Risk Pooling: Lowering Inventory Costs

An easy way to lower Inventory carrying costs is to implement Risk Pooling. Risk pooling is a way of analyzing your inventory over several DC's to lower the "Risk" of carrying too much inventory while also lowering the "Risk" of service failures due to stock outs.

Risk Pooling is very much like the idea of Portfolio Management in the Financial Industry where Risks i.e. costs are hedged by properly managing the portfolio of the Insurance or Mutual fund in order to balance risks and gain long term Portfolio performance.
In this example we will look at to DCs using the formula:

where

SS1	Safety stock in location 1
SS2	Safety stock in location 2
SSc	Safety stock in centralized location
s1	Std. deviation of lead time demand in location 1
s2	Std. deviation of lead time demand in location 2
sc	Std. deviation of lead time demand in centralized location
p12	Correlation of demand in locations 1 and 2

Example
		sigma		1. Safety stock in location 1?
Location 1		45		2. Safety stock in location 2?
Location 2		55		3. Combined safety stock (2 locations)?
				4. Pooled std. deviation of lead time demand?
	p12	0.9		5. Pooled safety stock?
	alpha	97%		6. Portfolio effect (SS reduction)?
	z	1.88

Using these two formulas together, we are basically looking for an optimal decision on whether to centralize the inventory for a given SKU based on whether the correlation in demand will yield a lower Safety Stock, and obviously when SS is Inventory levels for the Product is lowered through out the entire Supply Chain. In a properly managed Supply Chain which is optimized for Cost and Customer service, SS is the barometer by which a SKU can quickly be judged. If SS is high, then variance and customer service requirements are also likely to be high, when SS is low then we know that variance is typically reasonably low as well. 

I think this next chart will help to conceptualize the idea behind using Risk Pooling:

As you can see in this chart, SKU ABC from both Loc1 and Loc2 are close to having a -1 correlation. When demand for the SKU from Loc 1 is high, the demand from Loc2 is low, by combining this SKU into 1  well place Distribution Center the average demand becomes very predictable meaning that Inventories and SS can also be lowered. When analyzing across many SKUs you can quickly see how Inventory Carrying Costs can be greatly lowered. Of course you will need to factor other SC costs to see if there is a NET benefit, but it has been my experience that after doing a deeper dive into consumer data that you will quickly see that there is a huge Net Benefit, and that you can use an existing warehouse by simply changing some Supply Chain policies. 

I hope that I covered this topic well, please feel free to email me with any questions. 

Reducing Supply Chain Costs by Managing Variance

In this discussion I will look at one of the biggest factor in managing Supply Chain costs; Variance. Regardless of what industry you are in having a better understanding of measuring and controlling variance in your Supply Chain will go a long way in accomplishing lowest Total Costs and meeting customer demand.

In a perfect world, we would know the exact customer demand, all shipments would arrive on time, there would be zero defective parts/products, inventory costs would be low and every customer order would be filled in full and on schedule. We all know that this is not the case, so we must learn to understand how to measure and manage variance in order to achieve a Lean Supply Chain.

In contrast to the outdated EOQ model many supply chain managers tend to use Optimal decision models which can take into account Variance of demand and lead times along with the Costs of Level 1 and 2 service failures, Inventory holding costs, quantity discounts, logistics costs, ordering and back-ordering costs, and other factors that might influence Inventory policies like product obsolescence and life cycles.

In order to properly understand the real costs for any supply chain component there are really two things that must be understood: Variance and Costs. Concerning Variance; having data and information from the consumer end of the Supply Chain is hugely important for reducing costs due to variance. Walmart is probably one of best examples for sharing information through their Retail Link Point of Sale database. Walmart was a pioneer of sharing Point of Sale data to their suppliers who knew how to use the data to better understand demand planning. By giving their suppliers access to store level sales data Walmart gave their suppliers the ability to lower cost through-out their supply chain by reducing demand variance. Reducing demand variance leads to reducing supplier variance because as the Supply Chain moves away from the point of consumption the impact of Variance is compounded. Think about a supply chain that has  Raw Materials Supplier ==> Level 1 Manufacturer ==> Level 2 Manufacturer==> Wholesaler==> Retailer==> Consumer, in this example assume that the no one is sharing information. The retailer submits orders to the wholesales that varies from 2-10% each order, as this variance travels up stream in the supply chain the variance and resulting safety stocks increase at each level in the supply chain. This adds unnecessary costs through-out the supply chain. Now consider that the Retailer decides to switch from Product A to Product B due to their Category Strategy, the result is there is a tremendous amount of unwanted upstream inventory that now must be liquidated somehow.

