Are You Logistically Effective?
November 1 1987 by Hal Mather
Becoming a world-class manufacturer is a total company process. Besides having a good factory program, all departments, and management at all levels, must be involved in order to be successful. Manufacturing shares a good deal of the blame for America’s industrial plight, but it is not the sole cause; perhaps not even the primary cause. Because manufacturing has taken its share of blame I will highlight two other areas, product design and sales, to show the need for total company involvement. Improvements in these areas, added to the well-publicized improvements possible in manufacturing, will provide the synergy necessary to achieve the benefits previous writers have touted.
A manufacturer’s mission is to buy the right materials at the right time from vendors, process them effectively in the plant, and deliver quality products to customers. This process is known as business logistics, and is key to becoming a world-class competitor.
Let’s envision a manufacturing utopia: Inventories will be minuscule (hence the operation is flexible to customer demands); productive assets will be used as effectively as possible (making exactly the right amount of the right things customers are buying); and overhead costs will be at a minimum (few disturbances requiring people to react and few custodians of inventory). Quality will also be outstanding, a forced condition to arrive at the utopian logistics flow.
There is also a requirement for a company to make a profit. Profits are a variable managers manipulate to suit various conditions, such as growing market share, defending market share, milking the marketplace, etc. Long-term profits are the goal. Short-term, they may not be.
Effective logistics is a continuous requirement. It does not change as the profit strategy changes. It is a constant that needs to be continuously strived for. Because of its multiple beneficial effects on investments, costs, customer satisfaction, and quality, it will also contribute to the profit objective.
Many factors, internal and external to the plant, must be correct to achieve a utopian logistics condition. Faster machine changeovers, better floor layout, etc., are obviously needed. Relationships with vendors, in particular, must be carefully arranged. These are the traditional areas of logistics improvement, focusing on the operations side of the business.
The other factors necessary to achieve a utopia are not so obvious: How a product is designed can make achieving excellent logistics easy or impossible; how sales relate to the market, the objectives that are set, and credit and payment terms will also make logistics easy or impossible.
THE PLANNING DILEMMA
Most manufacturers buy materials and process them to some intermediate stage before a customer’s order is received. This gives rise to the phenomenon called the P:D ratio. “P” is the total lead time to buy raw materials and process them into finished goods. “D” is the customer’s lead time: when you get a customer’s order until the customer expects delivery.
The majority of companies have a P:D ratio greater than 1:1. Make-to-stock companies, by definition, have a high ratio. Large-contract job shops, such as shipbuilders and military-equipment producers, usually have a small ratio, often less than 1:1. In some cases the customer even orders before the engineering starts. But this proportion of industry is small compared to the total.
Any company with a P:D ratio greater than 1:1 is forced to forecast what the customer will buy. This forecast commits company cash to buy materials and commits productive assets to make products up to the coupling point where the “D” time starts. Customer orders consume the forecasted products.
In the case of a make-to-stock product, of course, the coupling point is the warehouse. Hence the finishing schedule is simply the pick, pack, and ship activities. For assemble-to-order, the coupling point is major modules and for engineer-to-order, it is raw materials or work-in-process inventories.
Forecast error will guarantee a mismatch between what was forecasted to be sold and the reality of what customers actually buy. Poor customer service, high inventories and excess costs from back orders are the inevitable result. Achieving a utopian logistics process is, by definition, impossible.
Several key alternatives are available to improve this condition, as defined in Figure 1. The departments responsible to initiate change are also identified. The manufacturing department has only two choices to improve the condition, whereas engineering has three, and sales has five. The need for a total company approach should be obvious.
Forecast error will always cost you when you have a P:D ratio greater than 1:1. It is obvious that a ratio where P equals D would be a great improvement. It may not be so obvious that P less than D would be a utopia. But with your procurement and production lead times less than the customer’s desired lead time, you can schedule production without the immediate pressure of customer delivery.
Reducing P is one key objective of the Just-In-Time (JIT) philosophy applied to manufacturing. Changeover reduction, flow layouts, and co-production relationships with vendors all help to reduce P. These narrow activities, however, function within the constraints of the existing product design. Unique components, with long procurement lead times specified in a product, will block a company from realizing a short P time.
Designs must be standardized wherever possible. The law of big numbers states that demands for these standardized components will be smoother and more predictable than unique items. This will make manufacturing’s work on reducing P time effective and result in reducing the P:D ratio.
One example which clearly shows the concepts of logistically effective designs comes from a top European multinational that makes a complete range of hi-fi equipment. The company introduced a new product range at a recent consumer electronics show. The equipment was very well received. It was aesthetically pleasing, easily outperformed the closest competitor, and was competitively priced. Many dealers placed orders at the show for prompt delivery.
