In a recent article in the Journal of Business Logistics, we presented a strategic planning methodology for multi-national manufacturing and distribution firms to maximize profits utilizing mathematical optimization models. Specifically, the article demonstrated a practical approach where firms could formulate integrated global manufacturing and distribution plans that incorporate the impact of exchange rates, local taxes and intra-company transfer prices in their planning process. This facilitates the development of global production plans that truly maximize profits by accounting for these factors plus the pertinent manufacturing and distribution capacities, costs and demands. Here, we will provide a brief non-technical overview of this approach. For more details on the methodology, see the Journal of Business Logistics, Miller and De Matta, 2008. We would like to acknowledge and thank the Journal of Business Logistics (JBL) for allowing us to excerpt a limited portion of the original paper for presentation in this article.

In a large firm with a presence spanning multiple countries, one often finds an organization consisting of many different manufacturing and distribution units. Developing integrated strategic, tactical and operational manufacturing and distribution plans for the global supply chain of such a firm represents a formidable planning, as well as organizational, undertaking. Moreover, to develop and execute plans that are not only integrated, but which maximize profits on a global basis presents a challenge of far greater magnitude.

The good news is that the methodologies and technology to support integrated profit maximization planning are well established, and the required resources are not exorbitant. Further, this represents an area of terrific opportunity for many firms because very few employ these techniques in their current strategic and tactical planning processes.

A well-constructed and maintained decision support system (DSS) represents a critical tool to facilitate coordinated supply planning and execution. A supply chain planning DSS typically has numerous components and will vary significantly by firm and supply chain. For global manufacturing and distribution planning, inclusion of mathematical optimization models within a DSS structure can represent the difference between a DSS that provides information and a DSS that truly facilitates integrated planning and execution.

Specifically, a global manufacturing and distribution optimization model that includes all of a firm's manufacturing facilities, distribution locations, transportation routes and modes, and customer demands; can facilitate the development, implementation, and maintenance of globally coordinated plans and schedules. A cost minimization methodology represents the most common optimization modeling approach for integrated manufacturing and distribution planning. Particularly in single-country domestic applications or in environments where tax rates in local regions do not represent major decision factors, a cost minimization methodology can help formulate an effective integrated plan. However, when planning flexibility or alternatives exist because of differing local country tax structures and rates and because of intra-company transfer pricing options, cost minimization methodologies generally cannot identify profit-maximizing global production and distribution plans. Instead, a profit maximization model that explicitly evaluates decisions such as where to incur tax liabilities and how to set intra-company prices may be required to develop the optimal, integrated global manufacturing and distribution plan.

To provide additional perspective on the problem, we consider a well-known hierarchical production and distribution planning paradigm (Figure 1). Briefly, the hierarchical production planning process stratifies manufacturing and distribution planning and scheduling activities into three levels: strategic, tactical (which includes annual) and operational. As Figure 1 illustrates, the methodology we describe in this article supports the strategic planning level, and has applications at the tactical level.

How does global profit maximization work?

A global profit maximization model should evaluate the trade-offs between factors such as production costs and capacities, distribution costs, taxes, local country profits and exchange rates. These evaluations and trade-offs facilitate the development of an integrated global supply chain production and distribution plan that maximizes global profits. Figure 2 illustrates this process.

The figure depicts a basic network consisting of a single echelon of plants, a single echelon of distribution centers (DCs), and external customers. In this example, a global firm owns plants in a number of countries. It also owns DCs in a number of countries, and it has external customers in each local country where it sells its products. Note that the firm may not have plants and/or DCs in every country where it generates sales (i.e., the firm may export directly from one country to external customers in another country).

In this model, the global firm has a “home” country of registry (e.g., the United States) and “local affiliates” in all other countries where it has a presence. Presence may take the form of a number of different entities (e.g., a plant; a DC; a sales office and sales force; or an autonomous operating unit with manufacturing, distribution, sales, finance and all other attributes of a stand-alone company).

Plants of local affiliates/countries (and plants of the home country) ship finished products to distribution centers of local affiliates around the world. Distribution centers receive finished goods from plants and subsequently ship products to the firm's external customers. This flow from the DC to the external customer represents the actual sale by the firm to its paying customers.

As Figure 2 illustrates, the price or value of a unit of product increases as it moves through the network. A plant in a local country ships (sells) a product to another local affiliate (country) at an agreed upon price. This price, at the minimum, includes the costs of production and distribution, as well as a markup on the production and distribution costs of the producing plant (country). This price, which also typically includes additional cost components such as administrative overhead, represents the transfer or intra-company price that a plant charges the local affiliate to which it delivers the product.

After it acquires the product at an intra-company transfer price, a local affiliate then sells this product to an external customer at the local selling price. The difference between an affiliate's acquisition price and its selling price consists of the distribution, sales, and other costs of the local affiliate, as well as a markup or profit margin that the local affiliate adds to its acquisition and delivery costs.

In summary, the global profit maximization model illustrated in Figure 2 evaluates and accounts for the incremental cost or value added to a product from its cost as finished goods inventory at a plant to its selling price to the firm's external customer. In the model, the combination of all costs accounted for after production through delivery to the external customer, (i.e., all costs added to the base production cost of a unit of finished goods inventory), plus the markups on costs recommended by the model, increase the product cost of a unit of finished goods inventory at a plant to its ultimate selling price to the local external customer. The selling price to the external customer is an exogenous, pre-determined input to the model.

