A Letter to Swiss Manufacturers

Swiss manufacturing companies are currently under extreme pressure from unfavourable exchange rates with the Euro. Their supply chains have huge potential for profitability increase, but unfortunately, the traditional planning tools embedded in their ERP system do not allow them to convert these potentials in real benefits. Demand Driven MRP is a new planning, inventory management and execution framework that has demonstrated impressive results and is revolutionizing supply chain management around the world. The survival of many companies may depend on their ability to innovate their supply chain operating model and become demand driven.

You are in trouble. You are a Swiss manufacturing company and you are under pressure. The recent developments in exchange rates make your goods forbiddingly expensive for international customers. At the end of 2007 the conversion rate was 1.65 CHF for one Euro. In 2012 the Swiss national bank managed to stabilize the rate at 1.20. Now, the rate has stabilized, on its own, at around 1.05. This means that for a European customer your goods in 2012 were 37.5% more expensive and now they are 57% more expensive than they were at the end of 2007.

There are some who would argue that the situation is less bad than it seems. One such argument is that your Swiss products are not competing on price but on quality, reliability and service. All true. But still, a 57% premium on price is a lot. And Switzerland is not the only country renowned for its high quality goods. Germany is, too.

If there ever was an ideal time to take a long, hard look at your supply chain operating model, then this time is now. I am not talking about moving operations to China or some other remote and low cost manufacturing countries. Quite the opposite in fact. I am also not advocating slashing costs everywhere you can find them – again: quite the opposite in fact; some cost cutting programs often damage the substance of the company, are not sustainable or may even have an opposite effect.

What I am calling for, is for you to challenge the most fundamental assumptions of how you manage your operations, and discover that a good part of the solution lies in your hands.

Let’s start by stating what is the goal of every manufacturing company: make money. To achieve that, you buy materials, convert them into finished goods and sell them to your customers. The more efficiently and effectively you can close this loop, the better your returns. Returns are determined by the cash velocity, which is the rate of net cash generation. This is defined as the sales (in Swiss Francs) minus truly variable costs (also known as throughput dollars or contribution margin) minus period operating expense (1). 
Cash velocity, in turn is determined by flow, which is the rate at which a system converts material into products required by a customer. The emphasis on required by a customer is central. Flow is meaningless if nobody wants to buy what is flowing. And here is where your company may be failing and where there is a huge potential to recover cash. In fact, many companies, under the imperative to cut costs take decisions that actually impede flow. All tactical actions aiming at increasing equipment efficiency and utilization, with the objective of decreasing unit cost are in fact resulting in hindering flow and increasing the total supply chain cost. There are multiple reasons for that, and going into depth would require writing an entire book. Here I will just shortly give the two main reasons, that revolve around common fallacies in supply chain management and leave it at that. If you want to know more about the issue you are welcome to read the literature (1). The first big fallacy is that we generally think of supply chains as linear systems. In a linear system, the whole is the sum of the parts. If I want to optimize the total cost in a linear system I just need to optimize the costs of its individual parts. Therefore I cut down my organization into functional silos and I mandate each function to optimize. Wrong! Supply chains do not work that way, because they are not linear systems. They are Complex Adaptive Systems (CAS) and they respond to a complete different set of rules. In fact, using this linear approach will guarantee that the whole system will be sub-optimal. The second fallacy is the unitized fix cost fallacy. Since the advent of MRP II it has become fashionable (yes, fashionable) in many organizations to track standard costs (which are including allocated fix costs and depreciation) and use these cost reports to drive tactical decisions. This drives a whole set of wrong behaviors with the end result of damaging the operations performance. The only costs that your should use for tactical decisions are the ones that are variable in the horizon in question. On a short horizon almost all costs are fixed. Even personnel cost are fix within a three-month horizon (if you exclude overtime and week-end shifts).

Your MRP is definitely not helping you. There is a third obstacle that stands in the way to achieving flow, and it is put in place by the very planning systems that should promote it in the first place. As most other companies, you may have implemented some sort of ERP system. One of the components at the core of each ERP system is a planning module built around an MRP (Material Requirement Planning) engine. This engine was developed in the ’60s and ’70s of the last century to respond to the planning challenges that companies were facing at that time and to leverage the power of these wonderful new machines that were appearing everywhere: the computers. MRP performs well under a set of very specific assumptions. Whether those assumptions were met at the time of its inception is dubious, but in any case they were met sufficiently well for MRP to represent a break-through. What is certain is that these assumptions are not met anymore today; and the results in term of lost operational performance are catastrophic. What is even more certain is the fact that the globalized marketplace is developing in a direction that makes these assumptions more tenuous every day.

