Every large auto OEM Company contributes significantly to the country’s economy. Not only does it contribute through its own business but also through a large cluster of Tier I and Tier II suppliers, which are set up to supply parts to the OEM company. With innumerable parts going into one automobile, the number of vendors involved is huge. The volumes done by the vendors are tightly linked to the volumes produced by the OEM. No other industry is so tightly coupled. With such an industry structure, the actions of the OEM have cascading effects on the entire supply chain. To understand more, let us go through the two case studies.&nbsp;Case Study 1In Oct 2009, I met the owner of a Tier II supplier to the auto industry. He was at his wit’s end in managing supplies to the OEM customer and was under considerable stress. By this time, for the OEMs, the so-called recession was over, and OEMs’ production figures had improved considerably. Though the OEM’s production figures had increased, the supplier’s business financials were in a mess. His cash was completely drained out, and his borrowings had increased significantly as he was not making enough money to pay off his fixed expenses and earlier purchases. His interest burden had increased significantly. He was struggling to get the necessary skilled manpower to manage the increase in load from his customer – the Tier I supplier. He was struggling even to produce quantities that he could manage easily before the recession. He was struggling to get the manpower, and at the same time, due to his cash position, he was hand-to-mouth with the raw material.&nbsp;The situation was further compounded by the changing schedules from his customers. Every time the schedule changed, he had to buy the new requirement of raw material, while his already scarce cash was locked in something he had bought three days back. His deliveries to his customer (Tier I supplier) were suffering in terms of quantity and reliability. As is the normal tactic, in such situations, each supply chain partner threatened the other with business diversions if they did not fall in line. In the short run, the business transition is difficult, so the supplier’s problems cascaded the entire supply chain, and the OEM production schedules got seriously affected despite the demand.&nbsp;Case Study 2Let us take another case in 'normal' circumstances. One OEM had to meet the year-end stretch target, so it started a promotion campaign to push a particular model. The OEM decided to produce this specific model at a rate three to four times higher than the normal rate. The plan was made for Jan to March 2011 with very short notice. They did produce the quantity in January to March and achieved very good numbers for the year. After March, the rate dropped to less than 40% of the rate of January to March, as a substantial quantity of these vehicles produced in the January to March period were either in the FG of the OEM or in the FG of the distributors.&nbsp;Higher numbers mean great figures for all suppliers as well. Right? Not so for some! One of the parts required an imported raw material, which the supplier had planned according to the normal rate. Under normal circumstances, the lead time to get the material by ship is about 60-70 days. As they were a single source, they had no choice but to airfreight this material to make it available for higher quantities from January itself. Unfortunately, the airfreight charges for this material are more than 15% of the cost of this material, and this material was nearly 50% of the material cost of the final product. Also, they had to arrange for additional borrowings for the huge increase in this material’s requirement as the terms for this material was on payment on landing in the country. The supplier also had to ramp up its production capacity to cater to this huge demand, which required investment in certain fixed assets. With firefighting, increased expenses and additional investments, they did meet the OEM’s requirement. Could they make the planned profit for this product? It doesn’t require much imagination to calculate that. Compound this with the fact that this supplier also ordered material to arrive by ship to cater to the higher rate for April-June. As the volumes have decreased considerably, this inventory went up to nearly 120 days of requirement. Fortunately, the product is not the highest volume product for this supplier, hence it could still manage the burden.&nbsp;What about the others who do not have this advantage? They can become weak due to increased expenses and considerably increased working capital. This does affect their delivery performance to the OEM, which in turn affects the plans of the OEMs, and then the vicious cycle of continuously changing plans starts affecting other suppliers and OEMs. The two case studies are not isolated. Industry players will agree to this and can narrate many such stories. Is this not what Lean was supposed to solve? One of the management philosophies that has inspired almost all auto companies is the Toyota Production System or the concepts of Lean Management. One of the fundamental philosophies of Lean is the concept of flow — the inventory in the entire supply chain should flow at a rate dictated by the pace of the market demand. Many auto companies swear by the concepts of Lean thinking, but the above case studies point to a lack of flow in the entire chain. Is it a case of ‘lip service’ to Lean, or is it that most auto companies are actually not in a position to implement the flow concepts of Lean beyond their production shop floor? For answers, let us understand the OEM way of working.