When customers step up pressure on prices and when economic growth flattens or dips, a supply manager’s mind turns to cost reduction. Or rather, it turns even more to cost reduction, as squeezing out savings that then show up directly on the bottom line is a goal that never goes away.
Some of the dollars to be recovered may come from immediate actions, such as reducing inventory. Others are the fruit of more fundamental changes that take longer to put in place: streamlining processes in the supply chain and improving systems for forecasting and planning, for instance. Nevertheless, valid cost reductions all obey the same two rules: increase overall supply chain profitability and, at the same time, maintain the right levels of customer satisfaction.
Low-Hanging Fruit as the First Savings
The ideal situation for an enterprise would be to ‘flick a switch’ and see cost savings mount up instantly. Dreams aside, there are a number of areas in a supply chain that can offer cost reductions rapidly.
- Elimination of redundant activities. Any activity that is repeated unnecessarily is a candidate. Some redundancy stays ‘under the radar’ because it is less visible, and so supply chain managers will need to scrutinise processes and activities throughout the chain – including those of upstream and downstream partners. Goods inspection is an example. If one part of the supply chain inspects goods it sends out, and the same goods are then again inspected by the next, receiving part of the supply chain, it may be possible to eliminate the time and expense of one of the inspections.
- Allocating tasks to the most cost-efficient partner. Production of customised product packaging may be done by the product manufacturer, but possibly at a distribution centre too. Factors like the ability to make short “just-in-time” production runs and cut storage costs of packaging produced may make the distribution centre more cost-efficient as a packaging producer than the factory producing the products.
- Multiplying discounts. Major suppliers to a market often use products and services also used by minor suppliers. Competitive situations notwithstanding, a major supplier may be able to add minor suppliers’ orders to its own, achieve greater levels of discount, and distribute the benefit between those concerned.
Inventory costs money. Reducing inventory reduces costs, although there are limits. In some instances, inventory is necessary in order to respond rapidly to customer demand, while new stocks are being delivered. On the other hand, products that sit in a warehouse beyond a certain period end up costing more in storage and associated expenses than their normal retail price. In other words, no matter how many you sell, such products make a loss. Scrutiny on a product-by-product and an account-by-account basis can reveal some shocking truths, in which supply agreements thought to be profitable are found to be loss-makers.
Neither should unjustified assumptions about sales and customer fill rates (demand satisfaction rates) be allowed to influence the levels of inventory at different points in the supply chain. A survey of companies carried out by Deloitte Consulting LLP showed there was little connection between increased inventory levels and improved fill rates. A better solution, confirmed by the highest-performing companies in the survey, was to keep inventory lower and save additional money by reducing the number of products being offered (eliminating the least profitable/costliest to the enterprise), and increasing forecast accuracy.
The Perils of “Slash & Burn” and Cost Postponement
Silo management of inventory and supposed cost reductions without due consideration can lead to bigger expenses than before. Thus, the purchasing team may try to reduce unit prices, without thinking about batch sizes or delivery frequency, causing inventory levels to rise. Production may seek to reduce time and effort to a minimum per product and maximise use of equipment, leading to production runs out of sync with demand, and further rises in inventory. Sales reps and managers may become over-optimistic in their sales forecasts, causing production and inventory to rise uselessly for the wrong products. Meanwhile, the finance director may attempt to impose draconian measures of inventory reduction, possibly causing profitable customers to buy elsewhere, and costing the company extra sales effort to find new ones to replace them.
Similarly, cost postponement such as ceasing to invest in supply chain people and improvement may also do more harm than good. Short term cuts may look tempting when business conditions are tough. However, longer term customer loyalty, increased enterprise risk (of the negative kind) and future profitability may all be at stake. As long as there is a choice, supply chain cost reductions must be made with both the short term and the long term future in mind. In other words, cost reduction still needs to be part of sensible, overall cost management. By identifying key cost drivers and comparing them to industry benchmarks, supply chain managers may better identify suitable opportunities to save money by aligning more closely with cost structures known to work for their industry.
Strategic Changes for Cost Reduction – The End of Outsourced Manufacturing?
After the more immediate actions, strategic moves for cost reduction may provide even greater and more lasting benefit. However, strategies too must be aligned to relevant events and situations. Only a few years ago, outsourcing to low cost producers was all the rage. The unit manufacturing price difference, typically thanks to lower labour costs, more than made up for the longer supply chain, and increased buffer stocks and taxes. However, cost factors today are now pushing numerous enterprises to bring production back in-house.
- The difference in labour costs has narrowed. Wage inflation in China for example has made outsourcing less attractive and eroded the previous landed cost advantage.
- Improvements in production methods now allow enterprises to manufacture more cheaply by themselves.
- Rapidly changing market demand and customer requests for customisation can be costly or simply too difficult to satisfy from a production facility located thousands of miles away from the engineering and marketing departments.
Product and Packaging Design for Supply Chain Cost Reduction
Product development directly influences as much as 80% of product manufacturing cost. Design also affects supply chain costs of handling, storage, damage in transit, as does product packaging. Cost reduction after manufacturing starts is more difficult and less effective. It makes sense therefore for engineering and manufacturing to work closely together from the beginning of the product life cycle. Similarly, suppliers and vendors providing materials and components should be brought into the product development phase early, if their collaboration is required to design cost reduction into the product.