Now the bad news. There were 56 end products in the range. Some of these had minor differences (labeling, instruction books, etc.) for the variety of languages in Europe. Others were external changes only (e.g., colors of the cabinets). These 56 end products all contained an important sub-assembly: a printed circuit board. There were 22 varieties of the board. All 22 boards could be assembled from six bare boards. The selection and mounting of components determined the 22 completed boards.
The lead time build-up of the product is shown in Figure II. The distribution time from the factory to the customer averaged three months. Most of this time was warehouse stocks in the various countries plus stocks in their corporate distribution system. The final assembly and test lead time was one month; printed circuit board assembly and test was two months, and unique component procurement was 10 months. The build-up of P time from the customer to order unique components was 16 months! To make matters worse, uniqueness was added to the six standard boards at the first step. This means commitments of these standard boards to 22 end varieties were made six months before the consumer bought them. The same was in final assembly; the 22 boards were made unique to the 56 end items in the first operation.
The predictable results? Inventories of finished goods were high at the same time as the company had huge back orders. Customers were furious. This, in spite of the fact that the product was received enthusiastically at retail and its price/performance ratio was excellent. This company did more to sell its competitors’ products than the competition did-they raised the desire in consumers for new hi-fi equipment but couldn’t supply it. Consumers opted for second best, the competition’s products.
Not only was customer service poor and inventory high, but costs were seriously inflated. The factory operated in a state of chaos. Overheads were added to try and resolve the confusion, but conflicting priorities from each sales outlet arrived daily, and the supply of long lead time components slowed their ability to react. The design, although outstanding technologically, was logistically ineffective.
What should have been done? Figure II should have been drawn before the product was completely designed. This would have clearly shown the problems in flexibility, customer service and inventory levels that such a design was sure to cause.
After discussing this problem with the engineers involved, the company quickly described how they could have made the design more logistically friendly. The long lead time unique components could have been replaced with standard components through a redesign of the circuitry involved, with no loss of performance. The vendor’s quoted lead time on these components was only eight weeks and could have been reduced to four weeks or less with some long-term agreements. The variability that made the six bare-printed circuit boards unique could have been left until the last operation, not the first. The same was true of final assembly. Shorter range and more accurate forecasts would have been available to drive production. Why didn’t they do this with the original design? No one explained to them the need for logistically effective products. The primary objective of an engineer is to design a product to perform a function at an acceptable cost. Rarely do the objectives of customer service, inventory and flexibility enter the discussion. The decision to buy unique components, adding uniqueness early in the production process, was cost driven. The direct standard cost of the original design was about $1 cheaper than the revised design. With the volumes of production planned, this was a significant cost savings. But the savings were illusory. High inventories, poor service, excess overheads and a failure to achieve the projected volumes, made the first design a loser for the business instead of a winner as it should have been. Part of the blame is industry’s concentration on “hard” costs and a complete disavowal of the “soft” costs. Hard costs, such as purchase prices and direct labor, are calculable to two decimal places or more. But what is the cost of an inflexible design? We know there is one, but who can put a tangible number on it? How about the cost of poor customer service? Again, our gut feelings tell us it is significant but difficult to quantify. So we avoid these soft numbers and make decisions using only the hard facts. Attributing zero to soft costs, however, is worse than applying an estimated number. At least the estimate is a reasoned judgment. Zero is the most arbitrary number to apply to a key factor.
ENGINEER YOURSELF A MUSHROOM
What we need from the engineering community are “mushroom” designs. Customers demand greater and greater variety. If we plan to produce a variety, then designs must be from standardized components or modules. Variety must be added at the last possible moment, preferably during the D time. This way, the variety only occurs after receipt of the customer order. This concept must become the driving force for all designers and process engineers. It’s amazing to me how few designs have this concept embodied in them. An analysis of almost any product on the market today will show serious flaws in its design as it relates to logistics. The business problems associated with these designs are able to be predicted with a great deal of accuracy.
DEVELOP YOUR OWN DESIGN ARCHITECTURE
Some companies have developed a formal architecture to help their engineering staff design logistically friendly products. For example, a company in the Midwest makes a variety of products to help automate process industries. Their products are used by cigarette manufacturers, sawmills, pulp and paper mills, aluminum foil producers, and galvanizers. None of these markets are large because all these industries are characterized by relatively few, big installations. Left to their own devices, engineers would design specialized products to suit these industries and each specific application. The engineering costs would never be recovered and customer support would be poor because of the low predictability of the demands. The senior managers evaluated these markets and gave some clear directions. The electronic unit that accepted inputs from the process, analyzed them, and gave feedback to the operating controls of the process, would be the same for all applications. Components selected to make these units had to be standard and readily available.
