Understanding the Costs of Alternatives — Assigning Costs to the Range Forecast
Once the range of uncertainty is quantified, the company can next identify its alternatives for managing the possibilities and what each alternative will cost. There are numerous variables associated with each step up — or down — in capacity; and complex, often sequential dependencies complicate matters. For example:
- How does a company know exactly when a capacity increase is needed?
- How exactly should the company expand capacity? In what amounts and at what locations?
- Should the company build a new plant or add a production line in an existing one? Building a new facility takes time and significant investment — will market demand last? Will it be subject to low capacity utilization or high shortages when the capacity comes on-line? How does this affect revenue and market presence?
- Should the company outsource production? To whom, for how long and at what price?
While many companies turn to outsourcing, it can only provide flexibility based on properly structured supplier agreements, which historically are based on point forecasts. For example, a larger volume commitment to the external supplier often yields a better price but exacerbates the risk of excess capacity. Alternately, the company may reserve flexible capacity with an option to release if it is not required, at a price that can wipe out flexibility gains. With SCRM techniques, the decision-making process captures these complex dimensions, allowing the company to not only quantify the range of possibilities it may encounter, but also to know precisely its alternatives at each step.
A Portfolio of Options
Each alternative for a new product launch, component or capacity decision constitutes an option. An option consists of the ability to set up capacity expansion ahead of time, knowing how much it will cost, how long it will take to put into effect, and what its additional output will be. All sources of capacity — in-house or outsourced — should be viewed as options in a portfolio.
The company with a capacity range of 10,000 to 80,000 units would find it cost-prohibitive to spend on 80,000 units' worth of capacity. Instead, a SCRM approach would provide a portfolio of options that defined the costs of an alternative that would take the company from 30,000 to 40,000 units; another option that take them from 40,000 to 50,000 and so on. By breaking uncertainty into options, SCRM enables companies to cost-effectively structure their flexibility ahead of the event — and be prepared.
While many organizations rely on visibility solutions to alert them to shortages or excess inventory, by the time these solutions come into play, it's too late to cost-effectively avoid the problem. In contrast, SCRM techniques employ forward-looking capabilities — predictive analytics — enabling notification when an anticipated situation is pending — with time to exercise the appropriate option. They will also guide the company when to use its options, how much to use them and when to take them off the table. In effect, an SCRM approach will tell the company It looks as though a risk is pending; this is the appropriate option for avoiding the risk; this is what it will cost and this is the benefit.
Structuring Supplier Agreements That Win
With range forecasts in hand, OEMs can work with their suppliers to structure agreements that provide a fairer sharing of risks and rewards. After using a SCRM approach, the semiconductor testing equipment manufacturer communicated with its suppliers that demand would fall between X and Y levels, and provided them with trade-off analyses that granted flexibility through different lead times and location considerations. The resulting supply agreements reflected low-, medium- and high-demand scenarios, enabling suppliers to make their own decisions about how they could best meet each scenario. Eventually, the OEM was able to prioritize its supplier relationships based on suppliers' abilities to perform under the new approach.
Minimizing Under- or Over-Investment