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these areas must be managed so that they interact efficiently with each other to provide the level of service that the customer demands and at a cost that the company can afford.
Definitions
This material considers the four principal components of PDM: 1. Order processing; 2. Stock levels or inventory; 3. Warehousing; 4. Transportation. PDM is concerned with ensuring that the individual efforts that go to make up the distributive function, are optimised so that a common objective is realised. This is called the systems approach to distribution management and a major feature of PDM is that these functions be integrated. Because PDM has a well-defined scientific basis, this chapter presents some of the analytical methods which management uses to assist in the development of an efficient logistics system. There are two central themes that should be taken into account: 1. The success of an efficient distribution system relies on integration of effort. An overall service objective can be achieved, even though it may appear that some individual components of the system are not performing at maximum efficiency. It is never possible to provide maximum service at a minimum cost. The higher the level of service required by the customer, the higher the cost. Having decided on the necessary level of service, a company must then consider ways of minimising costs, which should never be at the expense of, or result in, a reduction of the predetermined service level.
2.
3.1
Order processing
Order processing is the first of the four stages in the logistical process. The efficiency of order processing has a direct effect on lead times. Orders are received from the sales team through the sales department. Many companies establish regular supply routes that remain relatively stable over a period of time providing that the supplier performs satisfactorily. Very often contracts are drawn up and repeat orders (forming part of the initial contract) are made at regular intervals during the contract period. Taken to its logical conclusion this effectively does away with ordering and leads to what is called partnership sourcing. This is an agreement between the buyer and seller to supply a particular product or commodity as an when required without the necessity of negotiating a new contract every time an order is placed. Order-processing systems should function quickly and accurately. Other departments in the company need to know as quickly as possible that an order has been placed and the customer must have rapid confirmation of the orders receipt and the precise delivery time. Even before products are manufactured and sold the level of office efficiency is a major contributor to a companys image. Incorrect paperwork and slow reactions by the sales office are often an unrecognised source of ill-will between buyers and sellers. When buyers review their suppliers, efficiency of order processing is an important factor in their evaluation. A good computer system for order processing allows stock levels and delivery schedules to be automatically updated so management can rapidly obtain an accurate view of the sales position. Accuracy is an important objective of order processing as are procedures that are designed to shorten
3.2
Inventory
Inventory, or stock management, is a critical area of PDM because stock levels have a direct effect on levels of service and customer satisfaction. The optimum stock level is a function of the type of market in which the company operates. Few companies can say that they never run out of stock, but if stockouts happen regularly then market share will be lost to more efficient competitors. Techniques for determining optimum stock levels are illustrated later in this chapter. The key lies in ascertaining the re-order point. Carrying stock at levels below the re-order point might ultimately mean a stock-out, whereas too high stock levels are unnecessary and expensive to maintain. The stock/cost dilemma is clearly illustrated by the systems approach to PDM that is dealt with later. Stocks represent opportunity costs that occur because of constant competition for the companys limited resources. If the companys marketing strategy requires that high stock levels be maintained, this should be justified by a profit contribution that will exceed the extra stock carrying costs. Sometimes a company may be obliged to support high stock levels because the lead-times prevalent in a given market are particularly short. In such a case, the company must seek to reduce costs in other areas of the PDM mix.
3.3
Warehousing
American marketing texts tend to pay more attention to warehousing than do British texts. This is mainly because of the relatively longer distances involved in distributing in the USA, where it can sometimes take days to reach customers by the most efficient road or rail routes. The logistics of warehousing can, therefore, be correspondingly more complicated in the USA than in the UK. However, the principles remain the same, and indeed the European Union should be viewed as a large home market. Currently, many companies function adequately with their own on-site warehouses from where goods are despatched direct to customers. When a firm markets goods that are ordered regularly, but in small quantities, it becomes more logical to locate warehouses strategically around the country. Transportation can be carried out in bulk from the place of manufacture to respective warehouses where stocks wait ready for further distribution to the customers. This system is used by large retail chains, except that the warehouses and transportation are owned and operated for them by logistics experts (e.g. BOC Distribution, Excel Logistics and Rowntree Distribution). Levels of service will of course increase when numbers of warehouse locations increase, but cost will increase accordingly. Again, an optimum strategy must be established that reflects the desired level of service. To summarise, factors that must be considered in the warehouse equation are:
3.4
Transportation
Transportation usually represents the greatest distribution cost. It is usually easy to calculate because it can be related directly to weight or numbers of units. Costs must be carefully controlled through the mode of transport selected amongst alternatives, and these must be constantly reviewed. During the past 50 years, road transport has become the dominant transportation mode in the UK. It has the advantage of speed coupled with door-to-door delivery. The patterns of retailing that have developed, and the pressure caused by low stock holding and short lead times, have made road transport indispensable. When the volume of goods being transported reaches a certain level some companies purchase their own vehicles, rather than use the services of haulage contractors. However, some large retail chains like Marks and Spencer, Tesco and Sainsburys have now entrusted all their warehousing and transport to specialist logistics companies as mentioned earlier. For some types of goods, transport by rail still has advantages. When lead-time is a less critical element of marketing effort, or when lowering transport costs is a major objective, this mode of transport becomes viable. Similarly, when goods are hazardous or bulky in relation to value, and produced in large volumes then rail transport is advantageous. Rail transport is also suitable for light goods that require speedy delivery (e.g. letter and parcel post).
