Supply chains explained
Sourcing, making, moving and storing goods: lead times, inventory, working capital, service levels, the bullwhip effect, resilience and nearshoring, with a total landed cost example.
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Key takeaways
- A supply chain moves materials from suppliers to customers. Its job is to meet demand on time at the lowest total cost, which includes transport, inventory and the cost of running out.
- Lead time: the time from placing an order to receiving the goods. Sea freight from China to Northern Europe usually takes several weeks.
- Inventory: goods held in stock. It protects against surprises but ties up cash, needs space, and can spoil or go out of fashion.
- Working capital: the cash tied up in running the business, mainly inventory plus money customers owe (receivables) minus money the company owes suppliers (payables).
Key idea
A supply chain moves materials from suppliers to customers. Its job is to meet demand on time at the lowest total cost, which includes transport, inventory and the cost of running out.
A supply chain is every step that moves physical goods: buying materials, making the product, storing it, moving it and delivering it. Many supply chain teams describe the work in five parts: plan, source, make, deliver and return. Service businesses have supply chains too. A hospital needs medicines and gloves, and an airline needs spare parts and fuel.
- Supply chain
- PlanForecast demand; decide how much to make and how much stock to hold
- SourceChoose suppliers: price, quality, reliability, distance
- MakeFactories: capacity, utilization, the bottleneck step, yield (share of good output)
- StoreWarehouses: stock held, space, handling
- DeliverTransport mode and distance, last-mile delivery to the customer
- ReturnReturns, repairs and recycling
Six ideas you need
- Lead time: the time from placing an order to receiving the goods. Sea freight from China to Northern Europe usually takes several weeks. Air freight takes days but costs much more per kilogram.
- Inventory: goods held in stock. It protects against surprises but ties up cash, needs space, and can spoil or go out of fashion.
- Working capital: the cash tied up in running the business, mainly inventory plus money customers owe (receivables) minus money the company owes suppliers (payables). The cash conversion cycle measures it in days: days of inventory plus days customers take to pay minus days the company takes to pay its suppliers.
- Service level: how often the company meets demand from stock. Two common measures are fill rate (the share of units ordered that were delivered) and OTIF, on time in full (the share of orders delivered on the promised day with the full quantity).
- Safety stock: extra inventory held to cover surprises in demand and lead time. The last few percent of reliability are the most expensive: going from 95 to 99 percent service needs much more safety stock than going from 90 to 95 percent.
- Total landed cost: the full cost of getting one unit to where it is sold: the product price, freight, insurance, import duty, and the cost of holding the inventory while it travels and waits.
The bullwhip effect
Small changes in what shoppers buy become bigger and bigger changes in orders as you move up the chain. The shop orders a little extra to be safe, the wholesaler adds a bit more, and the factory sees a big jump. Hau Lee, V. Padmanabhan and Seungjin Whang described this in 1997 and called it the bullwhip effect. The causes include forecasting from orders instead of real sales, ordering in large batches, price promotions, and rationing (buyers over-order when they fear shortages, as many did in 2020 and 2021). The fixes are to share real sales data along the chain, order in smaller and more frequent batches, and keep prices steady.
Resilience and nearshoring
Since 2020, many companies have learned that the cheapest chain can also be fragile. The COVID-19 pandemic closed factories and ports. In March 2021 a large container ship, the Ever Given, blocked the Suez Canal for six days. From late 2023, attacks on ships in the Red Sea led many shipping lines to sail around southern Africa instead of using the Suez Canal, adding time and cost to trips between Asia and Europe (UNCTAD, Review of Maritime Transport 2024). US tariff changes in 2025 and 2026 added more uncertainty.
Common responses, each with a cost
- A second supplier in another country, often called "China plus one", with India, Vietnam, Mexico and others as options.
- Nearshoring: moving production closer to the customer, such as Mexico for the US, or Türkiye and Eastern Europe for Western Europe.
- More safety stock of critical parts, which ties up cash.
- Better visibility of suppliers' own suppliers, so problems are seen early.
Resilience is insurance. The question is always how much it costs and what it protects: compare the extra cost per year with the expected cost of a disruption (the chance it happens times the lost profit if it does).
Worked case
Total landed cost: Vietnam or Mexico?
The prompt
A US retailer buys 100,000 garden chairs a year and compares two factories. Vietnam: factory price USD 10.00, sea freight USD 0.80 per chair, import duty assumed at 10 percent of the factory price, and 75 days of stock in transit and in safety stock. Mexico: factory price USD 11.50, truck freight USD 0.40, duty assumed at zero, and 15 days of stock. Holding stock costs about USD 0.01 per chair per day. Which source has the lower total landed cost?
The structure
- Total landed cost = price + freight + duty + inventory holding
- Vietnam
- Mexico
- Key: Difference per chair and per year
The exhibit
| Cost item | Factory in Vietnam | Factory in Mexico |
|---|---|---|
| Factory price | 10 | 11.5 |
| Freight | 0.8 | 0.4 |
| Import duty (assumed rates) | 1 | 0 |
| Inventory holding cost | 0.75 | 0.15 |
| Total landed cost | 12.55 | 12.05 |
Working it through
1. Vietnam duty
10 percent of USD 10.00.
Vietnam duty per chair (USD):10 × 0.1 = 12. Vietnam holding cost
75 days at USD 0.01 a day.
Vietnam holding cost per chair (USD):75 × 0.01 = 0.753. Vietnam total
Price, freight, duty and holding.
Vietnam landed cost (USD):10 + 0.8 + 1 + 0.75 = 12.554. Mexico holding cost
15 days at USD 0.01 a day.
Mexico holding cost per chair (USD):15 × 0.01 = 0.155. Mexico total
Price, freight, no duty, and holding.
Mexico landed cost (USD):11.5 + 0.4 + 0 + 0.15 = 12.056. Saving per year
The difference per chair times 100,000 chairs.
Annual saving from Mexico (USD):(12.55 - 12.05) × 100,000 = 50,000
What the exhibit shows
The cheaper factory is not the cheaper source once freight, duty and inventory are added.
The recommendation
The retailer should source from Mexico, because its landed cost is about USD 12.05 per chair against USD 12.55 from Vietnam, a saving of USD 50,000 a year even though its factory price is 15 percent higher. First, Mexico avoids the assumed 10 percent duty, worth USD 1 a chair. Second, 15 days of stock instead of 75 cuts holding cost from USD 0.75 to USD 0.15 and lowers the chance of holding the wrong stock. The main risk is that tariff rates change quickly. As a next step, confirm current tariffs and the Mexican factory's quality and capacity.
A distributor in Saudi Arabia holds 60 days of inventory, its customers pay in 45 days, and it pays its suppliers in 30 days. What is its cash conversion cycle, in days?
In one month, customers ordered 10,000 units. The warehouse delivered 9,200 of them. What was the fill rate, in percent?
A warehouse ships 2,000 units a day and holds 50,000 units. How many days of inventory does it hold?
Shoppers in Indonesia buy a steady number of nappies each week, but the nappy factory sees its orders swing up and down by 40 percent. What is the most likely cause?
What does OTIF measure?
Why might a company pay a higher factory price to produce closer to its customers?
A company raises its target service level from 95 to 99 percent. What usually happens to inventory?
Sources for this lesson (3)
- Recognized public explanations of case-interview concepts and frameworks
- Lee, Padmanabhan and Whang, "The Bullwhip Effect in Supply Chains", MIT Sloan Management Review, 1997
- UNCTAD, Review of Maritime Transport 2024
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