tariffs refer to any duties that must be paid when products and/or equipment are moved across international, state, or city boundaries. Tariffs have a strong influence on location decisions within a supply chain. If a country has very high tariffs, companies either do not serve the local market or set up manufacturing plants within the country to save on duties. High tariffs lead to more production locations within a supply chain network, with each location having a lower allocated capacity. As tariffs have come down with the World Trade Organization, and regional agreements like NAFTA (North America) and MERCOSUR (South America), firms can now supply the market within a country from a plant located outside that country without incurring high duties. As a result, firms have begun to consolidate their global production and distribution facilities. For global firms, a decrease in tariffs has led to a decrease in the number of manufacturing facilities and an increase in the capacity of each facility built. Tax incentives are a reduction in tariffs or taxes that countries, states, and cities often provide to encourage firms to locate their facilities in specific areas. Many countries vary incentives from city to city to encourage investments in areas with lower economic development. Such incentives are often a key factor in the final location decision for many plants. General Motors built its Saturn facility in Tennessee primarily because of the tax incentives offered by the state. Similarly, BMW built its factory, which assembles the Z3, in Spartanburg, mainly because of the tax incentives offered by South Carolina
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Exchange Rate and Demand Risk Fluctuation in exchange rates has a significant impact on the profits of any supply chain serving global markets. A firm that sells its product in the United States with production in Japan is exposed to the risk of appreciation of the Yen. The cost of production is incurred in Yen whereas revenues are obtained in dollars. Thus, an increase in the value of the Yen increases the production cost in dollars, decreasing the firm's profits. In the 1980s, many Japanese manufacturers faced this problem when the Yen appreciated in value. At that time most of their production capacity was located in Japan and they served large markets overseas. The appreciation of the Yen decreased their revenues and they saw their profits decline. Most Japanese manufacturers have responded by building production facilities all over the world. Exchange rate risks may be handled using financial instruments that limit, or hedge against, the loss due to fluctuations. Suitably designed supply chain networks, however, offer the opportunity to take advantage of exchange rate fluctuations and increase profits. An effective way to do this is to build some over-capacity in the network and make the capacity flexible so that it can be used to supply different markets. TIlis flexibility allows the firm to alter production flows within the supply chain to produce more in facilities that have a lower cost based on current exchange rates. Companies must also take into account fluctuations in demand caused by fluctuations in the economies of different countries. For example, the Asian economy slowed down between 1996 and 1998. Firms that had plants with little flexibility saw a lot of un utilized capacity in their Asian plants. Firms with greater flexibility in their manufacturing 2007 Pearson Education facilities were able to use the extra capacity in their Asian plants to

Political Factors The political stability of the country under consideration plays a significant role in the location choice. Companies prefer to locate facilities in politically stable countries where the rules of commerce are well defined. Countries with independent and clear legal systems allow firms to feel that they have recourse in the courts should they need it. This makes it easier for companies to invest in facilities in these countries.
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 Infrastructure Factors The availability of good infrastructure is an important prerequisite to locating a facility in a given area. Poor infrastructure adds to the cost of doing business from a given location. Global companies have located their factories in China near Shanghai, Tianjin, or GuangZhou, even though these locations do not have the lowest labor or land cost because of better infrastructure at these locations. Key infrastructure elements to be considered during network design include availability of sites, labor availability, proximity to transportation terminals, rail service, proximity to airports and seaports, highway access, congestion, and local utilities. Competitive Factors Companies must consider competitors' strategy, size, and location when designing their supply chain networks. A fundamental decision firms make is whether to locate their facilities close to competitors or far from them. How the firms compete and whether external factors such as raw material or labor availability force them to locate close to each other influence this decision.