The result is a slightly overengineered design, theoretically at a higher cost than designs unique to each application. The actual result is higher volumes of standard items, producing lower overheads and more opportunities to apply repetitive manufacturing techniques. True costs are lower.
The predictability of need for the units also is considerably increased. They are much more flexible to demand shifts in any one market, and inventories to support the business .are far lower. The establishment of a design architecture is a primary reason for this company’s success in a difficult marketplace.
LOGISTICALLY EFFECTIVE SALES
The earlier utopian manufacturer’s mission statement defined that raw materials arrive at the plant regularly, are processed immediately and delivered directly to customers. Little, if any, inventories are in the logistics chain. To achieve this condition, demand for products must be reasonably smooth and repetitive. Huge demand swings will make achieving the utopian condition difficult, if not impossible. Few sales departments consider smooth demands their objective. Instead, many of their objectives and policies amplify the underlying market dynamics.
A large computer company based in the Northeast has a regularly repeating sales pattern that destroys its ability to achieve a good logistics flow. In the first month of every quarter, they sell and must deliver, 20 percent of the quarter’s revenue target; in the second month 30 percent, and in the last month a whopping 50 percent of the quarter’s revenue. A look at weekly sales within each month finds 10 percent in the first week, 15 percent in the second, 25 percent in the third and 50 percent in the last week of the month.
There is no way that these demand patterns are naturally this cyclical for large, expensive computers. It is an induced sales pattern simply caused by periodic revenue targets. It is bad that they have trained their customers to order in this manner. Customers get better deals at the end of the month and the end of the quarter. Free software, extended credit terms, and free maintenance are the benefits customers get for ordering cyclically.
The factory subjected to this ordering pattern is forced to uncouple the erratic demand from the smooth factory operations with inventories. These inventories are built in the first month of the quarter to a forecast of what customers will buy. Reconfiguring programs in the third quarter produce the right products customers want out of the wrong inventory. Overtime is high, morale is low, vendors are jerked around, and quality suffers. Billing errors are huge because of the scrambling for issuing invoices to meet the quarterly revenue targets.
This is not to imply that some markets are not inherently dynamic. They are. But who needs artificially induced dynamics from periodic sales targets, billing practices, credit terms, advertising programs, and discounts? Review and change these to reduce their influences. Give the factory the task of responding to what dynamics are left.
THE VOLUME/VARIETY DILEMMA
Product variety is very difficult to manage with P greater than D. Low-volume items or accessories will almost always be ordered erratically, making it very difficult to be logistically effective in this scenario. The whole volume/variety picture needs a thorough evaluation as part of becoming a world-class manufacturer. A good way to start this analysis is as shown in Figure III. The vertical axis is dollars, the horizontal is variety. This could be the number of catalog-finished goods or the number of components, raw materials, and sub-assemblies needed to build your products. The items are sequenced on the horizontal axis based on their annual sales revenue, the highest on the left, the lowest on the right. The curve of cumulative annual sales revenue is then plotted as curve 1 and a typical Pareto, ABC, or 80/20 curve will result.
The second curve is that labelled Cumulative Support Costs. This is how all business costs, other than direct materials and unburdened direct labor, are truly incurred to support the variety along the horizontal axis. If you don’t believe the shape of the curve, ask the managers of each support area. They will agree wholeheartedly. If we ask the same people how they think the company’s assets are used to support these products, a line similar to curve 3 will be the answer. Inventories will be relatively higher per dollar of revenue for the low-volume items. So will warehouse space, machine time, factory floor space, specialized tooling, computer size and even office space. Only accounts receivable closely tracks the shape of the revenue curve.
The profit contribution line (curve 4) can now be drawn. It is calculated as annual revenues less direct material and unburdened direct labor (assumed to be a curve with the same shape as the annual revenue curve, which is not shown) less support costs. The return on assets line (curve 5) is also shown-probably a little fictitious, because I assume all assets are variable. However, the concept is still valid.
WHAT DO THE CURVES SAY?
Having seen the concept from these curves, assuming you accept they are fundamentally correct for the majority of industry, what can you do?
The sales revenue curve is easy to draw. Every company has the information to create it. Support costs and asset curves are not so easy. To my knowledge no financial system allocates support costs correctly, that is, how they are truly incurred. Arbitrary allocations of factory overheads are made based on direct labor hours or machine hours. The largest part of total support costs is put into separate budgets for sales, engineering, accounting, general and administrative, with no attempt to relate these costs to the products. Few designate assets to products, either, even including inventory, the easiest to allocate.
