Know your Supply Chain Costs & Optimize!

Dr Vijay Sangam, 23:15, 05 Jul 2010

Successful implementation of an Integrated Supply Chain is based on cost trade-offs between and among the various components of entire supply chain. Before we dig deep into different Supply Chain Costs, let us understand the definition of cost according to accountants, “… a reduction in the value of an asset for the purpose of securing benefit or gain.” Where as the Management definition is, “… an expense to a business for goods or services, when the good are produced and services rendered.” Is there a difference between cost and expense? Cost is, “a resource sacrificed or forgone to achieve a specific objective.” And expense means, “a cost that has been charged against revenue in an accounting period.” In short expense is an expired cost.

The most important part of Cost analysis is identifying fixed costs and variable costs. Supply Chain efficiency can be improved by reducing cost and that could be achieved by converting a fixed cost to a variable cost. How is that possible? For example, a warehouse rent is a fixed if owned by an organization. However, if the same organization hires the warehouse based on usage (no. of pallets stored), the cost becomes variable and it is aligned to the business volume.

What is the difference between variable and fixed costs? In fixed costs the unit cost could change depending upon volume and where as the total cost will not change. In variable costs the unit cost will not change and the total cost will change based on volume.

Further one more characteristics of cost are controllable and uncontrollable element. Controllable costs can be changed in a short term and where as uncontrollable costs cannot be changed. For example, if we optimize travel, the travel related costs are controllable in a short period where as cost such as building rent for a fixed period is not controllable in a short span of time. One more classification could be semi variable costs and the best example could be payroll costs. Further, we can classify costs into direct costs and indirect costs. A cost that is not linked to a specific cost centre is direct cost and indirect costs are not linked to any specific cost centre such as corporate overheads. It is very important to understand that costs are driven by cost drivers and the drivers vary from organization to organization. “A cost driver is the unit of an activity that causes the change of an activity cost.”

In order to manage supply chain costs efficiently and optimize, one can introduce activity based costing. Activity based costing allows organizations to understand variance in costs effectively in order to initiate corrective actions. Under activity based costing (ABC) manufacturing overheads are assigned to a specific product based on activity instead of allocation based on volume. ABC traces historical costs (resources consumed) to activities and then through those activities to products or services provided.

The advantage of the details in ABC for the manager is to give visibility to value added and non-value add activity. Once we have ABC cost model implemented, we can make use of Variance Analysis in order to understand the cost variance due to cost, volume and norm variance. In a manufacturing environment if costs go up due to increase in volume it would be considered as a volume variance and no change in unit cost. If we notice change in unit cost and it is considered as cost variance. Very important variance could be norm variance. If the costs go up or down due to productivity norm, it is known as norm variance. The simple example could be diesel consumption of a truck. If the truck is expected (standard) to consume “X” litres of diesel to travel a particular distance and if the truck travels less than standard the additional cost incurred is classified as norm variance. In order to analyze the costs this way, we need to set up our budgets using activity based costing.

ABC and Variance analysis allows us to understand costs behavior and also allows us to optimize costs based on logical conclusions. One more important factor that needs your consideration in optimizing supply chain costs is cost trad-offs. Particular cost delivers a particular level of service to customer. One should take care to ensure that service levels are not affected all maintained within allowed level due to cost optimization. Some of the common costs vs. service trade off challenges are:

1. Faster (premium) transportation – versus reduction in pipeline (transit) inventories
2. Make versus buy decisions (manufacturing Vs. Trading)
3. Centralized versus decentralized warehousing
4. Own Fleet versus outsource
5. Public versus private warehousing
6. Orders consolidation versus shipping ASAP
7. EOQ versus Inventory Carrying Costs
8. Higher Service levels (fill rate) versus higher inventory levels
9. Back-orders versus higher inventory
10. Push system versus pull system
11. Build to Order versus build to stock.

In a typical business situation the common beliefs are:

1. Not enough sales to be profitable
2. Economic condition not just suitable
3. Cut-throat competition
4. Constant drop in bottom-line.

And in reality:

1. An increase in sales does not necessarily increase profit;
2. Some products are money makers and some are money losers;
3. The product mix may not be appropriate;
4. There are too many money losers;
5. Nobody is sure where money is being made or lost;

Now it is up to the Supply Chain manager to investigate the costs and address above mentioned four issues using advanced costing tools such as ABC and Variance Analysis. One need not be a cost accountant to handle cost innovation. Any supply chain manager with a desire to add value to the business process and with an objective to take business to next level could achieve Supply Chain Cost Optimization which is critical to the business success!

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