There are two markups on cost that create profit margins and profits. These markups occur at the point of shipment (sale) from the producing country to the receiving local affiliate, and at the point of shipment (sale) from the local affiliate to the external customer. The model recognizes and evaluates the local taxes paid on the profits recorded by the plant (country) selling to another local affiliate, and on the profits generated by the local affiliate selling to the external customer. The model utilizes the appropriate exchange rates between local affiliates and the home country of the firm to project the total global profit of the firm. Note also that this modeling methodology can explicitly account for cost factors such as freight duties, insurance on freight, and other customs charges.

Global operations plan developed

This model generates an integrated global operations plan that maximizes the firm's global after tax profits subject to satisfying inventory, production capacity and customer demand constraints. The model develops a profit-maximizing solution that takes into account manufacturing costs, distribution costs including customs and duties, taxes and exchange rate impacts. The plan maximizes the after tax profits of plants plus the after tax profits of markets which are based on the product landed costs. The output of the model includes a production plan for each plant by production line. Additionally, the model creates a global shipping and sourcing plan that indicates plant-to-market-to-customer assignments. Finally, a model solution develops recommended intra-company transfer prices (i.e., markups) between plants and markets, and between markets and customers taking into consideration local tax rates and foreign exchange currency impacts.

We should note that a multinational firm often has internal guidelines or policies regarding the range of markup percentages it will allow on transactions between its plants and local markets around the world. In many cases, local country regulations also heavily influence or dictate these corporate guidelines. The methodology described can easily account for these types of constraints.

Applications and benefits

In summary, there exist a number of potential applications for the global profit maximization model. We will briefly highlight several applications which address the strategic planning horizon, and also discuss how our model can be employed for tactical planning purposes.

This modeling methodology provides an integrated production and distribution framework for developing global supply chain plans for a 12 to 24 month planning horizon. Typically, planners would run this model once a quarter or every six months to update production plans for each plant and sourcing plans that recommend plant-to-warehouse to country (customer) assignments. In this tactical application, the model assists in determining the global plan that maximizes profit using existing supply chain infrastructure

This methodology provides excellent sensitivity analysis capabilities for both tactical and strategic planning. Specifically, planners can employ these models to evaluate the impact of potential changes in exchange rates and local country taxes on medium and long-term plans. Examples include:

At the tactical level, once an initial global plan is developed, the model can be run with alternative exchange rate assumptions to determine how robust the recommended production plan is. Do production and sourcing decisions remain relatively constant over a wide range of exchange rates, or do plans vary significantly with relatively minor changes in exchange relationships?

At the strategic level, the potential impact of exchange rates or changes in local tax policies on long-run plant and distribution center location decisions can be evaluated.

This methodology can also support strategic decisions such as potential changes in production strategies using existing plants. For example, decisions regarding potential shifts in production of major products from one plant or set of plants to others can be evaluated.

One can also address questions such as the impact of duty drawback opportunities and “local content” type production and distribution regulations.

There exist numerous other potential applications of the global profit maximization model. These few examples provide a brief glimpse of the potential broad perspectives and applications that this type of planning methodology can facilitate.

In this article, we have stressed that the global profit maximization model addresses the strategic and also tactical planning levels. We believe that models such as this can play a particularly important role in guiding the overall operations of large-scale manufacturing and distribution networks at these longer-term planning levels. There are relatively few “reported” implementations of global profit maximization models for large-scale networks. Thus, we believe that the implementation of global profit maximization models represents a potentially significant unrealized opportunity worthy of serious consideration by many firms. This methodology remains heavily underutilized in private industry. Further, as previously noted, the investment and resources required to develop this capability within a firm are relatively modest, and the potential return on investment is extremely high.

Tan Miller is Harper Professor and Director of the Global Supply Chain Management Program, Rider University tmiller@rider.edu. Renato de Matta is Associate Professor of Management Sciences, College of Business Administration, University of Iowa renato-dematta@uiowa.edu.

References

Bitran, Gabriel R. and Arnoldo C. Hax (1977), “On The Design of Hierarchical Production Planning Systems,” Decisions Sciences, Vol. 8, No. 1, pp. 28-55.

De Matta, Renato and Tan Miller (1993) “A Note On The Growth Of A Production Planning System: A Case Study In Evolution,” Interfaces, Vol. 23, No. 4, pp. 116-122.

Hax, Arnoldo C. and Harlan C. Meal (1975), “Hierarchical Integration of Production Planning and Scheduling,” Studies in the Management Sciences, M.A. Geisler, Editor, Vol. 1, Logistics, North Holland, Amsterdam.

Liberatore, Matthew L. and Robert Nydick, (1998), “Decision Technology For Business Application,” McGraw-Hill Companies, Primus Custom Publishing, Villanova, PA.

Liberatore, Matthew L. and Robert Nydick (2000), “Introduction To Decision Technology Modeling. Software And Applications,” LN Publishing, Villanova, PA.

Miller, Tan (2002), Hierarchical Operations And Supply Chain Management, Springer-Verlag: London.

Miller, Tan and De Matta, Renato (2008). “A Global Supply Chain Profit Maximization And Transfer Pricing Model,” Journal of Business Logistics, Vol. 29, No. 1, pp. 175-200.

Raimondos-Moller Pascalis and Kimberly Scharf (2002), “Transfer Pricing Rules and Competing Governments,” Oxford Economic Papers. Oxford: Vol.54, Iss. 2, p. 230.

Sahay, Savita (2003), “Transfer Pricing Based on Actual Cost,” Journal of Accounting Research, Vol. 15, 177-192.