May 25, 2016

Two Big Reasons You Don’t Want to Maximize Profit in your Supply Chain Model

You may Think Maximizing Profit is Better Than Minimizing Cost, However, it Isn't in Most Cases

You are about to start a supply chain network design project.  You will build a model to help determine the best number and location facilities (warehouses, plants, and lines), where to make product, how to assign customers to facilities, and how product should flow through the supply chain. 

Watson Says... You might as well just minimize cost and save yourself the extra hassle of collecting the price and revenue data. What do you say? Click here to send us your comments

You are quickly confronted with a model design question:  Should you build the model to minimize cost or maximize profit? 

When given this choice, it seems obvious that you would want to maximize profit.  And, why not?
Profit is what the CEO and investors care about, profit keeps you in business, and maximizing profits seems like it captures the business better than just worrying about cost. 

But, this is wrong.  You rarely want to maximize profit in your network design model.

Here are two big reasons why:

#1  Demand is an Input 

In most models demand is an input.  You are asking the model to come back with the best design for the given demand.  The demand may be a single scenario or you may have multiple scenarios (like a best and worst case or a case where one market grows much faster than others).    
 

But, what you are not asked to do is to come back with a recommendation on how much of that demand you can meet.  For example, it is not acceptable to come back to the business and suggest that you will no longer serve demand on the west coast or and you will exit your third top selling product line.

Once demand is a given, a profit maximization model is exactly the same as a cost minimization model.  You have to meet all the demand, so the total revenue is fixed (unit sales multiplied by price).  The only way to maximize the profit in this case is to minimize cost.

You might as well just minimize cost and save yourself the extra hassle of collecting the price and revenue data. 

As a side note, there is no harm in going back to the business and suggesting that the cost to serve the west coast is disproportionally high.  You can easily do this with a cost minimization model. 
  

 #2.  You Don’t Really Have the Necessary Data

If you get past the first reason for not maximizing profit, and most models shouldn’t, this second reason can be equally difficult. 

If you are going to truly maximize profits and make decisions on what markets you will be in or what product lines you will sell (that is the revenue is not fixed), your supply chain model most likely won’t have the right data or even the ability to add it. 

There are many reasons for this:

• Supply chain costs may be a relatively small percentage of the total costs.  That is, there may be a lot of costs in sales and marketing, services, or even R&D as part of the overall costs.  If you don’t include these other costs, every customer and every product looks very profitable.  The profit max model simply meets all demand.
  
  
• Adding non-supply chain costs to a model is not easy.  How do you allocate the sales and marketing, services, and other overhead costs to specific customers and products?  This is very difficult to do and a reason why Activity Based Costing hasn’t seen widespread use.
  
  
• Finally, if you haven’t given up yet, the data to needed to do this right can be very difficult.  It can be hard enough to get good production costs at new locations or transportation rates for lanes you don’t currently use.  You now need demand curves for products you haven’t sold before in regions you have sold in, you need to allocate overhead costs to possibilities you have no experience with, and you need to quantify how demand will change as you change your supply chain design. 

Final Thoughts

Because of these two items, most network design models focus on minimizing cost.  Don’t think you are giving anything up with this.  You can still do very interesting analysis that gives deep insight into the profitability of the business and make valid suggestions on what markets and products you should and shouldn’t pursue.

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