Piorities in Supply Chain Design
Many executives operating regionally and globally are shifting their priorities to drive supply chain design.
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AT LAST YEAR'S COUNCIL of Supply Chain Management Professionals (CSCMP) Annual Conference, an executive panel from the fast moving consumer goods, electronics, and petroleum industries reflected upon the challenges of designing and optimizing a supply chain in today’s dynamic environment. During executive education sessions, I have reflected on these challenges and how they have changed over time with executives from many firms around the world. While they had often not organized their decision criteria in the same format, most executives operating regionally and globally agreed with the general shift. After ending a week and a half in China with further discussions, I am even more convinced about the nature, importance and implications of the shift.
My comments this month review this shift and discuss the implications for today’s logistics and supply chain executive. The shift refers to the prioritization or importance of the factors driving supply chain design. My training and experience in supply chain design suggests that the major decision factors, in no particular order, include:
1) Demand location; 2) Labor cost; 3) Material cost; and
4) Transport cost.
Demand location refers to the geographic location and shipment profile (relative volume, size and characteristics) of the market. All other things being equal, firms would rather locate production and/or distribution centers near the consumer markets. The fact that demand in Asia, India, South America, and Eastern Europe is growing at double digit rates strongly motivates global firms to shift supply chain activities to those regions. Labor cost refers to the relative cost of production and distribution activities such as manufacturing and handling. This factor is a driver of the move by many firms toward low-cost-country production such as in China, India, and Eastern Europe. Labor cost includes direct labor rate as well as both benefits and assigned overhead cost. Material cost refers to the total cost of the raw material and components, including both the direct and indirect cost. The direct cost represents the specific purchase cost of the material as well as the duties and packaging. The material indirect cost includes the transaction and risk related costs such as security, obsolescence, and potential intellectual property risks. Transportation cost includes the freight cost required for obtaining raw material, moving material between plants and distribution facilities, and ultimate distribution to customers and consumers.
Tax structures and tax rates have always been design considerations, particularly when selecting between alternative sites within a local geography. These tax incentives have often been done through property tax allowances or holidays. While such tax incentives have been used to attract facilities to specific municipalities within a specific region, it was not typical that they could make enough difference to substantially change the region. Of late however, tax allowances have been extended to include holidays from value-added, income, and duty payment terms. As a result, the location of production and other value added sites is now often strongly influenced by regional and national tax strategies. For example, Ireland’s use of reduced value added tax rates on manufacturing of electronics and pharmaceuticals has done much to return industry and jobs to the Emerald Isle. Similarly, Singapore has established tax advantages for goods that have value added activities completed in Singapore. The value added activities could include everything from physical manufacturing processes to inventory risk management. Major Chinese cities are employing the same strategy to attract firms or industries to their industrial parks, and their success is copied in other countries, such as Vietnam and Cambodia. Even the U.S. has witnessed increased interest in “Free Trade Zones” or “Tax Free Zones” as a motivator to attract jobs.
According to last year’s CSCMP panel, the result has been a shifting in the priorities for supply chain design. While proximity to market demand is still the primary factor (“Location, Location, Location”), the panel suggested that the order of importance (most to least important) for the remaining four factors is: 2) tax policy; 3) transportation cost; 4) production cost; and 5) raw material cost. In many cases, the differential due to tax policy often overwhelms the differences due to production or labor rates.
In many discussions with executives over the last year, I have witnessed substantial agreement regarding the veracity of this shift. This shift in factor priority offers some interesting challenges for logistics and supply chain managers.
First, it is important that supply chain managers understand the various dimensions of local, state and federal tax policy and how that may impact supply chain design. The use of incentives for property, income, value added and corporate taxes and their relative impact on various supply chain activities need significant consideration for supply chain design. As an academic, I find these had not typically been discussed in supply chain curricula and executive education. Now they need to be significant considerations.
Second, use of tax policy as a strong consideration in supply chain design introduces a number of issues for logistics and supply chain management. These include infrastructure concerns, tax policy dynamics and activity integration. Infrastructure concerns refer to the logistics and transportation infrastructure that is in place to support supply chain activities. For example, while both Ireland and China used tax incentives to attract supply chain value added activities to their countries, the transportation infrastructure was not initially able to handle the capacity required. While the Irish infrastructure is beginning to catch up, it will be a while before the Chinese infrastructure can accommodate the new level of activity. Supply chain and logistics managers need to understand the implications of these infrastructure problems and be able to communicate them with the planners evaluating the design strategy. Tax policy dynamics refers to the fact that such tax incentives may change quickly, resulting in a need to adapt the supply chain design. Specifically, the decisions based on the tax incentives are inherently long term while the tax incentives may sunset after a prescribed time or may change due to the political environment. Activity integration refers to the combination of locations within the supply chain when specific value added activities take place. For example, the tax incentive may motivate production or other value added operations or inventory risk. For example, some firms manage global or regional inventory from Singapore by having a Singaporean entity purchase product from global production operation at the standard production cost and then resell it to markets around the world, resulting in the profits being generated in a tax preferred environment. While there are certainly limits in a firm’s ability to manage the location of global profits, such strategies can make a significant impact.
Third, since tax incentives and transportation cost have an increasingly important role in supply chain design, logistics and supply chain managers need to develop a deep understanding and awareness regarding their dynamics and interactions. Specifically, what is the relative impact of value-added income, property, or income taxes on specific supply chain activities? Similarly, changing transportation cost resulting from capacity congestion, lane imbalances, and mode shifts can be an incentive for a change in the supply chain network design.
These challenges call for the enhancement of transport cost dynamics and inclusion of tax policy implications in supply chain academic and management education. These are two topics that not many supply chain managers have much knowledge about today. Individuals involved in supply chain design need an in-depth understanding of the relative impact of transportation and tax incentives and their dynamics based on policy, fuel volatility, congestion and capacity. In an era of increasing congestion and governments looking for employment and growth, it is likely that more locales will consider these strategies as a means to attract jobs. It is important that supply chain and logistics managers begin to develop this understanding to accurately evaluate, compare, and explain the relative trade-offs.