&nbsp;The OEM Way&nbsp;Most OEMs provide monthly component requirements derived from their sales forecast of vehicles but prefer to pick the components daily based on actual consumption. They limit their component inventory to a maximum of a day or two, and their offtake is aligned to actual consumption – a perfect pull system. But at the same time, they expect the suppliers to operate on a push mode – the monthly or weekly forecasting system. As with every forecast, the actual vehicle production is different, and as a result, the vendor production system is in a frequent mode of expediting. Not expediting every time helps, which means some vendor misses out on the immediate requirement of a component. The problem gets aggravate because the OEM is an assembly plant. Even a single missing part prevents the production of the vehicle. But at the same time, the OEMs want their capacity to be utilised fully. With many items in various states of availability, they have no option but to load the lines with anticipated arrivals, resulting in some vehicles being loaded much more than the daily rate conveyed to the suppliers. A small variation in forecasting in one model can result in a surge of production in some other SKUs.&nbsp;If the suppliers do not supply according to the daily changed plan and cause line stoppages with the OEM, they get penalised. Frequent failures to supply carry a huge business risk for the supplier—they may lose business permanently. So suppliers try to overcome the problem with their own buffering—build finished goods inventory to cater to any increases. They do their own forecasting on what will sell and try to maintain a high inventory of parts/subassemblies from Tier II suppliers. The same logic applies to Tier II suppliers, but they have to keep an even higher level of inventory as the Tier I is producing in batches, which means that if the OEM is carrying 2-3days of parts, the Tier I will carry 15-30 days of FG and 15-30 days off parts inventory. The Tier II vendor carries about a month of FG+ WIP (due to high batches of production) and about 30-45 days of RM. The problem is despite all the inventory, the supply chain is in a continuous state of expediting due to poor availability at an SKU level. This is a normal state of affairs for managing an auto supply chain. Frequent schedule changes and expediting are the way of life. During a time of growing demand, organisations have a way to stay in equilibrium and make some money despite the severe issues of flow in the entire supply chain. But the same supply chain can inflict devastation on itself when the end demand starts moving downwards.&nbsp;Blaming RecessionLet us analyse the events in the middle of 2008. OEMs were getting the signals that the market was slowing. The finished goods inventory was pilling up, and distributors were filled up to the brim. Under the pressure to utilize capacity, the OEMs kept on producing to full capacity, obviously based on a forecast, for about two months. When finally, it was no longer possible to push further, the OEMs took the decision to cut down their production, nearly three months of FG was available in the sales pipeline.&nbsp;The same effect was seen with the Tier I and Tier II suppliers; they continued to produce full blast even after the OEMs started to reduce their production. This led to the ballooning of inventory at individual nodes. With the lower sales rate, the FG inventory at Tier I and Tier II suppliers was nearly 45-60 days, and so was their RM. In the period that the OEMs were asking for much lower volumes (their factories were operating at lower production rates), the suppliers were supplying from FG. They could foresee their workforce idling for about 2-3 months, while the net inflow in the company reduced significantly. They had no option but to trim down the workforce considerably. Tier I vendor slowed down for an additional 3 months, and the Tier II vendor for an additional 6 months.&nbsp;When the time came to ramp up, the workforce and capital were not available, and these suppliers took time to gather workforce and capital. The last to react and last to ramp up was the Tier II/III supplier. By the ninth month the inventory in the pipeline dried up. Meanwhile, the reduced output did not bring in enough gross contribution to pay all the fixed expenses. &nbsp;The other fixed cost head that gets compromised in such situations is the interest on working capital. So when the OEM wanted to ramp up, the suppliers was not ready; that took another 4-6 months. The OEMs are better equipped to survive the slowdown for a shorter period of 6-9 months. Are the Tier II equipped to float for 12 months or more at less than half the capacity utilisation? They are not, and hence, you hear horror stories. Also, those who survived are not ready to further the risk by increasing investments. If they increase investments, i.e. fixed costs, the period for which they can survive such a slowdown decreases. So we have a key question before us: “Was the impact of the recession so bad?” or did the OEM’s way of operations worsen the situation and cause the real damage.&nbsp;What Do We Learn?When demand started falling decisively, the level of corrections imposed on the supply chain partners farther away from the consumption point was very severe. This effect is known as the bull-whip effect, and this time, the whip almost wiped out a few players.&nbsp;The reason for such devastation is the lag in reaction to the change in market demand. The higher the lag in response, the bigger the damage. The lag in response is triggered because of a push mode of operations between the distributors and the OEMs, which cascades into push mode between suppliers and OEM production. The monthly forecasting system, along with pressure on department managers to meet their monthly or quarterly performance targets, increases the lag in reaction time in such a supply chain.&nbsp;So, we need a supply chain across all nodes to produce/deliver only according to actual consumption. But is this not what Kanban supposed to do? Why is it not implemented in the entire automobile supply chain? There is not a single case study in India of principles of Kanban implemented right from distributors to Tier II component suppliers. This is despite the fact that the principles of TPS are well documented and known to the industry for decades.&nbsp;Theory of Constraints (TOC) ApproachEli Goldratt, in his path-breaking article ‘Standing on the Shoulder of Giants’, clearly proved why it is almost impossible to implement Kanban in an environment of changing product mix, varying demand loads across time buckets, and rapid new product introduction at component levels unless one is able to impose smoothening of demand on to its customers, the way Toyota has done. Not many auto OEMs are in a position to implement such smoothening. So, they implement only parts of Lean Management which is easier to implement (like principles of SMED, 5S, standardisation, etc.).