What is a value (supply) chain?
customers and suppliers that work together to convert, distribute and sell goods and services
among themselves, leading to a specific end product
First level might be extraction of raw materials-> next level refinement into sheet metal -> freezer manufacturer -> retailers -> end users.
- The more efficient and high quality at beginning of supply chains, the better for the rest of chain.
Value (supply) chain management
- VCM/SCM is the management of key business processes that extend across the value (supply) chain, from the original suppliers to final customers.
- VCM/ SCM involves:
- creating close/collaborative relationships with suppliers and customers. Avoid looking as just transactional relationship
- Managing costs
- measuring performance of activities, suppliers and customers
- accelerating the time-to-market of new products
- Why is this of interest?
- SCM can lead to performance improvements for organisations
- as well as their suppliers and customers.
- –To understand how a company creates a competitive advantage, and to then
- –Manage those activities better than other companies
- These improvements may include improved efficiency, cost performance and profitability, as well as improvements in product quality, product innovation and delivery performance.
- What are those activities?
- Supplier relationships (this week)
- Customer relationships (last week)
- Within the firm (weeks 11) techniques include
- –ABM & BPR
- –Target costing
- –TQM (wk. 8)
Using technology in SCM
- E-commerce is the conduct of business transactions using electronic media, such as the internet.
- E-commerce technologies may be used to create electronic linkages with the suppliers and customers who are part of an organisation’s supply chain.
- Business to consumer (B2C): refers to e-commerce exchanges between a business and its non-business customers. eg. online shopping and banking. Customers may purchase and pay for products and services, make sales inquiries, and search for and receive customer support and assistance, all on-line.
- business to business (B2B): refers to e-commerce activities that take place between a business and its suppliers and customers. In the case of suppliers, these activities include purchasing and procurement, supplier selection and management, and inventory management.
- For customers, they include internet-based systems for customer inquiries, ordering, payments and support. Such technologies may lead to enhanced communications and coordination across the supply chain—between the organisation and its suppliers and customers, and within the organisation itself.
- Eletronic data interchange (EDI): the direct linking of parts of an organisation’s computer system with that of its customers and suppliers. For example, a computer link between a wholesaler and its retail customers may allow the wholesaler to analyse customers’ daily sales activity and to determine when customers require additional inventory.
- Customers also gain from these systems, as they receive products as soon as they need them from their suppliers without having to incur the costly activities of raising and processing purchase orders.
- Enterprise resource planning (ERP): within a firm. may assist an
- organisation to achieve efficient supply chain management. They are complex software packages that support information systems spanning many different functional areas of an organisation.
- They provide the advantages of consistency and standardisation of data definitions and business processes across an organisation, more efficient retrieval of information for managers’ decisions, and electronic access and data sharing across an organisation.
DRIVING SUPPLY CHAIN IMPROVEMENTS AT COLES
When Wesfarmers acquired Coles, revamped of Coles’ supply chain to increase operating efficiencies and cost competitiveness.
- Changes made: investment was made in new systems and technologies. This included systems to generate data that could be used to identify potential problems and trends in the operation of the supply chain and forecasting systems.
- The new systems provided Coles with improved knowledge of customer buying patterns and proactive marketing campaigns.
- On-line supplier portal: to promote greater communication with the company’s top 60 suppliers. Allowing suppliers to view data on stock levels, plans for future orders as well as supplier's performance on supply chain performance indicators.
savings, better understanding
of customer needs, close supplier relationships
and the introduction of sophisticated supply chain metrics to improve SCM and performance.
- As purchased material and components can make up a large proportion of the cost of producing a product, many organisations realise the importance of carefully selecting suppliers and creating and managing collaborative relationships with them.
- Good collaborative relationships with suppliers can
- –help to minimise supplier and inventory-related costs (particularly important if the strategic focus of the firm is cost leadership)
- –Improve product quality
- –Improve production lead time (Production lead time, or cycle time, is the period from when an order enters the manufacturing department to when the finished products are ready for deliver)
- Strategic alliances
- –formalised cooperative arrangements between two or more organisations involving sharing of resources and activities in order to achieve common objectives.
- (eg. company might send their engineers to suppliers to help them. Or invite suppliers to provide input when considering producing new product. This allows them to help with product design but also provides suppliers with insight on what their future needs might be)
- Selecting suppliers
- Purchased materials and components are a major part of the total production costs in a manufacturing business.
- However, purchasing activity can drive many other activities and costs within an organisation. This includes selecting a new supplier, communicating with a supplier, inspecting a delivery of materials from a supplier and storing inventory.
