Supply chain strategies

Distributors, manufacturers and customers must work together to create efficient relationships

By Barry Lawrence; Anoop Varma -- Industrial Distribution, 1/1/1999

Supply chain management is a new, powerful force in the interaction between distributors, customers and their suppliers. SCM shapes the roles of distributor, manufacturer, retailer, and contractor in materials management and customer service. The focus is on the final consumer -- your customer's customer. This forward look has caused distributors to form alliances designed to meet customer needs.

The alliances can take the form of "vertical" alliances between the distributor and their customer. Vendor managed inventory and certified supplier status are examples of vertical alliances between distributors and their immediate customers.

Another common form is the "horizontal" alliance where the distributor allies with other distributors to serve a wider array of the immediate customer's needs. Consortiums like Affiliated Distributors and iPower are horizontal alliances whose mission is to match the total needs of a customer from both a product and geographic standpoint.

The alliance movement has caused many customers, especially large OEMs, to look for suppliers that can meet their needs across a wide range of products and geographic regions. In recent years, supplier reduction has led to a conclusion amongst OEMs that fewer suppliers means the remaining ones must offer a wider product selection. Distributor consolidation followed as large houses like W.W. Grainger recognized the competitive advantage in "having it all under one roof."

Large strategic accounts tend to have operations across the nation, if not globally. These customers look for suppliers that can meet their needs anywhere in the world. This further fuels the consolidation movement as distributors try to extend their global reach. Those firms that can meet the "just in time" needs favored by large customers are more likely to get the sale.

Another driving force is the move to core competencies by manufacturers and other customers/suppliers. Most manufacturers do not consider inventory management a core competency. Distributors and third party logistics companies (like UPS and Federal Express) are finding their services in- creasingly in demand as many firms outsource this function. For distributors, however, this poses a problem. Unlike third party logistics companies, distributors have not typically charged for their inventory management services. As inventory management increases as a component of distributor operations, distributors must find ways to charge for these services.

Integrated supply is a rapidly growing program for handling all customer needs in inventory management. The lead supplier or integrator takes over all procurement, materials management, sourcing, and materials forecasting for their customer. Since customers for integrated supply are typically large manufacturers, the integrator must have a broad product offering and a wide geographic scope, or be able to form a consortium with those characteristics. Integrated supply implicitly treats inventory management as a compensated service for the integrator. As such, the issues of separating service costs from product costs must be dealt with in the arrangement.

Motivation for integrated supply

Supply chain management attempts to drive costs out of the supply chain through whatever means possible. In the 1970s, U.S. companies -- following the Japanese example -- introduced just in time management with similar goals. Inventory was identified as a major cost driver, which masked much inefficiency. If processes could be improved, inventory could be reduced or would decline on its own while maintaining -- if not improving -- customer service. Prior to JIT, and persisting to this day, the dominant form of inventory management was the "push" method.

The push method operates as "just in case." Inventory costs are considered far less important than stockout costs. On the surface this seems reasonable. Problems arose, however, when inefficient processes were accepted as unchangeable and inventory was used to ensure that customer service levels were maintained. One of the biggest contributions of the JIT movement was to connect poor processes to increases in inventory. Quality problems, adversarial supplier relationships, poor forecasting and inadequate information systems were just a few of the things identified as causes for exploding inventories.

Companies began to realize that reducing process costs would help them become more efficient. This would ultimately lead to a JIT schedule. The significance of the SCM movement is that customers and suppliers are pursuing JIT for their operations and pushing the inefficiencies off on someone else.

If the customer and the supplier are simultaneously pursuing JIT, what is the likely outcome? A customer running a JIT operation will seek smaller order sizes. Smaller order sizes means narrower and more accurate time windows for delivery. Additionally, smaller orders favor distributors since manufacturers usually only offer bulk delivery -- but a narrower time window means inventory must be available for JIT delivery. If supplier lead times are long and highly variable, the distributor's inventory must be expanded to meet customer demands.

