The Key Supply Chain Challenge of Cost Reduction
Supply chain costs often represent a considerable percentage of the sales price of a good or service. Cost savings flow directly to the bottom line.
If net profit on sales is 5%, for example, a reduction in supply chain costs from 9% to 4% (or from 12% to 7%) will double net profits. This is the big attraction and importance of cost reduction in a supply chain: profits can be increased without having to increase sales.
The field for potential reductions is wide open. Given the complex, multi-faceted nature of today’s supply chains, there are many aspects that can be considered for cost savings. However, they cannot necessarily be reduced in isolation. Even if it is important to break a supply chain down into its components to see where the opportunities lie, cost reductions and their impacts must always be assessed for the supply chain as a whole. Otherwise, careless cuts for one part can end up increasing costs elsewhere.
How Much Does Your Supply Chain Cost You Today? And What Should It Cost You?
Running a spend analysis is the first step to understanding what you are spending, and therefore where you might look for savings. Depending on how your systems are set up, this may be information you can rapidly pull out of other data bases. If not, this might be the right time to invest in a suitable (IT) solution, because these data will change and you will need them again to maintain and consolidate cost savings later.
To get an idea of the return on such an investment, consider these figures from Benchmarking Success. They have audited almost 1,000 enterprises in different sectors to find that whereas supply chains accounted on average for around 9.8% of sales, the overall rating for best in class for supply chains as a portion of sales was just 5.7%. In particular, they found:
- Pharmaceutical: best in class <5.3% industry average 6.3%
- Manufacturers: best in class <6.8% industry average 10.3%
- Retail Suppliers: best in class <5.8% industry average 8.6%
- Industrial Suppliers: best in class <7.9% industry average 13.2%
- Distributors (Local): best in class <6.3% industry average 10.6%
- Distributors (Import): best in class <6.8% industry average 10.3%
- Food & Bev Ambient: best in class <4.3% industry average 7.6%
- Food & Bev Chill/Froz: best in class 8% industry average 10.7%
Your spend analysis and this basic benchmarking will show you where you are, and where you could be. They also give you better negotiating information for suppliers and other third parties (transporters, warehousing companies, product assemblers and others) contributing to your supply chain operations. More detailed cost benchmarking will help even further.
Be aware also that different individual costs change. For instance, oil prices were relatively low during the period between 1984 and 2004, while labour and technology costs changed more quickly. This situation naturally incited enterprises to make more use of parcel and air transport modes. When oil prices rose, so did these transport prices, and the cost savings focuses of the smarter enterprises shifted to re-balance their supply chain spend in the light of this new development.
Three Fundamental Areas for Supply Chain Cost Reduction
Supply chain cost reductions may be end up being applied bottom up, but the start should to be top down. This helps keep the big picture in mind, as well as increasing the chances that you will scrutinise all of the right areas, departments, categories and elements.
- Transaction costs. The act of placing or accepting an order can be surprisingly expensive. When the activities of issuing and managing invoices, organising deliveries, responding to customer queries and checking progress all add to the overall cost. Following a work flow, such as the arrival of an order through to the delivery and invoicing, is one way to estimate these costs, although inefficiencies in the work flow may still be hiding more expenses. Some of the cost of transactions comes from overly complicated processes, and some of it comes from poor information sharing due to a reluctance to collaborate. As a consequence, technology such as e-commerce platforms can solve some of the problems, but other parts of cost reduction may only happen if human beings work better together.
- Mismatched processes. Within an overall process, such as order supplies and produce finished goods, there may be several different processes, such as the supplier’s own process to deliver, the reception and stocking process within the client enterprise, and so on. If the end of one process does not dovetail with the beginning of the next one, there may be interruption and duplication of work, both of which increase costs. For example, if a supplier’s product codes or pallet sizes do not match those used by the enterprise, products will have to be recoded and reorganised. In the consumer packaged goods sector, this problem is big enough to have prompted the use of collaborative planning, forecasting and replenishment (CPFR) between manufacturers and retailers. The same idea can be applied in other sectors too.
- Uncertainty. Those who do not know what will happen must take out insurance. When the uncertainty is in product demand and supply, the insurance is the stockpiling on inventory “just in case”. This can affect both producers that do not know which orders they will receive and resellers and end-customers that stockpile because of doubt about the producer’s ability to supply as needed. These safety stocks can grow at each juncture of the supply chain, from raw materials to work in progress, from finished goods to regional distribution centre holdings, and more. Holding inventory costs money in more ways than one. Inventory costs money to store and to manage, it consumes working capital and blocks possible income from that capital, and it increases the risk of having to write off obsolete stock. Depending on the item concerned, inventory holding costs of as little as one month can eat up the entire profit margin on that item.
From Improved Information and Processes to Lower Supply Chain Costs
From the three areas described above, it becomes clear that cost savings depend on having the right information and processes. Accelerating a fundamentally inefficient process, such as the recoding and re-organising of goods received, still leaves potential cost reduction on the table, so to speak. If on the other hand the right strategic processes are being used, then opportunities for tactical improvement may be many.
- Economies of scale. These may be available in terms of supplies ordered, but also in terms of batches of goods manufactured or assembled, spreading overheads like setup time over larger numbers of products. Similarly, learning time to produce a particular article or supply a certain service can be better amortized over a greater number of iterations of the same process.