- The careful management of these activities can lead to cost reduction and improved financial performance for the firm.
- So achieving cost reductions in the supply area does not simply mean engaging suppliers who provide the cheapest materials or components, or ordering materials in the most cost-effective order quantities
- –Based on a range of criteria: price, quality, delivery (important for JIT system), performance history, capacity, communications systems, geographical location (not just price)
- –Long-term supply contracts and preferred suppliers (suppliers that they will engage with on an ongoing basis or for a fixed period of time)
- This is efficient for the buying organisation as continually undertaking supplier selection is very costly, and entering into a long-term supply contract can provide both buying organisations and their suppliers the opportunity to negotiate favourable prices and conditions.
- Long-term contracts also allow buying organisations the opportunity to assess the ongoing performance of the supplier, which helps them decide whether or not they will continue to transact with the supplier at the end of a contract.
Total cost of ownership
- The total cost of ownership is the total cost of dealing with suppliers (similar to customer profitability- using ABC) including
- –Costs of purchasing: These include the cost of the materials, the costs of ordering inventory, delivery, receiving and inspection
- –Costs of holding inventory: These are carrying costs, including storage, insurance, obsolescence, and opportunity costs associated with holding inventory.
- –Costs of poor quality: These include the costs of rework, scrap, returning defective material to suppliers, and downtime caused by using low-quality material.
- - Costs of delivery failure: These are the costs triggered by late (or early) delivery by a supplier, and include expediting costs, additional labour costs to receive late or early deliveries, downtime due to late deliveries, and lost contribution margin from lost sales due to failed deliveries.
- Expediting costs: the extra costs associated with processing purchase orders or production orders faster than normal.
Many of the above costs are difficult to uncover
, as they tend to be hidden
costs in a traditional costing system even though they may be significant and may vary between suppliers. Use ABC
Analysing supplier costs
- Activity-based costing can be used to estimate total cost of dealing with and managing suppliers, suppliers are regarded as the cost object, and the costs of purchases and specific supplier-related activities are assigned to each supplier (activity levels are- unit, order, and supplier)
- This activity-based costing analysis also involves the identification of cost drivers, and so provides opportunities for cost management.
- Cheapest supplier (i.e., cheapest purchase cost) may NOT always be the cheapest when the total cost of ownership is considered.
- This includes costs that arise due to the supply of poor quality materials and poor delivery reliability.
Activities and activity cost for suppliers- 3 levels
- When using activity-based costing to determine the total cost of ownership, a hierarchical structure can also be used and this will lead to more accurate allocation of costs to suppliers.
- There are three levels of supplier activities and costs that are incurred by a buying organisation:
- Unit level activities: additional activities that occur as a result of problems related to faulty quality or late delivery of materials by a particular supplier. These activities will lead to internal failure costs (such as the cost of extra machine set-ups, rework of products, and scrap) and external failure costs (the costs of replacing a faulty product that a customer has purchased that has failed owing to faulty materials from a particular supplier).
- Order level activities: triggered each time an order is placed with a particular supplier, and are independent of the number of units in an order. These activities are those involved in ordering material from a supplier, receiving and inspecting an order once it is delivered, and processing and paying a supplier’s invoice.
- Supplier level activities: activities that are incurred over the course of a supplier contract. They are independent of supplier orders, or the materials that are supplied.
- These activities include undertaking a quality audit to evaluate the supplier, the employment of a dedicated purchasing manager to manage the relationship with the supplier, and research and development (R & D) activities that relate specifically to a supplier.
- The type of supplier-level activities undertaken by a buyer may be different for each supplier. For example, a buyer may consider that some suppliers provide such high quality materials that quality audits do not need to be undertaken.
Supplier activity costing example
- Step 1: The first step was to analyse the major activities that were driven by suppliers, determine their activity drivers and calculate the cost per unit of activity driver. Along with the number of activities
- consumed by each supplier
- Note that the cost per unit of activity driver is an average cost that was calculated by estimating the total annual cost of an activity and dividing it by the total number of times that activity was performed during a year.
- Step 2: The next step was to determine the total cost of ownership, by calculating the total costs of supplier-related activities for the year.
- In Exhibit 15.3 the supplier costs have been calculated in total, and as a cost per unit. This allows us to estimate the total cost per unit for each supplier. Note that the purchase price must be included in the analysis.
- The supplier costs for each activity are based on the number of times the activity was performed, multiplied by the cost per unit of activity driver.
- What can management conclude from the data?
- In the past year, it was cheaper to order the handles from Handles Ltd than from Plastex Industries.