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Positive Externalities between Firms

Positive externalities are instances where the collocation of multiple firms benefits all of them. Positive externalities lead to competitors locating close to each other. For example, gas stations and retail stores tend to locate close to each other because doing so increases the overall demand, thus benefiting all parties. By locating together in a mall, competing retail stores make it more convenient for customers who need only drive to one location and find everything they are looking for. This increases the total number of customers who visit the mall, increasing demand for all stores located there. Another example of positive externality is when the presence of a competitor leads to the development of appropriate infrastructure in a developing area. In India, for example, Suzuki was the first foreign auto manufacturer to set up a manufacturing facility. The company went to considerable effort and built a local supplier network. Given the well-established supplier base in India, Suzuki's competitors have also built assembly plants there, because they now find it more effective to build cars in India rather than import them to the country.
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Locating to Split the Market When there are no positive externalities, firms locate to be able to capture the largest possible share of the market. A simple model first proposed by Hotelling explains the issues behind this decision.2 When firms do not control price but compete on distance from the customer, they can maximize market share by locating close to each other and splitting the market. Consider a situation where customers are uniformly located along the line segment between 0 and 1 and two firms compete based on their distance from the customer as shown in Figure 5.1. A customer goes to the closest firm and customers that are equidistant from the two firms are evenly split between them.

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If total demand is 1 and Firm 1 locates at point a and Firm 2 locates at point 1 - b, the demand at the two firms, d1 and d2, is given by

1 b a 1 b a d1 a and d 2 2 2
Clearly, both firms maximize their market share if they move closer to each other and locate at a = b = 1/2. Observe that when both firms locate in the middle of the line segment, the average distance that customers have to travel is 1/4. If one firm locates at 1/4 and the other at 3/4, the average distance customers have to travel drops to 1/8. This set of locations, however, gives both firms an incentive to try and increase market share by moving to the middle. The result of competition is for both firms to locate close together even though doing so increases the average distance to the customer.
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A Framework for Global Site Location

Competitive STRATEGY GLOBAL COMPETITION INTERNAL CONSTRAINTS Capital, growth strategy, existing network PRODUCTION TECHNOLOGIES Cost, Scale/Scope impact, support required, flexibility

PHASE I Supply Chain Strategy

TARIFFS AND TAX INCENTIVES

COMPETITIVE ENVIRONMENT

PHASE II Regional Facility Configuration

REGIONAL DEMAND Size, growth, homogeneity, local specifications POLITICAL, EXCHANGE RATE AND DEMAND RISK

PHASE III Desirable Sites

PRODUCTION METHODS Skill needs, response time FACTOR COSTS Labor, materials, site specific

AVAILABLE INFRASTRUCTURE

PHASE IV Location Choices

LOGISTICS COSTS Transport, inventory, coordination

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Phase I: Define a Supply Chain Strategy The objective of the first phase of network design is to define a firm's supply chain strategy. The supply chain strategy specifies what capabilities the supply chain network must have to support a firm's competitive strategy (see Chapter 2). Phase I starts with a clear definition of the firm's competitive strategy as the set of customer needs that the supply chain aims to satisfy. Next, managers must forecast the likely evolution of global competition and whether competitors in each market will be local or global players. Managers must also identify constraints on available capital and whether growth will be accomplished by acquiring existing facilities, building new facilities, or partnering. Based on the competitive strategy of the firm, an analysis of the competition, any economies of scale or scope, and any constraints, managers must determine the supply chain strategy for the firm. 2007 Pearson Education

Phase II: Define the Regional Facility Configuration The objective of the second phase of network design is to identify regions where facilities will be located, their potential roles, and their approximate capacity. An analysis of Phase II is started with a forecast of the demand by country. Such a forecast must include a measure of the size of the demand as well as a determination of whether the customer requirements are homogenous or variable across different countries. Homogenous requirements favor large consolidated facilities whereas requirements that vary across countries favor smaller, localized facilities. The next step is for managers to identify whether economies of scale or scope can playa significant role in reducing costs given available production technologies. If economies of scale or scope are significant, it may be better to have a few facilities serving many markets. If economies of scale or scope are not significant, it may be better for each market to have its own facility. For example, Coca Cola has bottling plant in every market that it serves because the manufacturing technology does not include large economies of scale. Semiconductor manufacturers like Motorola, in contrast have very few plants for their global markets given the economies of scale in production.
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Next, managers must identify demand risk, exchange rate risk, and political risk associated with different regional markets. They must also identify regional tariffs, any requirements for local production, tax incentives, and any export or import restrictions for each market. The tax and tariff information is used to identify the best location to extract a major share of the profits. Managers must identify competitors in each region and make a case for whether a facility needs to be located close to or far from a competitor's facility. The desired response time for each market must also be identified. Managers must also identify the factor and logistics costs at an aggregate level in each region. Based on all this information, managers will identify the regional facility configuration for the supply chain network using network design models discussed in the next section. The regional configuration defines the approximate number of facilities in the network, regions where facilities will be set up, and whether a facility will produce all products for a given market or a few