The second variance that must be controlled is logistics variance, which is a simple as building and maintaining carrier scorecards, and working with the logistics companies to remove any variance in deliveries.

Concerning costs, these are somewhat more difficult to calculate. Inventory holding costs can usually be easily calculated by understanding what it cost to have money tied up in inventory, warehousing costs, and shrinkage costs due to damages and theft. The cost that are much more difficult to calculate are service level costs, when you are not able to fill an order for a customer, what does it cost to make that right. Do you miss that sale forever? How many back-orders can you have before you might loose a customer? Are there any charge-backs because your customer's customer walks out because your item is not there? These costs can be calculated by coordinating with your marketing and sales team.

At the end of the day it is a good idea to collaborate with your upstream and downstream partners as much as possible in order to create a Lean supply chain because once variance is well managed the cost components typically fall into place.

Gas and Diesel Prices 2012: My Projections for 2012.

Fuel is a major concern for everyone businesses and consumers alike are affected when the price of fuel increases because this one Super-Commodity drives drives prices up at every stage in the supply chain. Oil prices are very difficult to understand because it is not a normal commodity because Oil is a key component to everything that is produced today in some shape or form. Oil also has two distinct markets Crude Oil(downstream) which impacts the prices of all Petroleum Products, and Refined Oil the largest of which are Gasoline and Diesel which mostly impacts the price at the pump.

A little timeline to why the Price a the pump has increased and will likely continue to do so for the rest of 2012:
Currently the US is exporting more Refined Oil products than we are importing i.e. Gasoline and Diesel. The daily export rate is around 3 Million barrels per day, the US consumes around 8 Million Barrels per day. So we exporting a 38% surplus of REFINED petroleum products( not crude). Were it not for increase in world demand for Fuel then the price at the pump in the US would be substantially lower.
Let's see what has happened recently
- In 2011 the US consumption of fossil fuels decreased dramatically compared the preceding several years. US consumers did a lot of things to prevent those dreaded trips to the gas station.
- While consumption of Fuel in the US has decreased, the demand for Fuel in emerging markets has been on the increase.
-Brazil for example entered the world market in a heavy way late 2011. Brazil has depended on ethanol from sugar for that last several years, but in 2011 there was a major shortfall in the sugar crop and ethanol production, so Brazil had to go out and buy Gasoline, a good portion coming from the US. This added pressure to demand for Fuel and the world  price increases. In late October 2011 the Brazilian government announced that they would lower the taxes on Fuel to help ease the prices at the pump because Brazil was going to the world market to supplement their gasoline needs. After the announcement Fuel Prices in the US surged for the next 4 weeks.
-In mid-February China announced that they would be raising the ceiling for Gas Prices in a response to their need for Refined Fossil Fuels, and the increasing price in the world market. A week later the fuel prices surge to a record high for February.

I am only presenting two small examples about how the world market is affecting the price we pay at the pump. As world consumption has increased due to emerging markets. Fuel prices which were once driven mainly by Crude Oil prices, are now under pressure in both Crude Oil markets and Refined Oil markets. For US consumers the problem is even worse because in the world market the US is competing against countries that have energy policies that help consumers and businesses. The recent energy policies in the US have been punitive in nature towards the consumer and businesses which will only propel our fuel prices even more as other countries enter the market to buy our refined oil. This is not a political statement, but an observation.

For 2012 the price of Fuel is Likely to increase Significantly. 
The price for Diesel has increased in 2012 an average of 12.42%, however from week to week the rate of increase has slowed as Diesel reaches an equilibrium price. The coefficient for the rate increase using the current numbers is 0.0052. Please see the chart below.

The chart above shows the increase in Fuel price this 2012 over 2011, as you can see the rate of increase is declining each week as the price of Diesel approaches an equilibrium price in the world market. Please note the R2 is 66% which means that the Line with a Coefficient of 0.0052 explains 66% of the data. Which important in the next graph below.

The above graph are the projected prices for 2012. This based on the benchmark of how high prices have been over 2012 versus 2011. This is also considering the Regression Line which show a decline in price increases over last year, but the increase in fuel prices over last year seem to have plateaued at this time.

Third Party Logistics; Is it the best Solution for you?

Over the past 20 years or so 3PL’s have been growing and new logistics companies are started every year. Based on the growth in this segment alone,  there is a definite need in the market place for the services that Logistics companies can offer their clients. The problem for many shippers that have decided to take a look at a 3PL is what do they really do for me, and which company best suites my need.  I would like to discuss the more general types of 3PLs and what the customer should look for when considering partnering with a 3PL.

Why?

