What are the Costs of Running a Supply Chain?
Many companies are unaware of the most pressing issues pertaining to supply chain management. As a result, they often adopt a supply chain approach that doesn’t match their market, their customers’ needs or their business philosophy. What are the main issues of managing a supply chain? More importantly, when businesses look to adopt a specific supply chain management approach, what are the essential criteria for success?
1. Start With Understanding the Real Inventory Costs
Inventory costs are much more than just paying for parts and raw materials. Included in inventory costs are the freight costs to get those parts in and out of the warehouse. There are other costs relating to how long inventory is held, and still other costs related to obsolete, slow moving, outdated and damaged inventory. The basic rule states that the longer inventory is held, the more expensive it becomes.
- Freight costs to and from warehouse: Paying for freight from suppliers and out to customers is a direct cost of inventory.
- Length of time inventory is held: Typical inventory holding costs are about 2% to 3% a month. Since inventory is often financed by business loans, this cost includes the daily cost of money.
- Outdated and damaged inventory: The longer inventory is held, the more likely it risks becoming outdated and damaged. This is why it’s essential to liquidate slow moving stock.
2. Understand Different Types of Supply Chain Approaches
Before deciding upon a supply chain approach, it’s best to discuss the two main approaches available to businesses. One is the push-pull or JIT (Just in Time) inventory approach, while the other is the rolling forecast or Min/Max approach. Each has its merits and each has its drawbacks. In order to decide which one best suits a business, it requires a thorough understanding of the strategy behind the approach and a summary of both its benefits and drawbacks.
What are the Different Approaches to Managing a Supply Chain?
JIT is meant to reduce inventory costs in all its forms by only purchasing what’s needed, when needed. Companies using JIT only order just enough to meet current demand. The approach is to only bring into the company what is guaranteed to be used or sold, thereby keeping inventory levels low by month end.
- Benefits of JIT: By buying only what’s needed, businesses look to avoid those aforementioned month to month holding costs. They also save money as they don’t encounter issues pertaining to damaged or outdated inventory. Properly managed, using JIT can keep inventory costs low, and improve the company’s gross profit margins on sales.
- Drawbacks of JIT: While reducing the month to month costs of inventory sounds ideal, there are still costs associated with JIT. One of them is the cost of receiving bad quality or defective product. In this case, it can be an absolute disaster as the company doesn’t hold any safety stock. In addition, any delivery delays are incredibly costly to the business and result in high expedite fees on freight and overtime to both receive and ship out late orders.
The Min/Max supply chain management approach is based on maintaining a minimum and maximum amount of inventory at all times. This minimum amount is often referred to as a company’s safety stock and allows businesses to capitalize on opportunistic sales. It’s simple and relatively easy to manage compared to the logistics involved in JIT.
- Benefits of Min/Max: Min/Max supply chains allow businesses to lower their purchase price on parts and materials and lower their freight costs, by buying in bulk. This allows businesses to lower their per-unit costs on inventory. Also, because there’s a safety stock, companies running Min/Max save money by not requiring expedited shipments. They also avoid those large expedite freight bills and costs of overtime.
- Drawbacks of Min/Max: While companies are able to lower their purchase price and freight, they often find those savings can be affected by their month to month holding costs. In addition, because inventory is held longer with Min/Max, there is more of an incidence of damage or obsolescence. Another concern involves customers’ order patterns. Because they change so frequently, companies running Min/Max face a constant battle between buying too much or too little inventory.
Match Supply Chain Approach to Company Philosophy
3. Managing a Supply Chain Means Matching it to the Company’s Needs
Many companies choose to run a supply chain management approach because they are enamored with the results achieved by other businesses. Companies must not only understand the true costs of inventory, but must use this knowledge to match their supply chain approach to their business philosophy, their industry and their customer’s purchasing patterns. Wondering what types of businesses are best serviced by either JIT or Min/Max?
- Companies Benefiting From JIT: In order to be successful running JIT, a company must be a big player in terms of its economies of scale and purchasing power. It absolutely must be front and center in the eyes of its suppliers and their number one priority. JIT works best in linear markets where customer demand is consistent over time. Examples of JIT applications include the automotive industry or the cellular phone industry where a small number of models are sold in extremely high volumes. Because JIT requires a disciplined workforce and large purchasing power, it’s not ideally suited to companies with large product lines and small volumes sold across those lines. It’s also not suited to markets with infrequent and cyclical customer order patterns.
- Companies Benefiting From Min/Max: On the opposite end of the spectrum, are those companies that operate in cyclical and fluctuating markets where demand rises and falls. In this case, companies must maintain emergency safety stock in order to capitalize when customer demand increases. Min/Max is ideally suited when servicing customers who have infrequent purchases. Companies using this supply chain approach know they’ll eventually receive an order, but as to what week or month it occurs, they aren’t absolutely sure. In Min/Max, the sales cycle times can often be measured within a quarter, while JIT can be measured within a day or less.
When companies look to decide which supply chain management practice to run, they must first look within their own market and their customer order patterns. JIT seems like the perfect system in a perfect world, but it has several drawbacks that make it a difficult system to run successfully. While there are costs to Min/Max, it does allow businesses to capture opportunistic sales. Each is good for its own reasons and each requires a different set of circumstances to be successful.