Phase III: Select Desirable Sites The objective of Phase III is to select a set of desirable sites within each region where facilities are to be located. The set of desirable sites should be larger than the desired number of facilities to be set up so that a precise selection may be made in Phase IV. Sites should be selected based on an analysis of infrastructure availability to support the desired production methodologies. Hard infrastructure requirements include the availability of suppliers, transportation services, communication, utilities, and warehousing infrastructure. Soft infrastructure requirements include the availability of skilled workforce, workforce turnover, and the community 2007 Pearson Education receptivity to business and industry.

Phase IV: Location Choices The objective of this phase is to select a precise location and capacity allocation for each facility. Attention is restricted to the desirable sites selected in Phase III. The network is designed to maximize total profits taking into account the expected margin and demand in each market, various logistics and facility costs, and the taxes and tariffs at each location. In the next section we discuss methodologies for making facility location and capacity allocation decisions during Phase II and Phase IV.
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Conventional Network
Vendor DC Materials DC

Finished Goods DC

Customer DC

Customer Store

Vendor DC

Component Manufacturing Plant Warehouse Components DC Customer DC

Customer Store Customer Store

Customer Store Customer DC Customer Store
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Vendor DC Final Assembly

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Finished Goods DC

Tailored Network: Multi-Echelon Finished Goods Network

Regional Finished Goods DC Local DC Cross-Dock Customer 1 DC Local DC Cross-Dock Customer 2 DC Local DC Cross-Dock Store 1 Store 1 Store 2 Store 2 Store 3 Store 3

National Finished Goods DC

Regional Finished Goods DC

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Gravity Methods for Location

Ton Mile-Center Solution
x,y: Warehouse Coordinates xn, yn : Coordinates of delivery
location n

dn : Distance to delivery
location n

Fn : Annual tonnage to delivery

location n

Min

d n Dn F n

( x x n) ( y y n) D nx F d x D nF d D ny F d y D nF d
n

n 1

n 1

n 1

n 1

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Network Optimization Models

Allocating demand to production facilities Locating facilities and allocating capacity
Key Costs:

Fixed facility cost Transportation cost Production cost Inventory cost Coordination cost
Which plants to establish? How to configure the network?
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Demand Allocation Model

Which market is served by which plant? Which supply sources are used by a plant? xij = Quantity shipped from plant site i to customer j
Min cij xij
i 1 j 1 n m

s.t.

x
i 1 m j 1

ij

D j , j 1,...,m
i

x K
ij

, i 1,...,n

ij

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Plant Location with Multiple Sourcing

yi = 1 if plant is located at site i, 0 otherwise xij = Quantity shipped from plant site i to customer j
Min
i 1 n

f y c x
i i i 1 j 1 ij

ij

s.t.

x D , j 1,...,m
i 1 n ij j

x K y , i 1,...,n
j 1 m ij i i

y k ; y {0,1}
i 1 i i
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Plant Location with Single Sourcing

yi = 1 if plant is located at site i, 0 otherwise xij = 1 if market j is supplied by factory i, 0 otherwise
Min
i 1 n

f y D j c x
i i i 1 j 1 ij

ij

s.t.

x
i 1 n j 1

ij

1, j 1,...,m

D j x K y , i 1,...,n
ij i i

xij, y {0,1}
i

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Summary of Learning Objectives

What is the role of network design decisions in the supply chain? What are the factors influencing supply chain network design decisions? Describe a strategic framework for facility location. How are the following optimization methods used for facility location and capacity allocation decisions?
Gravity methods for location Network optimization models
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