The diamond supply chain

Some retailers like to vertically integrate. For example, in clothing the two large players (Gap, Inditex/Zara) are vertically integrated into production (though not to fabric production). Other do not. For example, in athletic shoes (Nike/Adidas), the firms like to outsource production and do not reach all of the way back into the production of materials (such as cows for leather). The Internet giant, Amazon, doesn’t make the stuff it sells (I suspect it outsources production of the Kindle) and the physical world giant, Wal-Mart, also primarily sticks to retailing.

The supply chain for diamonds is special, in particular due to the existence of the “legal cartel”, De Beers. The WSJ yesterday (Diamond Industry Makeover Sends Fifth Avenue to Africa – 10/26/09) reported how Tiffany’s has invested in diamond cutting and polishing in Botswana. Why would they do this?

The technology for diamond cutting and polishing doesn’t seem to be particularly complex or proprietary (protected by patents, etc.). It isn’t a very capital-intensive step in the process(unlike mining), which is reason to get into it (i.e., it isn’t a big investment) and reason to let others get into it (there must be lots of competitors due to the low capital requirement). There doesn’t seem to be evidence of a cartel at that step in the process or substantial barriers to entry.

One theory is that controlling the diamond supply chain facilitates branding, and in particular avoiding the tarnish of “conflict diamonds” (see Blood Diamonds).  But, to quote a quote in the article:

“We really want the focus…to be on the quality of the diamond ring, not how it came to be,” said Mr. Kowalski, the CEO.

In other words, they are not investing in Botswana cutting and polishing to convince consumers that their diamonds are “clean”. In fact, they want to completely avoid the discussion of where their diamonds come from.

Hence, it must be that (i) the ROI on this investment is at least as high as opening up new stores and (ii) the ROI is high because vertical integration into this step creates efficiencies that cannot be had from buying cut and polished diamonds on the open market. (i) is plausible if they are running out of good places to put their stores, but they might not want to signal that to Wall Street. (ii) is plausible if the market is not sufficiently efficient to drive down margins.  Alas, the article doesn’t provide enough information to know if these theory holds water or not.

Capacity shortages of H1N1 vaccine

Have you been able to get your H1N1 vaccine? Probably not – it has been widely reported that there are delays in the distribution of this vaccine. The interesting question is why? Reading a bunch of articles on this topic doesn’t shed a whole lot of light. But one figure jumps out at you – as reported in WSJ (10/19/09 – Delay Undercuts H1N1 Vaccine Campaign), the U.S. government has ordered 251 doses from 5 manufacturers. The current U.S. population is just over 300 million, so they have ordered enough to vaccinate over 80% of us. To put this in perspective, the U.S. normally vaccinates about 100 million. In fact, 114 million dose of seasonal flu was ordered in addition to the 251 million does of H1N1. The two types of vaccines are made with nearly identical manufacturing processes. So that adds up to about 365 million doses of vaccines, which is at least 3 times the typical production volume.

Given that manufacturers had to more than triple their capacity, it is not surprising at all that they are behind schedule in production.  Making matters worse, the quick ramp up may have contributed to the their lower-than-hoped-for yields. 

So instead of complaining that you can’t get an H1N1 shot, maybe you should be thankful that they have been able to produce as much as they have. Given the number of deaths among children, let’s hope better news will come soon.

Volatility in autos – and the demise of brand loyalty

Any casual observer to the auto industry can sense that brand loyalty has been declining. But the following graphic, posted in today’s NY Times (http://www.nytimes.com/2009/10/21/business/21auto.html) illustrates how dramatic the decline has been:

So what does this mean for strategy? Clearly, this has interesting implications for marketing (does it mean you have to do more advertising or less?).  But it also has interesting implications for operations. Logic suggests that if brand loyalty decreases, market shares should be more volatile – customers will move quickly to products they like and then just as fast they will move away to another brand’s products. It would seem that this places an extra premium on flexibility – it should become (or has become) harder to predict a model’s market share, and so flexible capacity is needed to manage the unavoidable demand-supply mismatches.  Throw in uncertainty in the economy, fuel prices, and the diffusion rate of green transportation and you have a very challenging environment ahead – as if we didn’t know that.