A supplier pursuing JIT will seek to smooth the production schedule. Smoother schedules are more predictable and, therefore, allow the supplier's suppliers to plan for JIT delivery. This scenario leads to problems for the distributor. If an order comes into the supplier after a run on that product has been exhausted, it must wait for the next run. If it comes in just before the run completes, it will go out immediately after the run. If the stated lead time is eight weeks, the distributor could get it anytime between one and eight weeks. The lead time will most likely be an estimate of the total time necessary to complete a manufacturing cycle.

Compounding the problem, the distributor is frequently a small customer for the supplier. Distributors tend to buy from many manufacturers and usually only have a major relationship with a few suppliers. The other suppliers will meet the needs of their larger customers first, adding even more variability to their lead times. Hence we have the distributor's dilemma, narrow customer time windows and wide supplier windows leading to exploding inventories.

JIT has created headaches for distributors, but it has also created opportunities. As manufacturers move down to their core competencies, a great deal of business is being outsourced to distributors. Demand for added value is growing exponentially. Customers and suppliers are asking distributors to take over additional product processing/customization, inventory management, and scheduling, to name just a few of the opportunity areas.

There are also new threats. Third-party providers, contract manufacturers, and electronic commerce are both tools and potential competitors. Third party logistics companies are carrying out warehousing, transportation, and even procurement for their customers. Although they do not claim to be distributors, they have manifested many of the characteristics and are offering themselves as alternatives to traditional distribution.

Distributors have many advantages, but they must continue to pursue better processes in order to remain the low-cost provider. One area in which distributors have had considerable success and some spectacular failures is integrated supply. Integrated supply was developed as a strategy to capitalize on the distribution core competencies to meet SCM goals.

The integrated supply process

The early models for integrated supply set the integrator up as the single point of contact for the customer. A consortium of manufacturers and distributors backed up the integrator with material outside of its product base. This method held advantages and disadvantages for both the customer and integrator.

Customer advantages included decreases in holding costs, since the integrator held the inventory and reduced procurement costs due to the single point of contact. In addition, the integrator's expertise in inventory management led to less waste in the system. In many cases, the integrator's purchasing skills also led to better deals on supplies.

A major disadvantage for customers was that the lack of competitive bidding could lead to complacency on the part of the integrator. An under-financed integrator could fail and send the alliance back to square one. Further, the integrator serves as a layer between the customer and the technical expertise often needed on products. If the second-tier supplier is another distributor, technical expertise has to pass through two levels to reach the customer. Besides the time and difficulty associated with the layers, the distributors (integrator and second tier) may feel the need to shield their suppliers and customers from each other.

The advantages for the integrator are long-term contracts, significantly higher volume, a more secure relationship with the customer, and increased information flow for forecasting. The disadvantages for the distributor, however, are a direct reflection of the advantages. The long-term contract and secure relationship is often viewed by the customer as "guaranteed business" that should lead to reductions in product or service pricing. It can be difficult to explain to a potential customer that not only are discounts unavailable under integrated supply, but that they must also compensate the integrator for services formerly regarded as free. Many distributors, in fact, report a drop from double to single digit margins in an integrated supply relationship. This leaves little room for error in negotiating inventory management fees.

To overcome the customer problem with technical support, a second model has been introduced for integrated supply. This model allows the second tier to ship and interact directly with the customer. The integrator continues to act as the single point of contact in ordering and managing the customer's material needs, but the second-tier distributors are treated as direct-ship suppliers. The trust implicit in integrated supply is elevated to a new level under this model. The customer must demonstrate that second-tier suppliers will not be used as potential replacements for the integrator. Although the second tier typically supplies product not carried by the integrator, the members of the second tier will undoubtedly contain firms who act as integrators elsewhere.

Before deciding the second model is unacceptable, however, potential integrators must consider a few points. First, customers may not leave the integrator an option. Second, remember the focus is on the "final customer" who is driving the SCM movement. Failure to meet the optimal value for this customer may result in your customer's failure to remain a viable supplier to the market. Lastly, the threat of competition and interaction with the second tier will keep the integrator agile and, therefore, more likely to succeed in winning more integrated supply contracts. Fundamental economics states that the more efficient relationship will prevail. The integrator and its customer are allies and any secrets or other betrayals of trust will result in someone else's supply chain winning the end customer's business.