- This was mainly because of the higher costs of receiving late deliveries
- from Plastex, as well as the costs of rework. It was also because of the cost of R & D undertaken to ensure that the Plastex handles could be used on new production equipment.
- Management will need to consider whether this R & D cost is one-off or whether it will be incurred on an ongoing basis.
- The total cost of ownership for Handles Ltd is $9.0467 per unit, whereas for Plastex Industries it is $10.2340 per unit. The management of Hardy Saucepans now has some useful data to consider in its future supply decisions.
- It may decide to place a greater reliance on Handles Ltd in the future, or it may inform Plastex Industries that it will have to improve its performance if it wishes to be retained as a major supplier to the company.
- Note that total cost of ownership may be understated when a supplier’s poor delivery performance leads to downtime, as the total cost of ownership does not include the lost contribution margin due to lost sales.
Evaluating supplier performance
- The above analysis of supplier costs can form the basis for evaluating suppliers’ performance
- Supplier performance index (SPI): one technique that we can use to compare the performance of a range of suppliers. The ratio of total supplier costs to the total purchase price
Thus, Plastex Industries costs more per dollar of purchase
than does Handles Ltd. This confirms our analysis based on the data in Exhibit 15.3 that Handles Ltd is more cost-effective to deal with than Plastex
Evaluating supplier performance- other measures
- However, organisations may evaluate suppliers’ performance using a variety of criteria, including-
- ability of supplier to supply at the contracted purchase price
- material quality
- supplier delivery performance
- quality of relationships between employees, unions and management
- Reputation for managing environmental issues for environmentally sensitive industry
As part of establishing long-term contracts with suppliers, specific performance measures and targets for these criteria are often developed.
Supplier performance measures p. 661
- Delivery: Percentage of orders delivered on time. Average lead time* for deliveries.
- Suppliers may be required to deliver an order within a short time frame.
- Quality: percentage of orders rejected. Achievement of quality certification
- Cost: Percentage reduction in price of materials supplied. Manufacturing cost reduction targets
- Organisational change: implementation of team structures. Adoption of EDI system (the buying organisation may require suppliers to make changes in their production methods and administrative systems over time)
- Relationship: supplier satisfaction surveys, number of disputes between suppliers and the organisation resolved within 7 days.
- Measures may be developed to assess the quality of the relationship between the supplier and the buying organisation.
- The effective management of inventory is an important part of supply chain management, because it can help to reduce supplier costs, as well as manufacturing raw materials and finished goods costs.
- Inventory management is planning, coordinating and controlling activities related to the flow of inventory into, through and out of an organisation
- Holding inventory may be expensive for a business
- Manufacturing, wholesale and retail businesses often hold significant amounts of inventory, and those resources could alternatively be invested in areas such as new equipment or staff training, or just invested to earn interest.
Why hold inventory?
- To cope with uncertainties in customer demand and in production processes, such as machine breakdowns—the inventory acts as a buffer against the possibility of running out of materials or finished products. (just in case supply chain is affected eg. corona)
- Qualify for quantity discounts available on large orders
- Avoid future price increases in raw materials
- Avoid the costs of placing numerous small orders (eg. placing order, delivery costs, more orders to inspect)
Traditional approaches to inventory management
- Conventional (traditional) approaches to inventory management focus on balancing three classes of costs:
- 1. Ordering costs: incremental costs of placing an order
- Where inventory is purchased, the ordering costs include any costs associated with placing the purchase order and receiving the inventory. Where inventory is manufactured in-house, the ordering costs include the costs of placing the work order and, more importantly, the costs of setting up the manufacturing equipment to produce the required inventory
- 2. Carrying costs: the costs of carrying inventory in stock
- 3. Shortage costs: (or stock-out costs) refer to the costs of running out of inventory. (may lose a sale if we don't have the inventory)
Examples of inventory ordering, carrying and shortage costs
- Ordering costs: inventory that is purchased:
- Costs of finding suitable suppliers
- Clerical costs of preparing purchase order
- Transportation costs
- Costs of receiving order (eg. unloading and inspecting)
- Cost of processing the invoice
- Costs of expediting orders
- Ordering costs: inventory that is manufactured in-house:
- Clerical costs of preparing work order
- Costs of setting up for production
- Preparing equipment and facilities for production of the item
- Wages of idle workers/machines during set up
- Cost of test runs
- Carrying costs:
- storage costs (eg. warehouse cost)
- Handling cost
- Spoilage and obsolescence
- Opportunity cost of committing resources to inventory.
- Shortage costs:
- Lost sales (current and future)
- Cost of interrupted production when raw materials are not available
- Wages of idle workersExtra machinery setup costs
- Costs of expediting
Economic order quantity (EOQ)
- A traditional approach to minimising the costs of inventory
- The EOQ model determines the optimum order size for individual inventory items.