The primary assumption for MRP to perform well is that the demand signal is accurate, both in time and quantity. This may well have been the case in 1970, if your company had a full order book and you were operating in a make to order environment, using raw materials procured locally within a relatively short lead time. What MRP does is very simple. It takes the demand signal and calculates backward in time what needs to be ready by when for each manufacturing step, including the procurement of raw materials. But let’s look at the reality today; your customers don’t want to wait for the entire manufacturing lead time to get their products. You may be procuring some materials and intermediates globally or you may be outsourcing to third parties around the globe; lead times are longer than they used to be. This forces you to procure and manufacture some of your products based on a forecast. This is the first big assumption break. A forecast is not an accurate demand signal. Procuring goods or running production based on forecast data is guaranteed to build inventories that your customers don’t want yet. And while you are doing that you are using materials, capacity and resources that could have been better used to manufacture products that your customers actually want. This goes against flow. As said earlier, MRP calculates backwards in time each step of the bill of materials. There are several parameters in the MRP that drive its calculations. Some of them have a truly dreadful impact: dynamic safety stocks, minimum order quantities, rounding factors, time fences and so on contribute to amplify the error in the demand signal and amplify the variability which is inherent to every manufacturing process. This effect is not linear. A small change in the initial forecast will result in major shifts down the manufacturing chain. These effects are well documented and known under the terms of bull-whip effect and MRP nervousness. Because in an MRP the entire bill of material is made dependent, all variability in the system is amplified. The result of all this is that the supply chain performance of your company has become just unacceptable. Inventories are generally too high and not positioned where they are needed. Some inventory positions are too high, resulting in slow moving and obsoletes, while other positions are too low, resulting in loss of sales or delay in production due to missing materials. When these delays in productions affect bottleneck resources, this results in an additional loss of precious capacity. The costs of correcting these inventory misalignments are enormous and they are never captured as cost of goods. These costs include all frenzy expediting activities that result in massive productivity losses (meetings, emails, phone calls, re-prioritizing, rescheduling, crisis management), distribution costs (express shipments), capacity loss (over-utilization and rescheduling of capacity bottleneck resources). At the end of the day you may well have achieved an acceptable service level to your customers, but at what cost!

Demand Driven supply: a revolution in supply chain management. In the last 20 years or so, many process improvement philosophies have been proposed and used more or less successfully. Lean Thinking, Theory of Constraints (ToC), Six Sigma, have all provided benefits in the past and will still be useful in the future. Unfortunately, many implementations of these concepts were celebrated as local best practices but never managed to spread across entire supply chains. There may be several reasons for that. One primary reason is that none of these methods could provide a viable planning and execution alternative that can be deployed across an entire supply chain. In addition, major ERP houses with their marketing power and the complicity of corporate IT departments were able to steamroll local Lean best practice implementations under the “standardization” imperative.

In the last few years however, things have started to change. Some of the best ideas from Lean, Theory of Constraints, Six Sigma and planning best practices have been combined to create what is today officially known as Demand Driven MRP (DDMRP). Demand Driven MRP provides a complete planning, inventory management and execution framework that can be deployed to entire supply chains, including the integration of customers and suppliers. Powerful DDMRP planning software is available as Software as a Service (SaaS). These software packages are extremely flexible, can be implemented within weeks or months and come at fraction of the typical cost of an MRP implementation. Demand Driven is fully aligned with CAS theory. The two main principles behind Demand Driven are a) the decoupling of the supply chain in discrete units by the use of specially designed stock buffers. These buffers are positioned in critical points in the supply chain and have the function of stopping the variability (bull-whip, MRP nervousness) to be passed across, both from the demand side and from the supply side. And b) the use of true demand signals (not forecasts) to generate manufacturing orders, purchase orders for raw materials and distribution orders (stock transfer) for finished goods. Hence the tagline of DDMRP: Position and Pull. A complete description of the methodology was first published in 2011 in the third edition of Orlicky’s classic “MRP” (2). There is a crescent number of companies that have and are implementing Demand Driven MRP or more generally Demand Driven Supply approaches (3) and the results in all cases are stunning. Where there used to be chaos on the shop floor, due to constant expediting, now there is quiet; schedules are stable and capacity is fully utilized to produce what matters. Planners can generates their production plans in hours instead of days. Customer lead times are shorter and market responsiveness is increased, and with it sales and financial returns as well. Inventories are cut by 30-50% and optimally distributed to protect sales or critical operations. Flow and cash velocity are maximized and result in true financial benefits and increased competitiveness.

While Demand Driven will not solve all issues encountered by your Swiss manufacturing company, it can certainly help improving your cash position and reduce your total supply chain cost. These cost savings could be passed to your international customers, thus allowing you to recover some of the lost competitiveness. Additionally, you can use the increased responsiveness to the market as a competitive advantage: some customers may still be ready to pay the Swiss premium for a shorter delivery lead time and better service.

  1. Debra Smith, Chad Smith: Demand Driven Performance (2013, McGraw-Hill)
  2. Carol Ptak, Chad Smith. Orlicky’s Material Requirement Planning, Third Edition, (2011, McGraw-Hill)
  3. Implementations have succeeded in all kind of industries, from Engineering to Order to FMCG and retail and all in between.