&nbsp;The TOC flow solution framework works for the entire supply chain, from dealers to Tier II suppliers. The extent of variation in demand for the vehicles across weeks at the secondary sales level is not as high as the eventual variation imposed on the supply chain. But it does exist and is not entirely uniform across weeks. A mechanism that buffers the supply chain partners even from this variation will reduce the emergencies and chaos to a great extent. Such a solution should reduce the level of variability and prevent misuse of capacity (producing what is not required immediately) and locking of working capital. OEMs should hold a Finished Goods (FG) Inventory buffer designed at an SKU level. This is different from the default FG carried by OEMs.&nbsp;The central warehouse is the place to hold the designed buffers, as it is the aggregation point for all FG inventory. The forecasting accuracy is better at the aggregation point than at the dealer level. But to always maintain the designed buffers, the inventory should not be pushed to the dealer to meet targets of primary sales. They should supply only to real demand and not supply for inventory. Supply has to be as per consumption or ‘pull’ from the secondary sales or an end-customer order. For some SKUs where the tolerance time of the customer to wait is lower than the transportation time from the central warehouse to the dealer, the dealer can keep a buffer of regularly sold SKUs to cover paranoid sales in the replenishment time from the OEM FG warehouse. The other infrequently ordered SKUs can be ordered from the OEM FG warehouse, as for such items, customers do have adequate tolerance time. The dealers communicate their daily buffer status, and OEMs dispatch to fill these buffers as they get truckloads (Order daily, Replenish Frequently).&nbsp;The buffer depletion of the central warehouses provides the order quantities to the plants, which the plant can club over SKUs to get the best out of their plants. So, the plant does not operate on sales and production forecast – they operate their production based on consumption signals from a central warehouse. The priority can be a simple signal of the risk to stockout, which in the TOC solution is called buffers management (the stock is divided into three equal zones, with the 0-33% stock level being the red zone, the second 33% being the yellow zone and the last 33% being the green zone). The ‘red’ SKUs will always get the priority. The plants should not produce more than the quantities suggested by the buffers. This prevents the bull-whip effect on the suppliers. The negative is that some production lines may not be used from time-to-time when correction is required. The periods of small corrections are far better than taking a huge correction of operating at half the load or shutting it off for a long period of weeks/ months when the inventory piles beyond the working capital capacity of the OEM. The above steps will help in smoothening production to a large extent. Further, smoothening can be done for the Tier I suppliers, who can also maintain similarly designed buffers decided by consumption by OEM rate per day x their production lead time x a factor of safety. The OEM relays its daily requirement to the Tier I vendor and, it supplies from its buffer. Thus, the OEM can get varying quantities across components. The depletion of all SKUs is relayed to the plant every day. Based on the buffer penetration and colour priority the Tier I vendor takes up its production. Thus, it is decoupled from the daily fluctuations of the OEMs and can plan its batches.&nbsp;The buffer can be reduced by reducing the production lead time; the Tier 1 vendor maintains a buffer of its components and raw material, again in buffers with the three colours. This buffer status (stock level and colour) is relayed to the Tier II vendor who supplies from their FG buffers to fill these buffers. What happens when the secondary sales rate changes? There exists a mechanism in TOC called Dynamic Buffer Management (DBM) which adjusts the buffers of SKUs as the sales/ consumption rate or the lead times change. If the SKU is in red continuously for the replenishment time, the buffer is increased by 33% and if green for more than two replenishment times, it is reduced by 33%. With this system any variation in the OEMs’ sales is relayed within days to the Tier II and III suppliers.&nbsp;The OEMs can plan as per the market requirement and get out of the vicious loop of unwanted inventory of vehicles piling up in its warehouses at the dealers and affecting the sales as the credit limit of the distributor dries up due to non-moving stocks. The plants of the Tier I and Tier II suppliers are decoupled from the fluctuations of the OEM by the buffers, allowing them to get the maximum out of their plants. The system also prevents inventory buildup against a forecast, which could go wrong, thus assisting in effective working capital.&nbsp;TOC: An Alternative?The TOC system is built on the flow principles of the Toyota Production System. However, it scores over the Kanban system as there is no need to force the smoothening of production to the final customers. The TOC concepts of aggregation at the central warehouse and supply only as per consumption prevent the artificial spikes; the actual demand variation in secondary sales is managed using the Dynamic Buffer Management instead of a forced smoothening to the end consumer. The implementation of Flow principles is a paradigm shift in managing distributors and suppliers. The starting point is the flow of inventory between distributors and OEMs. Hence, this can only be led by the OEMs. If an OEM implements the principles of flow, it not only helps itself but also protects a cluster of companies from the damaging bull-whip effect.&nbsp;

An SOS for the OEMs

Download PDF

<h4>An SOS for the OEMs</h4> &nbsp;

Explore the critical challenges faced by auto OEMs and effective strategies for supply chain management from Vector Consulting Group's Kiran Kothekar.

Let's Empower Growth