It isn’t your father’s PC industry anymore

My first PC was an IBM PC with an Intel 8088 microprocessor, two floppy disk drives and a whopping 64K of RAM (not 64MB or 64G, the 64,000 variety) – and it cost about $4000 in 1985 (but my father worked for IBM so we got it for the employee discount price of something like $2700). HP is currently selling a laptop through WalMart for $298 (or $148.47 in 1985 dollars, http://data.bls.gov/cgi-bin/cpicalc.pl). 

The PC industry has gone through many stages in which one firm was on top. Apple started it, then IBM took over. IBM tripped in the early 90s and Dell took over. Dell started to stumble about 5 years ago and now HP is on top as we see in the following graph reported in WSJ (HP wields its clout to undercut rivals, 9/24/09):

So how is HP able to do this. First, they are working with small margins, razor thin 4.6% margins. Next, the article gives some other clues to their strategy.

 (1) “Simplifying the specifications of the product”

i.e., reduce product variety so that contract manufacturers can have higher volumes and thereby offer lower prices. This is a standard recommendation in an OPs class.

(2) ”By getting orders in earlier, H-P could save on component and manufacturing costs, which are cheaper if they’re ordered far in advance.”

This line is intriguing. If component prices are falling, then ordering early is a disadvantage, not an advantage. This suggests several possibilities. First, component prices may not be falling rapidly and HP is better off giving suppliers a long lead time to get an advance purchase discount from them. Second, component prices are still falling but it is cheaper for HP to take on that risk than to let the suppliers take on that risk – i.e., if they take on that risk then they have to charge more, which is passed on to HP.

As I said, it isn’t your father’s PC industry anymore. What makes me think it could be entirely different in another 5 years?

A great operations management blog … check it out!

Our friends at Kellogg, Marty and Gad, are writing their own blog on operations management …

And here is the link:  http://operationsroom.wordpress.com/

Their style is very similar to ours (and maybe better!) – comment on current events as they pertain to operations management, especially the teaching of operations management.  This will be a great resource for people looking for examples to illustrate points (or for people looking for new research ideas).

Starbucks goes lean to pull out of its slump

In June Daniel Corsten pointed out to us a very nice article about Starbucks and how they are continuing to rethink their operations (WSJ, “For Starbuck’s  Baristas, It’s Back to the Grind, 6/17/09).  In some cases Starbucks had let efficiency reduce the customer’s experience, such as grinding coffee only once a day.  Now, they will grind throughout the day so that the shop is filled with the aroma of freshly ground coffee – less efficient but better for the customer.  That said, they are not backpedaling on all efficiency.  For example, they are making their coffee brewers more flexible (instead of brewing only one variety, now they will switch) and consequently customers will experience stockouts of their favorite variety less often. And they have a team of 10 people focused on bringing to their shops “lean thinking” alla the Toyota Production System. Given that labor represents 24% of revenue, even slight improvements in motion can make a significant difference.  That means looking for how the company can reduce the walking, reaching, and bending that goes into the making of a cup of java.  Classic process analysis. (WSJ, Latest Starbucks Buzzword: ‘Lean’ Japanese Technique 8/4/09).  The changes seem to be having a positive effect – they reported better than expected fiscal third quarter profits this year (WSJ, 7/22/09).  They’ll need to keep it up – McDonald’s and Dunkin Donuts also understand the importance of lean in how they make their coffee.

Apologies for the layoff

It has been a long while since our last post, back in Feb 2009! The radio silence is not for lack of interest, but rather for lack of time – it has been an especially busy period for us. Of course, it has been also a very busy period for the world. So we have a long backlog of posts to get up there and we look forward to being back on a more regular schedule.

