Challenging traditional models of supply-chain design

Customers demand more choice from their online retailers and they want this choice to be delivered faster.

In an environment when next – and sometimes same – day delivery is becoming the norm, the traditional tenets of supply-chain design are constantly being challenged. Forget what you've been told about the trade-off between economies of scale and responsiveness – the concept of 'agility' might very well be the next frontier.

If a firm has a number of geographically-dispersed customers in a large region, how does it best serve those customers at the lowest possible cost?

Traditionally the answer has been to pursue economies of scale by establishing a small number of very large distribution centres or warehouses in cheap locations to which all orders are sent. The distribution centres can hold a lot of different items, though will often stock only a small number of those which are less in demand.

However, customers increasingly expect not only a broad choice of products but also quick delivery, typically on the next day or even the same day. The shipping costs associated with this centralised model, therefore, start to rise. To meet this demand, firms are likely to opt for large numbers of smaller distribution centres that are close to customers. However, smaller warehouses will not be able to stock a wide range of products, and, because of additional administration and communication needs as well as expedited delivery, are likely to cost the firm more.

Choosing which model to follow involves trade-offs between location, inventory and shipping costs. For example, the closer distribution centres are to customers, the lower the shipping costs – but location costs are typically higher. Added to which, neither model considers the supply chain’s ‘agility’: that is, its ability to respond quickly to changing environmental factors, such as unexpected fluctuations in customer needs. In this study, Ho-Yin Mak and his co-authors investigated what happens when you add ‘agility’ to the cost/benefit trade-offs of designing a supply chain distribution network.

One crucial element of agility is being able to shift products quickly around different distribution centres. When a firm stocks a wide range of products in a central warehouse, for example, it reduces the risk that products are out of stock when customers order them, but increases the average shipping cost and response time. Through ‘second-order inventory sharing’ and ‘dynamic fulfilment,’ firms can increase their agility. Firms share information about the availability of stocks in nearby distribution centres and reallocate orders that cannot be fulfilled by the nearest centre. Second-order inventory sharing is only activated if an order cannot be fulfilled by its primary – or nearest – distribution centre, minimising the additional shipping costs. In this way, it is possible to achieve the same benefits of operating large warehouses by virtually pooling inventory among smaller (and closer-to-market) distribution centres.

The paper’s analysis shows that enhancing supply-chain design models with agile tactics changes some of the strategic trade-offs associated with both scale-focused (centralised) and proximity-focused (smaller local) models. For example, to enable higher product availability and avoid stock shortages, a non-agile firm would need to consolidate the warehouse network (i.e. manage fewer and larger warehouses). An agile firm, on the other hand, would operate more warehouses closer to the markets and simply increase their virtual stock-pooling. However, if shipping costs incurred by dynamic fulfilment increase, it could become more cost-effective to return to a centralised network of distribution centres.

Agility and proximity considerations in supply chain design. is co-authored by Michael K Lim, Ho-Yin Mak and Zuo-Jun (Max) Shen, and is published in Management Science.