- An optimum order size is one that minimises the total of ordering costs and carrying costs
- If the inventory is purchased, the EOQ model estimates the ideal size of the purchase order. If inventory is manufactured, the model estimates the ideal size of the work order (i.e. the production run).
- A=annual demand
- C= carrying cost
- B= cost per order
- Another way of solving the EOQ problem is the graphical method.
- Notice that the ordering cost line slants downwards to the right. This indicates a decline in total order costs as the order size increases and the order frequency decreases.
- However, as the order size increases, the average inventory on hand increases.
- This results in an increase in total carrying costs, as indicated by the positive slope of the carrying cost line.
- The EOQ is at 480 bags, where the best balance is struck between these two costs. In this situation total inventory-related costs are $1 200.
Assumptions underlying EOQ
- The EOQ model is based on a number of simplifying assumptions, including the following:
- Inventory usage/ customer demand is known and constant (so is lead time) (Yes, if we have been in business for a long time. Difficult if we are in market that fluctuates or new business)
- Incremental ordering costs are known and constant per order (we don't have fluctuations in delivery costs, inspection costs, cost per unit is constant)
- Acquisition cost per unit is constant (i.e., there is no quantity discount)
- Entire order is delivered at one time (i.e., batches arrive just as the old stock is exhausted, and hence there are no stockouts)
- Carrying costs are known and constant per unit
- On average, one-half of order is in stock at any time . (no demand changes)
- (May overcome uncertainty by having safety stock)
- Organisations using the EOQ model need to assess how reasonable these assumptions are for the business
- EOQ model may be a bit dangerous if we have fluctuating demands and costs.
- Will the EOQ model provide useful information, or will it need to
- be adapted? The EOQ model can be altered to allow for the quantity discounts that many suppliers offer for large orders. It can also be adapted to allow for different delivery patterns.
- However, in many organisations EOQ models are not used to manage inventory, as there are more effective systems available, including just-in-time approaches
Inventory management and safety stock
- Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model
- Safety stock is a buffer against:
- unexpected increases in demand
- uncertainty about lead time, and;
- unavailability of stock from suppliers
- Allowing for 20 extra bags to be kept as safety stock results in a reorder point of 212 bags. Thus, an order for 480 bags should be placed whenever the plastic pellets inventory falls to 212 bags.
- Although a safety stock will increase inventory carrying costs, it will minimise the potential costs caused by shortages
- Safety stock may be costly to maintain (may add non value added activities)
Managing inventory- Just-in-time (JIT) systems
- A just-in-time (JIT) inventory and production system: is a comprehensive system for controlling the flow of manufacturing in a multistage production environment. The underlying philosophy is the simplification of the production process by removing non-value-added activities
- A full-scale JIT system covers all aspects of the production process, not just inventories. However, as inventory can be a major cause of non-value-added activity, inventory management is a critical component of JIT.
- One goal of JIT is to reduce or eliminate inventories at every stage of production, from raw materials to finished goods.
- Under JIT, production and inventory purchases are pulled through the system, driven by the actual demands of the final customer.
- A pull method of coordinating production processes (identify what is the demand from the customers, based on that demand we make/order)
- –As opposed to a push system (goods are purchased or produced to meet inventory requirements rather than to meet actual customer demand) Found in traditional inventory management and production systems. We saw this under an EOQ approach, where budgeted annual customer demand for a product determines annual inventory requirements, which in turn drive the EOQ.
- A non-value-added activity is an activity that does not add value to a product from the customers’ perspective or for the business and, therefore, can be eliminated.
- Systematically remove NVA activities so we can respond quickly to changes in customer demand.
- Goals:–Timely meeting of customer demands (react to demand)
- –High quality products (high quality material, suppliers and processes) (we can't afford production delays caused by poor quality)
- –Lowest possible cost
Quiz: Total Manufacturing Time equals
Which ones of the above are value adding and which ones are not?
- VA: process,
- NVA: inspection, move, queue, storage
- JIT process will identify these NVA activities and systematically try to reduce/eliminate them
Key features of JIT production
- A pull method of coordinating production: Goods are produced in each manufacturing stage, and materials are purchased only when they are needed at the next stage. As a result, no components or finished goods are produced until they are needed, and therefore no inventories build up.
- Simplified production processes: An important goal of JIT is to simplify the production flow. Simplification is important as it speeds up the production process to help ensure prompt delivery of the product to customers. Non-value-added activities are identified and removed throughout the production process.
