Article: Wednesday, 20 February 2019
If you are a manager and you regularly order goods to be manufactured for you, you have two choices: you can order them from an offshore low-cost supplier, or from a more expensive local supplier. Generally, the local supplier can deliver the goods sooner, so, if there is a sudden peak in demand, you’re happy to order the product locally at a higher price. The shorter the lead time, the higher the cost premium. Assistant professor Işik Biçer of Rotterdam School of Management, Erasmus University (RSM) has discovered that this demand uncertainty often causes supply managers to follow the wrong strategy. He has developed a tool, the Cost Premium Frontier, which calculates the cost premium that is justified for shorter lead times for some purchasing decisions in a number of retail situations. So, when to order offshore for lower prices, and when to order locally for a fast lead time.
Say you are in charge of the supply of fan merchandise for a professional football club. You order custom jerseys, hats, scarfs, pennants and smaller items, with the club’s brand logo on them. Under normal circumstances, there is a relatively steady demand for those products. It gets complicated when the demand suddenly peaks with an upturn in the club’s performance, perhaps, or suddenly drops. When there is a sudden peak, you might run out of products. When there is an unexpected drop in demand, you will be left with useless inventory. In both cases, you will lose money.
Işik Biçer analysed patterns in the demand for Reebok sports jerseys by some football clubs in the USA. Biçer says: “In general there are three types of demand. The first is regular sales. The second is a positive peak that occur after a success. And the third is a negative shock that occur after a failure. In general, big clubs, such as Manchester United or Real Madrid have steady sales and negative shocks. Their fans have high expectations and stop purchasing the team’s merchandise after a failure. Small clubs, like Excelsior Rotterdam have regular sales and positive peaks. Their fans don’t have high expectations and reward their club after an unexpected success by buying the club’s merchandise. For example, if Excelsior Rotterdam are promoted into the Champions League, that would be very unexpected and most likely result in a peak in demand for their merchandise.”
Supply managers tend to ignore demand peaks and shocks because of their unpredictability. Biçer: “Small clubs usually underestimate the value of local sourcing and big clubs overstate the value of local sourcing.” So, small clubs usually order their merchandise from offshore low-cost suppliers. If they are suddenly successful, they don’t have a local supplier in place who can supply them quickly with new product.
Large clubs that use supply managing tools to deal with the peaks and dips in their fans’ demand for club merchandise often overstate the value of the short lead times from local suppliers. Are local suppliers’ higher prices worth the convenience of a quicker response to sudden demands for more – or less – merchandise at short notice?
In order to help supply managers optimise their ordering processes, Işik Biçer has developed a tool, the Cost Premium Frontier, that calculates how much cost premium (i.e. the price differential between the price from low-cost offshore supplies and higher cost local supplies) is justified for reducing lead time. Biçer says: “This tool is not just for football merchandise of course, it can be used for any product. In my research, I also analysed point-of-sale data from a supermarket chain.”
So, when comparing a low-cost offshore supplier with an expensive local supplier, this new tool helps you to determine which price difference between the two is justified when you are dealing with demand uncertainty. It might change your strategy significantly.
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