First I would like to look at the Why. The top reasons that companies consider using a 3PL are as follows:

1)      Cost Savings: As companies grow, supply chains expand, or competition increases companies start considering more innovative ways to drive costs savings without impacting customer service or reducing product quality, so looking at the supply chain is a good place to have a positive impact on the balance sheet without giving up any competitive advantages. At the end of the day logistics is a specialized commodity, but a commodity none the less. Since Logistics is a specialized commodity there is an element of leverage in negotiating prices, so customers many times choose the best two or three providers to get the best price many times at the expense of an optimized logistics network.  Certain 3PL’s bring leverage and a strong understanding that allows the client to realize the best rates and best carrier on a shipment by shipment basis.

2)      Technology: Clients wanting access to a TMS that can sync with their ERP system or act as a standalone system will also go to a 3PL versus spending anywhere from a $100k and up to buy technology that may or may not bring a return on investment.  Access to technology should be a standard offering from any 3PL that you speak with.  The other benefits of TMS are the ability to choose optimal routings based customer requirements and price, so a TMS further improves cost savings by looking at every possible option and presenting those options to the decision maker. Also, with a TMS comes the ability to warehouse and mine data for customer insights and trends which can be used to help in Marketing, Sales, Customer Service, and even Finance. With a 3PL you get a TMS and support at a fraction of the cost of buying your own system.

3)      Financial Settlement: When a client is shipping many items on a daily basis with many carriers, the finance department is getting hundreds of invoices from dozens of carriers, and many times the finance department has to review these invoices for accuracy against the agreement that they have with each carrier. This task is not helped by the fact that a carrier has a Rules tariff that acts as an addendum to the negotiated rates. These rules tariffs can be up to 300 pages long with all kinds of rules that make auditing the bills even more of a burden.  The right 3PL will have a simplified tariff, and an audit department that is able to audit your bills with 100% accuracy and the ability to GL code those invoices so that you can accrue your bills accurately and timely each month. Also, the audit process usually finds another 2% savings by correcting bills that were billed incorrectly in the past and paid.

4)      Service: Because of the leverage that a 3PL has with the carriers, the client gets better service and faster problem resolution than when dealing with the carrier directly.

5)      E-Commerce: Recently I have come across a lot of companies that are trying to maximize their E-Commerce channel. Most companies that I have spoken with are trying to satisfy this market with their existing supply chain, but in order to compete in the E-Commerce space you have to re-think your supply chain for this channel. Using a 3PL can give you instant expertise and optimization allowing you to grow this profitable segment of new business.

In many ways using a 3PL is a lot like shopping at a retail store versus dealing directly with the manufacturer. You get better prices and service buying your Tide from Wal-Mart than if you bought it from P&G directly.

Types of 3PLs

1)      Specialty: This is exactly what it sound like, for some industries there are some logistics networks that are so specific that using a 3PL that specializes in a certain logistics setup network is the best choice.

2)      Rate Re-Sellers: Rate Re-Sellers are not really 3PL’s in my opinion. These are companies that have blanket agreements with Carrier’s typically LTL, and they re-sell those rates to you with a markup. For companies that have relatively small spend, these companies offer better rates than what you would get with the same carrier. The downside is that these blanket agreements are used by the Carriers to fill excess capacity, so the blanket agreements are subject to change at any time. Also getting a problem resolved is very difficult since there is no service agreement between the Re-Seller and the customer. The other problem is that for the customer that typically uses Re-Sellers each shipment is hugely important, but since service is inconsistent you may be making a gamble by engaging a Re-Sellers services.

3)      Out-Sourced Logistics: These companies are handful of the Really Large logistics companies, and they are usually best for large companies that have decided to focus on their core business and outsource their logistics and supply chain completely. While using these companies offers companies to completely outsource their Logistics function, the downside is that it is often so costly to get out of these agreements for whatever reason. These companies are best suited for a company that is very good at marketing and R&D and wants focus its talent on developing those competencies. Also, you will need to have a very significant Supply Chain spend to justify using one of these companies.

4)      Co-Managed Logistics Partner: This type of 3PL allows companies to retain control of their Logistics, realize substantial cost savings, and improve logistics performance by partnering with a 3PL that offers price advantages and a logistics network that is specifically optimized for the client. These types of 3PLs are going to want to get understanding of your business in order to diagnose before prescribing a solution. 3PLs in this space are interested in know your value stream i.e. how is value created across your company, and how can they help reduce waste or create value.

In my opinion the best 3PL to engage first is one with a Co-Managed model, as they will first interview you on your supply chain, and if they have a solution they will suggest talking further. If they don’t they will tell you that they can’t help you, and suggest where you might want to look. As someone that worked for a carrier for many years I can tell you first hand that you will always benefit by using a 3PL versus dealing with the carriers directly. So I hope this little article helps to clear some of the confusion that exists out there and helps you in deciding which route to take. 