- Smarter use of storage. Using too much space or having employees spend too much time trying to find items are both costly. Better utilisation of space and information on stored goods can make savings. Note that the system you use will be the one that makes most sense for your organisation. Online retailer Amazon uses its own system of “chaotic storage” based on barcodes, not product categories, which in fact makes its operations more accurate and more efficient.
- Accelerated movement of supplies. When supplies move faster, you can order later and hold them for less time, which means less inventory holding costs, not to mention less risk of loss or damage.
- An improved ordering system. One central system and the strict minimum of people needed to raise and authorise an order are good ways to start.
A Grocery Chain Reduces Costs by Minimising Touch Points
Costco is the third biggest grocery retailer in America, with turnover of a little under a third of that of the global leader Walmart ($87.3 billion compared to $274.5 billion, for 2013). A big contributor to cost reduction and therefore increased profits for Costco is the elimination of product handling stages between supply and sales.
The chain purchases most of its merchandise direct from manufacturers. Supplies are delivered to a network of cross-docking points, where truckloads of goods are then consolidated for onward delivery to the retailing shops. Merchandise allocation and shipment to shops is generally done in less than 24 hours. Wherever possible, merchandise is also handled in full pallets without being broken out into individual cases. The first time an individual product is touched is when an end-customer or consumer picks the item off a rack to buy it.
Like the Amazon example above, this method works well for Costco, but depends on the nature of the retailing being done. This very low-touch method relies on moving huge volumes of goods through large shops, restricting consumer choice to a limited number of items and few if any options in terms of packaging. Consumers must often, for instance, buy products in multiples. Forklift trucks operate in the same space (though not at the same time) as shoppers, giving the shop a “warehouse” feel, which suits the Costco low-cost positioning.
Balancing Supply Chain Cost Reduction and Good Service
Squeezing costs downwards would be self-defeating if it put customers off. The Costco warehouse-style approach (above) works because it fits well with customer expectations. Customer satisfaction must always be maintained: cost reduction can only be secondary to this.
Nevertheless, cost reduction and good service do not always have to be diametrically opposed. In some instance, cost reduction can improve service and satisfaction. Product packaging is a case in point. Particularly in the sector of consumer packaged goods, wasteful packaging exists in many different product lines. This inefficiency costs retail shelf space for the seller and gives the consumer the headache of disposing of voluminous packaging after the purchase. Optimal packaging techniques allow packaging to be done to fit product dimensions, but using the least amount of packaging possible, both at unit and case levels, with reports of material savings of 10 to 25%.
Optimising Suppliers for Cost Efficiency
Whether supplier here means the enterprise delivering raw materials or subassemblies to your factory, or a third party service provider such as a shipping or logistics company, there is a happy medium to be found between possibly using too few (and sacrificing competitive prices) and too many (and sacrificing economies of scale). Other factors such as geographical location may also be important, where the money saved in fast, local resolution of problems may justify a few dollars more for the goods or services provided.
Over time, enterprises have evolved a number of approaches to increasing the efficiency and decreasing the costs of their supplies:
- Integrated supply. One supplier handles the supply and warehousing of all the materials for a particular product line. In this vendor-managed inventory scenario, items may be stocked at the customer’s site or in the supplier’s warehouse, according to the overall cost advantage to the customer.
- Just In Time II (JIT-II). Supplier employees are stationed at the customer’s site to optimize communication, coordination and procurement with the supplier. Often reserved for large, frequent order quantities of products and materials.
- Supplier city. Suppliers collocate close to the customer’s site to store all the inventory needed for the site to function. Typically for large manufacturing plants or complexes.
- Distributor Cooperative. Distributors come together to offer their combined product lines. A customer dealing with one distributor can order the products of the other distributors via the first distributor, cutting down the number of contacts and processes that the customer must manage, and often reducing geographical distance too.
In manufacturing, the JIT-II approach was pioneered by Bose Corporation, manufacturer of high-fidelity systems in Massachusetts, US. In the retail sector, retail chain Walmart and consumer goods manufacturer Proctor & Gamble blazed the trail; the approach was also called “efficient consumer response” in this case, but used the same principle as in JIT-II of continually replenishing stocks instead of holding inventories.
Not Every Supply Chain Cost Reduction is Crowned with Success
It would be unrealistic to assume that every kind of cost reduction is beneficial. As a general example, slashing transport budgets may result in holding higher levels of inventory. When inventory costs contribute more than transport to overall supply chain costs, as is often the case, this approach is clearly back to front. In fact, overall costs may be reduced, paradoxically, by increasing transport expenses instead. A big hurdle for many companies is however their own mindset: they consider the transport department solely as a cost centre, and seek only to reduce those particular costs, resulting in false savings overall.
To demonstrate also that even the most prestigious companies can get their cost-cutting wrong, take the case of car manufacturer Porsche’s ill-fated decision to pare certain suppliers down to one per category. When the sole manufacturer it was using for the thread in its seat belts went bankrupt (in 2009), Porsche was forced to suspend production for two weeks.
Effective supply chain cost reduction relies on a macro as well as a micro approach, and mental flexibility too. Those who still work in silo mode will be oblivious to the balances of costs between departments that will yield the best overall cost reductions, while safeguarding customer service and satisfaction. Those who unthinkingly apply somebody else’s cost reduction program may end up disappointed and out of pocket for similar reasons. Yet there are general principles that can provide good starting points: benchmarking against your industry is one, and “information rather than inventory” is another. From there, work in the specific characteristics and needs of your own organisation, compare the different techniques and solutions available, and build your own supply chain cost reduction programme, like you have built your own supply chain.