Tuesday, April 6, 2010

Best Practice: Network Optimization

By Dr. F. Barry Lawrence
Texas A&M University

The struggle continues in spite of the light on the horizon. Some are running out of rope, but most have adjusted. One could argue that wholesale distribution was built to overcapacity during the massive expansion associated with the Just in Time (JIT) movement of the 1980s and 1990s and that we’ve been struggling with adjustments in the 2000s. JIT drove a great deal of new business to wholesaler-distributors as manufacturers and retailers sought to decrease inventories, but it also decreased their net margins through an increase in cost to serve.

The initial impact was the 2002 recession, the first indication that the market would not grow continuously. The upturn from 2003 to 2008 gave distributors some relief but most would agree it was not like the 1990s. If distributor growth was not spectacular at that time, we should not have been surprised by how hard the next recession hit. The financial crisis further demonstrated how vulnerable distributors are when our overloaded services (accounts receivables, inventory) strangled cash flow almost instantly.

Going forward, the distributor’s market will grow steadily, but not nearly as rapidly as in the past. For distributors to experience real growth, they will have to provide excellent and innovative services and products. The combination requires best practices in asset management and supplier management. Past blogs have dealt with customer relationships, inventory, transportation, lean processes, and information technology. This blog will address network optimization, the process of aligning all resources in the distributor’s organization to optimize customer service and profitability simultaneously. Network optimization is a very mature best practice but has, to date, not been used extensively by distributors.

The popular-selling NAW Institute for Distribution Excellence book, Optimizing Distributor Profitability (available at http://www.naw.org/optimizdistprof), details best practices, their implementation, and return-on-investment (ROI). These practices are valid in any economy, but the significance of one best practice versus another may change under different market conditions. Each month in this blog, we have introduced a best practice and how it can improve earnings and/or ROI under current economic conditions. We encourage you as you participate in this blog to ask questions, debate results, and offer your own experiences with such practices, so that we may further the knowledge of the community and the understanding of the science of distribution.

The book breaks business processes into seven groups (SOURCE, STOCK, STORE, SELL, SHIP, SUPPLY CHAIN PLANNING, and SUPPORT SERVICES) based on various distributor asset categories. This month, we focus on SUPPLY CHAIN PLANNING as shown in exhibit 1.

Best Practice: Network Optimization

Network optimization involves mathematically modeling the distributor’s operations. The model will include an objective (maximize profitability or minimize cost) and a set of constraints (financial, customer delivery requirements) that may or may not be violated. Management establishes the goals of the firm and the model is based on real conditions. Once the model is created, it can be run repeatedly to determine the optimal configuration of assets in the distributor’s supply chain. Sound difficult? Let’s run through some examples to demonstrate how others have carried out a network optimization.

The practice levels for supply chain network optimization are as follows:

COMMON practice: (1) Experience, (2) Spreadsheet analysis

GOOD practice: (1) Single-asset focused mathematical model (for example, optimizing facility location or transportation)

BEST practice: (1) Multi-asset focused mathematical models (for example, optimizing inventory and transportation together), (2) Stochastic (uncertain) mathematical models

A building materials distributor had acquired one of its largest competitors. The firm’s network went from 50+ to 80+ locations with many redundant facilities. The firm conducted a network optimization with the following parameters:

  • Objective: Optimize profitability

  • Constraints: Next-day delivery and transportation fleet capacity.

It sounds deceptively simple, but the objective and the constraints are very complex to model. Once modeled, however, the firm was able to run it over and over with different assumptions: changing demand (forecasting), differing levels of transportation capacity (selling or adding trucks), different levels of financial investment (inventory levels), etc. After many runs, a solution began to emerge. The model recommended reducing the number of facilities from 80 to 49. The researchers, however, recommended only eliminating the top 10, since market conditions would change and an operation that was not quite optimal now could be in a few years.

The firm went about consolidating the top recommendations. The most extensive consolidation took place in northern California. Three branches were to be combined into one. The branches were on property valued on the firm’s books at $200,000 each, but could be sold for $1.2 million each (a $3 million windfall). The consolidated center was able to operate on $1.7 million in inventory as opposed to the $3.2 million, which had been scattered through the three branches. The firm had calculated a 40% holding cost, so the bottom line impact for inventory was $600,000 ($1.5 million times 40%), an increase in net margin for the three branches of nearly 100%. Customer service was not compromised, since the model treated it as a “hard” constraint.
Network optimization is to distributors what aggregate planning is to manufacturers. Aggregate planning is the process of determining how manufacturing resources will be used in the coming year. Conducted each year, it ensures that strategic goals for customer service are met with optimal usage of equipment (maximizing ROI). Distributors’ “manufacturing resources” are warehouses, transportation, inventories, accounts receivables, and all other resources engaged in customer service. Network optimization determines how to optimally deploy them. Unfortunately, this process is carried out only by a few distributors and then only after acquisitions or a long period of organic growth that has resulted in an inefficient network of investments.

Best practice states that distributors should conduct network optimization annually or every two years at least. The result would be more efficient use of resources and higher ROI, both necessities in the current market. Growth, in particular, will require higher levels of service or operations in new territories, which will consume additional resources. For most distributors, future investments will require squeezing or at least not wasting someplace else.

Some assume that network optimization is about closing facilities, hub and spoke, or some other consolidation scheme as in the previous example. In fact, it is about the optimal allocation of resources to meet customer needs. Customer requirements still tend to outpace distributor compensation, so the focus is not necessarily about reducing the distributor’s footprint, as it were, but about meeting those requirements as efficiently as possible.

An auto parts distributor was an excellent example of optimizing without closing facilities. The firm served car dealers and had grown rapidly with a highly effective business model. At the time of the network analysis, the firm was delivering twice a day in some markets, daily in others, and every two days in others. Multiple daily deliveries were very expensive in terms of trucking and human resources, so the firm wanted an analysis that would examine new markets for them to grow into and a service versus cost analysis of existing markets to determine if the number of deliveries could be safely reduced in some cases. The analysis showed a need for only one or two new facilities (the present network was very efficient) and made recommendations on service offerings going forward. Sample results can be seen in exhibit 2.

Since network optimization configures the distributor’s service offering, it moves huge resources like facilities, changes customer allocation to operations, determines transportation needs, places inventory and other value processes, and sets customer service levels. The decisions in a network optimization will determine the ability to operate profitably, achieve target ROI, improve cash flow, and optimize growth opportunities.

The process has been and continues to be conducted by best practice wholesaler-distributors, but most distributors are not utilizing network optimization. This lack of adoption puts distributors at risk as suppliers choose their channels to market and customers choose their suppliers. For this reason, network optimization will be further explored to establish more distributor best practices in the upcoming Council for Research on Distributor Best Practices consortium on the topic of “Optimizing Distributor Growth & Market Share.” To learn more and to join this new consortium, go to http://www.naw.org/crdbp/growth.php.

About this Blog

“Managing in an Uncertain Economy” is a blog created by the Council for Research on Distributor Best Practices (CRDBP). The mission of the CRDBP, created by the NAW Institute for Distribution Excellence and the Supply Chain Systems Laboratory at Texas A&M University, is to create competitive advantage for wholesaler-distributors through development of research, tools, and education. CRDBP encourages readers of this blog to send in comments and e-mail this blog to other interested parties.

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