Cash Flow: You Don't need AR Factoring.

Search the internet today, and one of the biggest problems facing businesses is managing cash flows. A business known as Accounts Receivable Factoring which has been around for quite some has recently shown signs of growth as businesses struggle with managing the flow of cash, which has been exaggerated by the credit markets where credit facilities are harder to get especially when you explain that you need it to help you with your cash flow problem. AR Factoring is the business world equivalent of Pay Day Loans, and on average it costs a whopping 2% to use these services. Factoring is where Company A gives their open invoices to the Factoring company for cash minus the 2%, and of course the other fees associated with the Factoring services. The Factoring companies will advertise the low rates of 1.95%, but don't forget that they are going to add a risk premium for your customers that have less than stellar credit history's. At the end of the day you walk away with about 98-92% of your cash, but you have cash to pay your bills and employees.
While factoring is a quick and easy way to fix a cash flow short fall, for many companies it is really treating the symptoms not the disease.

Step back and look at the Root Cause: Think of all of the steps in selling a product to you customer:
Day 1 Your customer places the order:
Day 4 You either manufacture it then or pull it from inventory, which mean that you need to make another one, CASH OUT.
Day 4 You ship the order to the customer. Cash Neutral
Day 8 You have to wait for the invoice to come back from the carrier.
Day 12 The carrier invoice has been audited if correct the Shipping and Product Invoice can be merged into a final document.
Day 15 The customer receives the Invoice, and it goes into audit.
Day 17 Audit complete, if the invoice is correct the the customer pays you in thirty days on terms.
Day 34 You pay for the freight. Cash Out.

Day 49 You finally receive payment for you product. In that time you have Paid for the making of the product and shipping the product, not to mention all of you other costs. This is assuming that the Invoice process went through without any problems which is not always the case.

Let's see what happens when you Partner with a 3PL that on average Pays you 2% to you Bottom line:

Day 1 Your customer places the order:
Day 4 You either manufacture it then or pull it from inventory, which mean that you need to make another one, CASH OUT.
Day 4 You ship the order to the customer. Cash Neutral
Day 5 The Shipment is billed an EDI is sent to the Auditors at the 3PL.
Day 5 The Freight Invoice is audited and put into General Ledger format which always you to automatically produce an invoice for your customer.
Day 5 The invoice is prepared and sent to the customer.
Day 7 The customer Receives the invoice, and since your bills are 100% correct your invoices fly through the auditing process. They will pay you in 30 days on terms.
Day 12 The freight is paid. Cash Out.
Day 37 You receive Payment for the product.

WOW!!! A 12 DAY Improvement Just from having more Control and Visibility to the Logistics portion of you Supply Chain.

Having a streamlined process for your logistics costs as it is tied to producing invoices for you customer can make a huge difference in you company's cash flow. Examples 1 and 2 while being examples are not far from the truth for many companies that I have encountered. Improving you cash flow by 12 days is a tremendous improvement, and can mean the difference of Factoring and order using credit and being able to cash flow your operation. This kind of cash flow control could be the difference maker for you company.

Logistics: Its what I do.

Today, I want to write something a little more personal, but don't worry it is related and relevant. People often ask me, "what do you do?", and I always respond, "I help other companies make more money and become better competitors in their industry" The next question is naturally "How do you do that?", I then explain to them about how many companies have a real need for turning their Supply Chain and Logistics operations into competitive advantages. I also explain how the Supply Chain is the link between every strategic function in a company, and can be the real difference maker between winning and loosing. At this point most peoples eyes have fully glazed over and they want change subjects. With this in mind I thought that it would be best to use Industry Averages along with real averages that I can bring to the table to show what I do for companies.

What I do is very simple, I look at a clients Logistics setup, and with a team of engineers we optimize their Supply Chain based on the client's needs. To give an example using averages here is what the numbers look like.

Figure 1

In Figure 1 is an example of what happens when we partner with a typical company that is doing $200MM in top line sales. I would just like to point that that client would have to figure out a way to sell 28% more product in order to realize the same addition profit that we can bring through supply chain optimization. I don't know many companies that are projecting 28% increases in sales this year. In addition to the First year Profits, look what happens when we continue to be partners with this sames customer.

Figure 2

As you can see in figure 2 as we continue to be partners, this client continues to realize increasing profits year after year.

In addition to these hard monetary improvements, this client is also experiencing a more agile and responsive supply chain, higher customer service numbers, better order execution, higher fill rates, increased market share due to consistent supply versus the competition, and even increases in brand equity due to better execution.