Except where goods are highly perishable or valuable in relation to their weight, air transport is not usually an attractive transport alternative for distribution within the UK where distances are relatively short in aviation terms. For long-distance overseas routes it is popular. Here, it has the advantage of quick delivery compared to sea transport, and without the cost of bulky and expensive packaging needed for sea transportation, as well as higher insurance costs. Exporting poses particular transportation problems and challenges. The need for the exporters services needs to be such that the customer is scarcely aware that the goods purchased have been imported. Therefore, above all, export transportation must be reliable. The development of roll-on roll-off (RORO) cargo ferries has greatly assisted UK exporters who distinguish between European and Near-European markets that can usually be served by road, once the North Sea has been crossed. Deep sea markets, such as the Far East, Australasia and America, are still served by traditional ocean-going freighters, and the widespread introduction of containerisation in the 1970s made this medium more efficient. The chosen transportation mode should adequately protect goods from damage in transit (a factor just mentioned makes air freight popular over longer routes as less packaging is needed than for long sea voyages). Not only do damaged goods erode profits, but frequent claims increase insurance premiums and inconvenience customers, endangering future business.
5.1
To use a simple example, a companys service policy may be to deliver 40 per cent of all orders within seven days from receipt of order. This is an operationally useful and specific service objective that provides a strict criterion for evaluation. A simple delivery delay analysis (see Figure 1) will inform management whether such objectives are being achieved or whether corrective action is necessary to alter the actual service level in line with stated objectives. Such an analysis can be updated on receipt of a copy of the despatch note. Management can be provided with a summary, in the form of a management report, from which they can judge whether corrective action is necessary. There can, of course, be over-provision of service, as well as under provision.
Percentage of total orders 37.2 14.2 9.8 7.0 7.6 5.6 2.8 2.6 2.0 1.6 3.4 3.0 2.0 1.2 100.0
5.2
Service elasticity
Provision of customer service is not free and its cost can be calculated in terms of time and money. This applies particularly in industrial markets, where potential customers often consider service more important than price when deciding to source supplies from a particular company. Service levels are of course a competitive marketing tool for companies supplying the automotive industry which applies lean manufacturing techniques. The concept of diminishing returns, for marketing companies wishing to raise their service levels, is illustrated in the following example: Suppose it costs a marketing firm x to provide 75 per cent of all orders from stock, with 60 per cent of all orders delivered within seven days of receipt of purchase order. To increase either of these targets by, say, 10 per cent may well increase the cost of service provision by 20 or 30 per cent. To be able to meet 85 per cent of orders out of stock, stockholding on all inventory items would have to increase. Similarly, to deliver 70 per cent of orders within the specified time may necessitate the purchase of extra transport which might be under-utilised for a large part of the time. Alternatively, the company might use outside haulage contractors to cope with the extra deliveries, which would add to costs. The illustration in Figure 2 further illustrates this point. In this example, 80 per cent of the total possible service can be provided for approximately 40 per cent of the cost of 100 per cent service provision. To increase general service levels by 10 per cent brings about a cost increase of approximately 18 per cent. 100 per cent service provision means covering every possible eventuality, which is extremely expensive.
100 90 80 70 60
In reality, maximum consumer satisfaction and minimum distribution costs are mutually exclusive, and there has to be some kind of trade-off. The degree of trade-off will often depend on the degree of service sensitivity or service elasticity in the market or market segments. Two industries may use the same product and may purchase that product from the same supplier, but their criteria for choosing a supplier may be very different. For example, both the sugar-processing and oil exploration industries use large high pressure on-line valves: a sugar processing company to control the flow of its sugar beet pulp in the sugar-making process; an oil exploration company to control the flow of drilling fluids and crude oil on the exploration platform. The oil industry is highly service sensitive (or elastic), and when dealing with suppliers, price is relatively unimportant, but service levels are critical. Because of the very high costs of operations, and the potential cost of breakdown, every effort is made to cover every contingency. On the other hand, the sugar-processing industry is more price sensitive. Sugar processing is seasonal, with much of the processing work being carried out within two months, so as long as these critical two months are not disrupted, service provision can take a relatively low priority for the remainder of the year. In theory, service levels should be increased up to the point where the marginal marketing expense equals the marginal marketing response. This follows the economists profit maximisation criterion of marginal cost being equal to marginal revenue. Figure 3 illustrates this point and it can be seen that the marginal expense (MME) of level of service provision x1 is Y and the marginal revenue (MMR) is Z. It would pay the firm to increase service levels, since the extra revenue generated by the increased services (MMR) is greater than the cost (MME). At service level x2, however, the marginal expense (Z) is higher than the marginal revenue ( X), so service provision is too high. Clearly, the theoretical point of service optimisation is where marginal marketing expense and marginal marketing response are equal, service level xe.