Traditional accounting systems don’t parallel these curves. They distort them. They transfer support costs to the high volume, high-activity items, giving a very different picture of what is truly profitable and what isn’t.
As an example, an American manufacturer of television sets transferred production of 13-inch, black and white TVs to Taiwan because they were losing money on them. They were making money on the large, multi-function, color and projection TVs. After the transfer was complete, profits dropped! The reason? The small black and white TVs needed almost no support. They were allocated a large share based on their volume of production. As the allocation made them nonprofitable, their production was moved offshore.
The large, complex units needed lots of support in sales, engineering, factory overheads, purchasing, scheduling, and accounting. When the small black and white sets were removed, the support costs didn’t diminish. Suddenly, what this company thought was profitable, wasn’t.
The support costs of a product are linked largely to the transaction volume for that product. Processing a sales order for $1 million costs about the same as one for $100,000. Therefore, the support costs are far higher per dollar of revenue for the smaller orders. This link of transactions-to-support costs holds true for many support activities: for example, order entry, billing, shipping, purchasing, accounts payable, receiving, scheduling, stockrooms, and planning. Use transactions as your base to draw the support-cost curve.
The asset curve can be drawn after an analysis of space consumed by product. Do this for the warehouse, on the factory floor and in the stockrooms. The machine-asset allocation can be calculated by the sum of changeover and run times multiplied by product. Use product coding to allocate inventories and accounts receivable to products.
SIX TOUGH CHOICES
It is now decision time. One choice is to do nothing. Accept that you must have losers to have winners, but recognize that a wide variety of products will make becoming a world-class manufacturer difficult, if not impossible. Realize, also, how vulnerable you are to specialty manufacturers offshore, who only make the limitedvariety/high-volume products. They can underprice you and still make a good profit because their costs, especially support costs, will be far lower. This is the primary way most offshore manufacturers have been successful in attacking American industry.
The second choice is to price your products to suit the true costs. One of three things could happen: First, your unit volumes stay the same. Because of your increased revenues from the low-volume items your profits and ROA increase dramatically. Next, customers stop buying the low-volume items and go elsewhere or convert to your higher-volume items. If this happens you must be ready to slash the associated support costs and drop the asset base needed to support these items. Otherwise you simply get less revenue but have the same costs, so profits decrease. Last, maybe there is a direct tie between supplying the low-volume losers and selling the high-volume, profitable items. Hence, overall volume decreases and profits drop. The possibility of this happening needs to be carefully tested before such a program is implemented. Market surveys or tests of limited parts of the line should be done if there is a great risk of this happening.
The third choice is to arbitrarily cut the product line and reduce support costs and assets. This is what many takeover artists who salvage losing companies have done. They can return a company to profitability rather quickly with this process. However, if there is a true need to support customers with a full line of products, this is only a temporary fix. Sales deterioration will occur in time to the products left in the line, hurting the business in the long haul.
The fourth choice is to exercise choice three, but supply the customers a full line through buying the low-volume items from competitors and reselling them. You could afford to do this at a break-even price if you could keep your profits from internal operations high.
To redesign the products to avoid the volume/variety dilemma is the fifth choice. A logistically effective design can provide variety in the marketplace without variety in the product.
Last, the sixth choice is to set up two production facilities, one for the highvolume/limited-variety products, the other for the low-volume/high-variety items. Structure the two businesses to focus on their unique product characteristics. This will minimize total support costs, and both will become profitable.
Many people are aware of the changes that are necessary on the factory floor in order to improve a manufacturer’s competitiveness. There is no question that manufacturing alone can make some gains. But they are seriously hampered if all departments don’t recognize their roles in creating the right environment for manufacturing’s changes to become really effective. Design strategies and sales characteristics are the two areas I feel need to change. However, all departments must be subjected to the same critical evaluation. Are their activities helping to create an optimum logistical flow or are they suboptimizing the business? If they are, then these activities must be changed to benefit the business in total.
A world-class manufacturer strives to achieve logistical perfection. The benefits should be obvious to all. Its results can be seen in those companies with outstanding logistics who dominate their markets. Create a company-wide logistics program for your business and see the results you will achieve.
Hal Mather is the president of Hal Mather, Inc., an Atlanta-based international management consulting and educational company. He is knowledgeable on MRP II, JIT and CIM, and is a leading figure in the movement of the factory of the future. He has written for several magazines and is the author of Bills of Materials, Recipes and Formulations and How to Really Manage Inventories.