Towards Zero Inventory with Build-to-Order
Besides leveraging product design and in-house manufacturing to reduce costs, a supply chain that is driven by customer demand can also help to keep inventory levels lower. Build-to-Order (BTO) systems are often well-suited to supply chains working with low-volume, high-value products, or products for which storage is disproportionately expensive, as in the aircraft industry.
Manufacturing technology for mass customisation then allows customer-defined versions of products to be produced from standard components. These standard components can be replenished more easily and more flexibly, on-demand as in Kanban systems or by regular visits from suppliers to top up quantities (“bread truck replenishment”). Cost reduction advantages of manufacturing that uses easily obtainable standardised parts in a build-to-order system with automatic replenishment include:
- Less or no reliance on forecasts, lessening risk of unexpected costs
- Less or no inventory, also reducing costs
- Higher quantities of fewer parts used, leading to larger supplier discounts
- Elimination of effort required to generate purchase orders and costs to expedite supplies, for example in case of forecast errors
Improving Sales and Operations Planning for Cost Reduction
Even a purely build-to-order enterprise is likely to work with supply chain partners that function with build-to-stock (BTS), rather than BTO. Suppliers of standardised parts to BTO companies may themselves be producing high volumes of low value products, the opposite of the BTO situation. High-volume production tends to be driven more cost-efficiently by historical information about demand. Consumer packaged goods companies typically use a BTS approach for this reason. Their supply chains depend on a sales and operations planning process (S&OP) that involves different enterprise functions to determine how much of which products should be manufactured or procured. Contributors to the process can include sales, marketing, logistics, finance, and various functions for demand, sales and supply planning.
In principle, the goal is to match supply as closely as possible with demand. Correct forecasting minimises costs of excess inventory or loss of earnings because of under-production. As research company Gartner, Inc. points out with its Sales and Operations Planning Maturity Model, S&OP is naturally positioned to orchestrate all these functions and optimise the results. The first three stages of the model are defined as:
- Stage 1 – React. S&OP exists to produce a “feasible plan” in terms of volumes, aiming to minimise stock-outs and make shipments on time. The focus is on revenue and the approach is “inside-out” as separate functions put forward their data and positions.
- Stage 2 – Anticipate. Optimisation is done at a local level, supply and demand are balanced between manufacturing and distribution, and a cost focus becomes more apparent.
- Stage 3 – Integrate. Supply and demand are balanced end-to-end across the supply chain. The inside-out approach of Stage 1 is now considerably more of an outside-in approach, as sales and marketing work better with procurement, manufacturing and logistics. Attention to cost management and reduction is even stronger than Stage 2.
The Gartner model goes on to define a Stage 4 (collaborate) and a Stage 5 (orchestrate), in which profit-driven optimisation and then complete enterprise and network coordination are major goals.
S&OP is also now referred to as integrated business planning or IBP. For some, IBP corresponds to “advanced S&OP”, which would then fit with the later stages of the maturity model above. In all stages, after Stage 1 at least, there is an increasingly strong focus on cost management and reduction.
Some industries are nonetheless more challenged than others to realise cost reductions through improved S&OP or IBP. The car industry in particular is characterised by high stock levels and a systematic use of the BTS approach, even though BTO and mass customisation would be applicable in certain parts of the supply chain. Car companies and their dealers justify high stocks of finished goods as the means of rapidly satisfying customer demand. The specific configuration required by a customer is likely to be procurable from the dealer network by a dealer, if the dealer does not have it in stock. However, inventory and transport costs (the vehicle may have to be transported over some distance to the dealer making the sale) then mount up. The overall insistence on BTS means that the automobile industry as a whole has billions of dollars tied up in inventory – a cost-reduction opportunity waiting to happen!
Other Supply Chain Cost Reduction Traps
Besides the internal silo-style problems mentioned above, companies may also fall into other traps of short-sighted attempts to reduce costs.
- Unthinkingly using low-bidder suppliers. This can jeopardise other critical goals such as quality and delivery performance, as well as ignoring the contributions that supply partners can make when they collaborate with product development engineers to design lower cost into products.
- Unethical business practices, such as unethical sourcing for lower prices. If your professional conscience doesn’t get you, it is likely to be only a matter of time before an activist group reveals your unethical behaviour to the world. Customers increasingly dissociate themselves from suppliers they perceive to be at fault ethically. The cost in reputational damage is then likely to exceed any short term gains.
Supply chain cost reduction opportunities continue to arise, because economies and markets change, as do supply chain partners, technologies and relationships. Short-term possibilities and “quick wins” can encourage supply chain managers to take cost reduction further. Every cost reduction must, however, be evaluated in terms of local and overall impact. Within manufacturing, product and packaging design have substantial impact on costs. Within the supply chain as a whole, inventory reduction is often the most powerful lever for cost reduction. Removing silo-style forecasting and replacing it with orchestrated sales and operations planning that spans the supply chain is then a practical way forward to lowering supply chain costs.