Cost
50 40 30 20 10 0 40 80 10 50 90 20 60 100 30 70
Service level (%) Figure 2 Illustration of possible diminishing returns to service level provision
MME
Cost/revenue
5.3
Z Y MMR
x1 xe Service level
x2
Inventory management
Inventory (or stockholding) can be described as the accumulation of an assortment of items today for the purpose of providing protection against what may occur tomorrow. An inventory is maintained to increase profitability through manufacturing and marketing support. Manufacturing support is provided through two types of inventory system: An inventory of the materials for production; An inventory of spare and repair parts for maintaining production equipment.
Similarly, marketing support is provided through: Inventories of the finished product; Spare and repair parts that support the product.
If supply and demand could be perfectly coordinated, there would be no need for companies to hold stock. However, future demand is uncertain, as is reliability of supply. Hence inventories are accumulated to ensure availability of raw materials, spare parts and finished goods. Generally speaking, inventories are kept by companies because they: Act as a hedge against contingencies (e.g. unexpected demand, machinery breakdown); Act as a hedge against inflation, price or exchange rate fluctuations; Assist purchasing economies; Assist transportation economies Assist production economies; Improve the level of customer service by providing greater stock availability.
Inventory planning is largely a matter of balancing various types of cost. The cost of holding stock and procurement has to be weighed against the cost of stock-out in terms of production shut-downs and loss of business and goodwill that would undoubtedly arise. These various costs conflict with each other. Larger inventories mean more money is tied up in stock and more warehousing is needed. However, quantity discounts are usually available for large orders (e.g. of materials for production) and if fewer orders have to be placed, then purchasing administrative costs are reduced. Larger inventories also reduce the risks and costs of stock-outs. When the conflicting costs just described are added together, they form a total cost that can be plotted as a U-shaped curve. Part of managements task is to find a procedure of ordering, resulting in an inventory level that minimises total costs. This minimum total cost procurement concept is illustrated in Figure 4.
Total costs (A + B + C)
Cost
Out-of-stock costs (C) Minimum cost re-order quantity 0 Figure 4 Cost trade-off model The economic order quantity (EOQ) is based on the assumption that total inventory costs are minimised at some definable purchase quantity. The EOQ method simply assumes that inventory costs are a function of the number of orders that are processed per unit of time, and the costs of maintaining an inventory over and above the cost of items included in the inventory (e.g. warehousing). The EOQ concept is simplistic in that it ignores transportation costs (which may significantly increase for smaller shipments) and the effects of quantity discounts. Because of these limitations, the EOQ concept decreased in significance in the management of inventory, but the widespread adoption of business computing has allowed the use of more sophisticated versions of EOQ. An example of the traditional EOQ method is provided to give a general understanding of the principles. The economic order quantity can be calculated using the following formula: Stock replenishment quantity
EOQ =
where: A = S = I = e.g. For:
2AS I
annual usage (units) ordering costs () inventory carrying cost as a percentage of inventory value Annual usage = 6,000 units Ordering costs = 13 Inventory carrying cost = 17% (= 0.17) Unit cost = 1.30 2 x 6,000 x 1.30 x 13 0.17
EOQ = =
= =
The EOQ concept and its variations basically seek to define the most economical lot size when
considering the placement of an order. The order point method can be used to determine the ideal timing for placing an order. The calculation uses the following equation: OP = DLt + SS where: OP D Lt SS e.g. For: is the order point is the demand is the lead time is the safety stock Demand = 150 units per week Lead time = 6 weeks Safety stock = 300 units
OP = (150 x 6) + 300 = 900 + 300 = 1,200 units i.e. A replenishment order should be placed when inventory levels decrease to 1,200 units. The actual size of the order placed when stock reaches this level can be calculated using the EOQ formula. As with EOQ, the order point method incorporates certain assumptions. The order point assumes that lead times are fixed and can be accurately evaluated, which is rarely the case. However, despite the limitations of both the EOQ and order point models, the basic principles are valid and form the basis of more realistic and useful computer-based inventory models.
Summary
Discussion of PDM usually takes place from the viewpoint of the supplier. Understanding of physical distribution is, however, just as important to the purchaser. In addition to understanding the distribution tasks that face the supplier, the purchasing department must also appreciate logistical techniques for inventory control and the order cycle. There is consequently a close link between PDM and purchasing. Work study-techniques and operations management can also be linked with PDM because management is concerned with efficiency and accuracy throughout the distributive function. Whilst a logistical system should not be inflexible, if routines can be established for certain functions they will assist the distribution process. As a function of the marketing mix, PDM is linked to all other marketing sub-functions and is an important element that plays a large part in achieving the goal of customer satisfaction.
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