- Purchase of materials, and manufacture of sub-assemblies and products in small lots: As materials are purchased and goods produced only as required, batch sizes tend to be small and inventory levels are low.
- Quick and inexpensive setups of production machinery: To produce in small batches, setup times must be reduced, or the production line will be too slow to meet customer delivery requirements. The analysis of activities, identification and elimination of non-value-added activities, and use of advanced technologies may help to reduce this time.
- High quality levels for raw materials, components and finished products: If raw materials, components and sub-assemblies are to arrive just in time for production, they must be just right for their intended purpose. Otherwise, the production line will be shut down and significant non-value-added costs of waiting will result
- Effective preventive maintenance of equipment: If goods are to be manufactured just in time to meet customer orders, production delays must be avoided, so frequent preventive maintenance of equipment is essential.
- Flexible work teams: To facilitate JIT, many businesses restructure their production processes from rigid assembly lines into work-based teams. Employees in these teams are multiskilled, being trained to complete all aspects of the production process. This assists in eliminating bottlenecks in the production process and non value-added idle time.
- A JIT system involves JIT purchasing as well as JIT production.
- The aim of JIT purchasing is to purchase raw materials from outside suppliers only as they are needed, to avoid costly inventory build-ups.
- Managing supplier relationships in JIT include the following:
- Reducing the number of suppliers- critical
- Entering into long-term contracts with suppliers- establishing preferred suppliers
- –win-win situation
- –price and quality terms established, hence no additional negotiation for individual orders
- Specifying quality targets in supplier contracts to reduce the need to inspect all deliveries
- Using e-commerce applications to place orders electronically with suppliers, to provide suppliers with on-line access to a firm’s inventory files, and to pay suppliers’ invoices.
Costs of JIT
- Substantial investment to change/set up production facilities to minimise non-value-added activities (prevention costs)
- An increase in the risk of inventory shortages and the associated loss of production and sales (because excess inv is NVA) (disruptions to supply chain are extremely costly to businesses that use JIT approach- thats why important to have reliable suppliers)
- Another issue is that it may be difficult for JIT to deliver benefits to small suppliers. While small firms may need to comply with the JIT requests of large and powerful customers, they may not have the power to push those same systems onto their own suppliers. Thus, small suppliers may keep excessive raw materials inventory and finished goods inventory on hand, to meet the JIT requirements of their customers.
Benefits of JIT
- Savings in inventory carrying costs: reduced storage and handling costs; lower insurance costs; fewer losses due to spoilage, obsolescence and theft; and decreased opportunity costs associated with having resources tied up in inventory.
- Fewer losses due to spoilage, obsolescence and theft
- No opportunity costs of high inventory (eg. have 1milk of stock- could instead use that 1mil to invest in other areas)
- Improves productivity, manufacturing lead times and quality by eliminating non-value-added activities
- Meets customers’ needs more effectively and quickly
These benefits don't just magically appear. JIT forces us to be more efficient and eliminate NVA activities because if we can't do those things, our business will fail. We have to do these things first before we can be JIT
- In theory, the JIT ideal is zero inventories. In practice, businesses must weigh up the substantial costs that may result from inventory shortages and compare them with the benefits of holding minimal inventories.
- In many companies, the JIT approach involves streamlining the production of products and reductions in inventory balances —not necessarily the elimination of inventory.
- It is not possible to quantify all these costs and benefits, and management judgment therefore plays a vital role.
The role of the management accountant in managing inventory
- With its emphasis on the elimination of non-value-added activity and the improvement of quality, the JIT approach requires a range of non-financial performance measures linked to business strategies, to supplement the traditional, largely financial, performance measures.
- JIT management requires just-in-time information.
- Useful performance measures include manufacturing lead time, throughput, days of inventory on hand, setup time and rework
- Many of these measures may be captured by employees within the work teams, but management accountants may coordinate the collection of this information, analyse it, and report it to various levels of management.
Performance Measures in JIT
- Financial performance measures such as inventory turnover ratio
- Non-financial performance measures of time, inventory and quality such as:
- –Manufacturing lead times (how long it takes to manufacture)
- –Units produced per hour
- –Days of inventory on hand (do we have enough)
- –Setup time as a % of total manufacturing time
- –Number of defective units as a % of total units produced
- –creating closer relationships with suppliers to increase efficiency and profitability
- –selecting the best suppliers, analysing supplier profitability and measuring and managing supplier performance
- Managing Inventory
- –Conventional technique of EOQ, which focuses on optimising orders to minimise costs
- –JIT involves working with suppliers to minimise inventory holdings and increase the efficiency of production and ordering processes