In my last post, I talked about the need for shock absorbers, or buffers, in the supply chain. This week I am looking at the trend for low cost supply chain(s) and the true costs behind them. I happened to have a discussion with Dr. Saravanan of the UNC Kenan-Flagler Business School and learnt about the work he has done with retail companies. It made me think about how modern supply chains might be going overboard with their cost reduction strategies when it comes to designing their supply chain. In the process, most supply chains are also eliminating most shock absorbers from their system. The net result can be quite catastrophic, especially in recession like conditions.
First let me describe the work done by Dr. Saravanan, Dr. Kushwaha and Dr. Gaur. They studied retail companies that seemed to have long lead times (or low inventory turns) and contrasted them with companies that have short lead times (or high inventory turns). What they found, was that when demand went through a major change in these supply chains, the two types of companies responded differently. Specifically:
- Companies with long supply chains responded by deploying a price based strategy: They lowered or raised their prices to move more or less product.
- Companies with short supply chains responded by deploying a quantity based strategy: They reduced or increased their inventory levels by changing the order quantities.
What they found was the companies with short lead times (or high inventory turns) were able to react to sharp changes in demand much more effectively. They were able to align their inventory with the new demand within a quarter; by contrast, it took up to four quarters for companies that had a supply chain with long lead times (or low inventory turns). And in general, the firms with short lead times also seemed to have superior stock market performance as well as lower bankruptcy rates compared to their long lead time counterparts.
Saravanan summarized it as follows: “Just like you look at the benefit of the higher margin you would get if you actually outsource from a far-away place, you should also look at the cost that comes along with it. The margin from the far-away place might not be enough to compensate for the risks associated with longer lead time, especially when demand suddenly changes.”
As I mentioned in one of my previous posts, long lead times impact safety stocks especially severely when the forecast accuracy is bad. And, when the lead time is long, the only forecast that really matters is the one that is done outside the lead time window. (Meaning, if the lead time is three months, you can only take action on forecasts that were generated three months in advance of the planned period or a with a three month lag). And, it is a known fact that the longer the lag, the worse the forecast is as we simply do not know that much about what will happen that far out in the future. All this to say that the long lead times are really fraught with other problems that make the situation even worse.
I compare this to what I see in the marketplace today and the push for lower costs. I have not seen much regard for a lower lead time. And to make matters worse, I often see a strategic relationship with a low cost provider at a far-away (long lead time) place. And then, I see a trend for all the risks being pushed down to these suppliers by way of pressure to reduce costs, vendor owned inventory at stores etc.
I agree that businesses need to look for that low cost supplier base in order to make the most margin and also to deliver value to their customers at a reasonable price. But, I do wonder whether this singular focus also drives out all, or most of the buffers in the system? After all, these buffers have a cost associated with them. And whether or not this makes the business more prone to failure as the authors of the above research found out. My recommendation would to be not focus exclusively on cost but rather take a balanced scorecard approach to the ROI.
What do you think? Are there hidden costs of the low cost supply chain (s) that you think are missing from the discussion? Let me know.