Toyota in the down-turn

Bad news about the auto industry has been all over the news and Detroit executives are becoming regular visitors in Washington these days (no matter if they drive there or if they take the corporate jets…). While GM has had some time by now to get used to big losses, 2008 was a bad year even for industry darling Toyota. After years of dramatic growth in volume and in profits, Toyota now reports a multi-billion loss. Will Toyota be able to master this crisis “The Toyota Way?”. So far, all we know is that the company continues to honor its life time employment promise – the cost cutting so far has only affected temporal workers. Yet, vehicle inventory continues to grow and it is unclear how long Toyota can afford to produce more that it is able to sell.

 

See http://www.nytimes.com/2009/02/15/business/15toyota.html?pagewanted=1&_r=2&sq=toyota&st=cse&scp=3 for some updates on Toyota, including their new management team

 

http://www.nytimes.com/2009/02/15/business/15toyota.html?pagewanted=1&_r=2&sq=toyota&st=cse&scp=3

Production smoothing on a grand scale

It was just reported that the US GDP fell at an annual rate of 3.8% in the fourth quarter of 2008 but it would have fallen 5.1% had it not been for the inventory adjustment – demand “fell off the cliff” but firms kept producing, thereby causing inventories to rise.  One might interpret this as a nice demonstration of the production smoothing strategy on a grand scale – it is costly to shut down production, so keep producing and build inventory with the assumption that eventually demand will exceed your production and you can then draw down your inventory.  Production smoothing is particularly effective for coping with seasonal demand because then the firm has a good sense that demand will indeed return during the high season.  Now it is a little bit different. The drop in demand is not seasonal but systematic and it is not clear when demand will level off or at what level it will converge to. In particular, if the economy is still producing above the new long term rate of demand, then further adjustments to production will be needed.

The depth of the downturn may hinge on firms’ willingness to hold inventory. If they want to reduce their current inventories to their levels over the past five years, then they will need to really slam on the break (in effect, we have already produced for future demand and to return to equilibrium requires stopping production so that demand can catch up).  However, if firms are willing to hold on to their additional inventories, then the adjustment need not be so severe – in that case all that is necessary is that the firms align their current production with their current demand rate.

These issues are exhibited on a more “micro” scale at Chrysler. They stopped production in December 2008 because their inventories were higher than they could manage (or wanted) and continuing to produce would have only increased them further. They only just resumed production. If their current production rate equals their current demand rate, then their inventory level will remain unchanged. If they want to reduce their inventories, then they will have to produce at a rate that is lower than demand for some time.

So this raises the question of whether inventories are stabilizing or destabilizing to an economy.  You can tell a story for either one, and some additional data collection is needed to resolve the conflict.

Wall Street Journal, Jan 31, 2009, Economy Dives as Goods Pile Up

Little’s Law everywhere – even in the “body of Christ”

Little’s Law dictates the relationship between three performance metrics in a process, Inventory, Flow Rate and Flow Time:

Inventory = Flow Rate x Flow Time

If you know two of them, then you can calculate the third. It is hard to not be a Little’s Law junkie – seeing the application of Little’s Law everywhere.  Here is an application that you might not expect – the production of communion wafers. The New York Times published an article about a company in Rhode Island that makes a lot of communion wafers – about 1 billion per year. It comes with a short audio slide show which is reasonably interesting.

So what is the Little’s Law question from the article? Wafers are produced at the rate of 100 per second. They spend 15 minutes in a cooling tube. How many wafers does the cooling tube hold on average? Use Little’s Law! Inventory = 100 x 15 x 60 = 90,000, or enough for 360 Sundays at a medium sized church that serves 250 per service. (360 Sundays is almost 7 years.)

If Little’s Law isn’t your thing, then you can calculate out their process utilization. At 100 wafers per second, that is 100 x 60 x 60 x 24 x 365 = 3.2 billion wafers per year.  They only sell about 1 billion per year, so their process utilization is about 1 b / 3.2 b  = 31%

New York Times, December 24, 2008: http://www.nytimes.com/2008/12/25/business/smallbusiness/25sbiz.html?pagewanted=2&partner=rss