Flow, Part 3

by David Schneider | Sep 26, 2016
[The following is Part 3 of the Flow series]

Water flowing in a stream. Oil flowing through pipelines. Gas flows through pipelines too. We typically use the word flow to describe the movement of water or gasses. But what about the flow of a crowd? How about gain flowing from a hopper? Flow is a description of movement, the movement of liquids, a bunch of solid objects, of work, of people, of ideas. If it moves, it can flow.

I like to think of a logistics network as a system of pipes in which the products flow from one connection to the other. Logistics networks are like pipelines, a physical network of pipes, compressors, and tanks that move liquids and gases from production to consumption. With pipelines, the size of the pipes limits the flow, the direction of the pipes limits the flow, the actual pipes used in the line limit the flow. Compressor stations create pressure, pushing the gas or liquid along the pathway. The valves control the direction. Tanks provide holding storage, acting as buffers that allow change in the flow.

In most supply chains, trucks, trains, ships, and planes serve in the role of the pipe in the system. Warehouses are like the storage tanks. Pipelines have central control centers, System Control Centers, where managers control all pipeline operations from a single point. In most supply chains, the concept of control is much more fluid, not as defined or centralized. Unlike in the pipeline, various people and entities control the “pipes,” i.e., the trucks, trains, ships, and planes. Different companies own these pipes, making strong central control a difficult proposition.

Most supply chains, like pipeline systems, are repetitive. Ships operate on routine, pre-determined schedules, as do planes and many trucking systems. With repetitive networks, we can observe performance in each cycle, measure the performance, and make predictions about future performance. With enough data and time, we can observe the relationships between the different steps and different nodes in the network.

In these routine systems, there are three different flows in the supply chain. The obvious one is the flow of the physical product. There are two other flows, however, each of which exerts considerable influence on the material flow: the information about the material flow, and the flow of the money behind the trade that created the material flow. All three flows are basic requirements of any supply chain system. Without the money, the method of value exchange is missing. Without the information, we can’t control the flow, we can’t monitor the flow, and we can’t protect the physical and monetary flow.

Looking into the Past

If we look back into the history of global trade, we can see that the original foundations of these three flows as broken loops, with each of the flows locked into step with the other two. In early trade, by sea or by long, land-based trade routes, the ship’s captain or the caravan leader took ownership of the cargo, taking title of the cargo and settling with the seller of the goods before loading. The seller signed the cargo over to the captain using a Negotiable Bill of Lading that gave the captain the title and rights to the cargo. The captain pledged to attempt to deliver the cargo to the consignee, the buyer of the goods, but he could sell the cargo if it became impossible to deliver it.

If the captain arrived at the port of delivery and could not find the consignee, or the consignee rejected the shipment, the captain could sell the cargo to another buyer for whatever price he could negotiate. Even if the original buyer wanted the cargo but could not pay the captain for it, the captain could sell the cargo to another buyer.

In that era of trade, the value, the information, and the material changed hands simultaneously and traveled together. This tightly integrated movement of cargo, information, and finance ensured that each trading partner received their value for the shipment.

The Bill of Lading defined the cargo — the terms of transit, the origin, destination, description, who shipped the cargo, who received the cargo, who carried the cargo, and the cost of the transit. Every shipment carried a Bill of Lading. The ship’s captain maintained a manifest that listed all the cargo carried on the ship by Bill of Lading number, and summarized the weight, value, and number of articles of cargo on board. The ship’s manifest was the captain’s inventory ledger.

It would take centuries of change in developing trade practice built on trust initiatives for the three flows to decouple.

Financial Decoupling

Banking practice and technology helped to decouple the lockstep timing of the three flows.

Money was the first place the flow started to decouple. A Letter of Credit (LOC), is a contract between banks, pledging that the seller will receive payment as long as the trading partners meet the terms and conditions of the letter. The buyer establishes credit with a merchant bank with connections to other merchant banks in the seller’s area. The buyer’s bank documents in the letter that the buyer has established the credit, and pledges to pay the bank redeeming the LOC, subject to proper documentation.

Let’s assume we are buying 100 sheep from an Australian rancher. We go to our commercial bank and establish credit, mainly through a deposit of funds and some pledge of credit. The bank identifies its partner bank in Australia and drafts a letter that outlines our establishment of credit. The letter defines the conditions that the person presenting the letter of credit must satisfy to receive payment. In most cases, the letter will outline documents that the seller must present to the bank to satisfy. The conditions can vary, but may include the submission of an invoice that documents the monetary value of the transaction, a delivery receipt documenting that the shipper loaded the cargo, and the particular quantity of the goods.

In our example, the LOC could state that the bank will pay the credit once presented with a proper BOL for the loading of 100 sheep onto a named ship, or delivered to a named location for loading. The remote bank collects all the documents and forwards them to the bank that issued the LOC. Once presented with the LOC and the documents that satisfy the LOC, the issuing bank pays the remote bank.

Letters of Credit obviated the need for the ship’s captain to take financial responsibility for the cargo. Letters of Credit opened the door for other forms of maritime financial process, like cargo insurance. Ship owners and masters, the captains, no longer accepted open risk of loss because they did not take financial responsibility for the cargo. The bank’s Letter of Credit lifted that financial responsibility. In most cases, the buyers accept the risk of loss, risking the monetary value of the cargo if it is damaged or lost, or buying insurance to cover the risk of the loss.

Cargo insurance grew with the growth of Letters of Credit. Over coffee at Lloyd’s Coffee House in London, investors calculated the risk of the shipment, and for a fraction of the value of the shipment, ensured the safe delivery of the cargo. The captain’s history, the nature of the cargo, the destination, the trade route, and the weather on the route all influenced the risk and the price of the insurance.

Distributed credit and insurance helped decouple the financial flow from a direct relationship to the flow of the goods. Under the letter of credit, the flow of the money depended on the flow of documents, not the direct flow of the goods. The cargo could continue to move, while the documents that validated the physical flow triggered the flow of the money. Without this decoupling, modern trade on the scale we are accustomed to could not exist.

Next … The Flow of the Information Age

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