So this is basically what I do, and I hope the visuals give a better understanding of the value of partnering with a logistics solutions provider.

.Com, A Big Opportunity for Traditional Retailers.

I have been paying attention to a couple of trends in how consumers’ (me included) purchase different items through different channels i.e. traditional go to the store versus online. The other trend that I have seen is how the traditional retailers like Wal-Mart have responded to the online opportunities, but have been a little slow in finding ways to match the dominate online retailer Amazon.com. With the state of the economy in the last several years retailers have been under tremendous pressure to lower operating costs, increase same store sales, and expand their revenue streams beyond general hard-lines and grocery. While a few years ago some retailers were focusing on SKU rationalization, which is basically reducing the variety of items that are offered in a particular category in order to optimize sale through and operating costs. The tide has turned and retailers have not only increased their SKU count to offer customers more variety, but many big-box retailers such as Wal-Mart, Sam’s Club, Costco and Target have expanded their offerings to the consumers through their online marketing channels. A person can buy appliances like washers and dryers, mattresses, furniture, electronics and much more through the .Com channel of these traditional retailers. The online retail space is projected to be a $250 Billion industry by 2014, and traditional retailers must learn to be leaders in the online channel as they have been in the traditional store channel, and the winner in this space by far is Amazon.com, not Wal-Mart or Target.
Retailers like Wal-Mart, Sam’s Club, Costco and Target have become powerful brands, and in many cases the Retailer’s brand is stronger than the product being sold. To give an example, I just bought a mattress for my son through Sam’s Club.com. The mattress was a brand that I have never heard of, but I have been a customer of Sam’s Club for years, and I trust their ability to source quality products at excellent prices, secondly, I know that if I am not satisfied with the product I can simply return it to Sam’s Club without any problem, so while I know nothing about the maker of the mattress I trust Sam’s Club, that’s brand power. This brings me to my point, which is traditional retailers have an obligation and a huge opportunity to become major players in the online space. The big box retailers have several things going for them; they have a traditional store footprint, they have tremendous scale and operational efficiencies, and they have powerful brand names. The one thing that retailers have not done well in my opinion is to make the make the online buying experience as easy and seamless what I would expect online. I think that the reason for this is because traditional retailers are very good at getting a lot of product to hundreds of stores; this expertise does not automatically translate to being good at getting one product to one customer’s home. Until recently the traditional retailers have used their regular supply chain channel to support their online channel. Sam’s Club has made major improvements in the past year; I can say this as a consumer who has been using samsclub.com for a while now. The retailers will have to learn how to develop another supply chain network to support their online channel because there is now way the economics in store replenishment are anywhere near the same as fulfilling one order to one customer.
Let’s take a look at Amazon.com, who by the way has been the reigning champion as an Online Mass Merchant for several years running. Amazon.com has been very successful in making online shopping very easy and cost effect for the customer, and think about this Amazon.com does 13.1% of the sales that Wal-Mart does in the U.S, but they don’t have a single store in the country. Amazon has done this by completing online channel for the customer. Amazon.com provides a very good and intuitive virtual shopping environment and then provides the customer with seamless delivery of the product to the customer’s home. We have to admit that buying online is a bit different than the traditional buying method that has been employed since the beginning of trade in human civilization. Consumers are giving-up the ability to touch and feel the item that they are about to purchase, so there could be less of a connection between the consumer and the product depending on their familiarity with the product, so when you sell an item online, you need to complete that connection between the customer and the product as quickly as possible. What Amazon.com has done well that other traditional Mass Merchants have not; is to get the product to the customer’s home as quickly and efficiently as possible. The traditional retailers have relied heavily on their store locations and DC to store supply chains to fulfill online orders, while this makes sense initially, long term this is not a good strategy for the big retailers for several reasons. First of all retailers’ don’t have those big back rooms anymore, and when you consider that Amazon did $34BB in sales in 2010, which is about 13.15% of Wal-Mart’s U.S sales of $258BB, then it becomes very clear that as retailers increase the strength of their .com channels they run the risk of increasing their inventories, increasing operating costs, and lowering customer service because the stores are just not set-up for or staffed to pick an pull customers’ online orders.
The opportunity as I see it is for the traditional retailers to apply their know-how and leverage their brand to complete the online buying experience all the way into to the customer’s home. If retailers like Wal-Mart can execute an online channel that allows customers to choose service levels such as home delivery, inside delivery, or even some light assembly at the customer’s home, then the traditional retailers will soon become as dominate in the online space as they have been in the traditional Brick & Mortar space.