Made to Order

Dec 01, 2005 10:30 PM  By

“What do you mean, Acme is costing me money?” asked Rusty, CEO of AAA Widgets Corp. His old friend Woody smiled. “Sure, Acme is one of your oldest and most loyal customers,” he said. “But you’ve rewarded that loyalty by not raising Acme’s prices in eight years and extending to them all the benefits of your best value-added services at rates lower than your costs. I’m just telling you what I found in the random sample you asked me to look at.”

“So what’s your recommendation?”

“Rusty, I think you need to take a comprehensive look at your costs. Six of the 10 accounts I analyzed were red-ink operations. Some were part of your recent growth spurt. I think your costing is out of whack, and that’s why you’re not making money even though you’re growing.”

“You know, Woody, you may be right. We’ve grown quickly in the past couple of years, and I can’t say I have my finger on the pulse of each account like I did in the old days. Dig as much as you need to, and get me some answers as fast as you can.”

A week later they met again. The more Woody had dug, the more Acmes he had turned up. He concluded that of the 2,000 accounts to which Rusty’s firm was selling, only 100 were profitable. The remaining 1,900 were marginally profitable or money-losing accounts.

I first heard a version of this tale a couple of years ago at a supply chain conference. Whether entirely true or not, it offers several lessons for all of us:

Know your costs, especially the hidden ones

Most organizations have accounts like Acme. They start out as very attractive, win-win arrangements. Once things have settled down and are working well, the Rustys in us tend to focus on the newer, greener grass or on firefighting in other places. With the passage of time, things change to the point where Acme is the antithesis of a desirable account. And not long after that, Rusty’s company becomes lunch for his competitors.

Track accounts individually

When you use overly simple indices, such as the average cost to fill an order line, the true picture of where costs are and what constitutes a good or bad account can be obscured. You run the risk of missing hidden costs or added services that are below the radar.

Keep up with cost changes

Factors such as the steep rise in fuel costs are easy to spot and adjust for, because they are noisy and expensive and affect every account. More insidious are those costs generated by high-maintenance customers — the ones who always need special treatment, whether it’s extra customer service help, last-minute orders, or expedited shipments. Such costs go up in small increments and over time, but they can get big.

Work aggressively to control and reduce operating expenses

Despite the many large gains that distribution centers have made in this area during the past two decades, there remain substantial opportunities to cut costs. For example, in a recent survey by the Warehousing Education and Research Council, more than 27% of 384 members surveyed reported overtime costs in excess of 15% annually — a huge and largely controllable number. For a DC with 100 workers at a pay rate of $15/hour, that represents about $700,000 each year!

SEPARATE AND UNEQUAL

Now let’s look at how Rusty might approach his problem. First, he needs to recognize that not all orders are equal. Therefore, calculating their cost needs to be adjusted accordingly. Errors in per-order costs affect different sectors differently. For example, in electronics the high cost of inventory make accuracy a premium consideration. In retail, chargebacks (customer penalties for non-compliance, deducted directly from invoices) are a way of life. They need to be managed but cannot be avoided and thus must be calculated into the cost equation. They will vary widely by account as well. In the online world, a high level of returns ties up inventory and increases handling costs even for the perfect order, so it is imperative to avoid returns caused by budgeting errors.

Second, Rusty must understand that although order patterns and their implications vary widely, they share some fundamental characteristics that should be taken into account in building a model for calculating costs. If nothing else, the listing below (certainly not intended as comprehensive) may stimulate your thinking about key elements that are pertinent to your operation:

Order-taking procedures

If an operator keys in faxed or mailed orders, the process is labor-intensive and prone to error. Online ordering has the double benefit of partially automating the process and of shifting the burden of key entry to the customer. One small company I know of saved about 10% in costs by doing so.

Order preparation

Are there any credit and other holds that require operator intervention? Is the account qualified to order that item or line? Consider such factors as the cost of incomplete data, backorders, substitutions, printing and distribution of paper pick documents, and marrying pick tickets and labels.

Order fill

Examine whether the order requires specific pick methods (one order at a time vs. batch picking), value adds (stickers, assortments, repackaging, inserts), unique packaging or labeling, consolidation, or special documentation. You must factor in costs for shipping backorders and holding safety stock.

Shipping

All freight options carry a variety of associated costs, including “accessorial” charges and extra fees for redelivery.

Returns

The elements to look at here include the customer service rep’s time, phone costs, the labor and freight costs incurred to reship the product, lost or damaged inventory costs, reduction in inventory turns, and lost sales, especially for seasonal and promotional items.

Quality control

Dollar values need to be affixed to the time it takes to discover defects and the time and resources — electronic and physical — allocated to correct them.

Third, as Rusty discovered, it’s important to be able to differentiate among customers in exploring the issue of costs. Basic questions to ask are:

  • What is this customer’s rate of claims and returns?
  • Compared with the customer base as a whole, is this account high-maintenance?
  • How does this account compare with similar accounts in regard to profitability?
  • Is the account resource-intensive? What are the cost burdens resulting from expedited handling, add-on orders or lines, driver waiting time, unplanned inbound freight, and exceptional customer service and reporting requirements? Have these unusual requirements been factored into the per-order cost calculation?

All of the items listed above may add to the cost of filling an order, and many are invisible. A quick examination of the processes of your own organization will likely produce more questions to add to the list.

FITTING MODEL

The table “Order-processing costs” on page 40 shows a hypothetical order processing cost calculation that does not include returns, quality control, or inventory considerations. It does include allocated costs for online functions. By expanding and fine-tuning this model for each customer, Rusty can take a good first step toward understanding what is actually required to fulfill individual customers’ needs. The model assumes different levels of compensation for different functions. It also imagines an organization that is heavily dependent on Internet ordering (almost 75% of orders). The resulting cost could be compared with relevant sales data on a customer-by-customer basis or for groups of similar customers.

Of course, few direct commerce companies have the time, resources, or will to maintain an ongoing calculation process like this. Most marketers use key indicators to provide early warning of problems, which then trigger further analysis. Here are a few examples:

Labor ratio

This measurement compares the cost of labor to the volume of sales in dollars ($ wages/$ sales). If one can safely assume some consistency in labor rates over time and roughly the same mix of value in the items sold, a growth in the number can be a reliable indicator of a cost change that bears more-intense scrutiny. This can be a good measure for comparison between DCs as well as within a single operation.

Expense ratio

Similar to the labor ratio, this calculation relates total cost of facility operation to sales ($ operating expenses/$ sales). It also makes the same assumptions about consistency across time but probably serves better as a guide to internal facility performance than to comparisons between facilities.

Line-item monitoring

Many hard-lines companies track the average cost per line shipped and compare it with the average value of the lines shipped as an indicator of whether targets are being met. They also use the relationship between the numbers as a starting point for more-detailed investigation.

CUSTOMIZED CALCULATIONS

At his next meeting with the CEO, Woody would be well advised to make recommendations for how Rusty can attack his problem. Woody’s suggestions might very well include some or all of the following:

Analyze individual accounts for cost and profitability

We’ve spent some time on this above, but it bears repeating. Whether you examine a few accounts each month or go over them by category (highest volume, market segment, most growth), do the work. It is bound to reveal things worth knowing.

Automate

This option can take on several forms, but it is often cost justifiable and is a constantly evolving part of the business. Online order processing is one tactic that can change the cost structure in important ways. Another is the use of warehouse management system applications that process transactions in real time. This means you can address tasks such as replenishment, cycle counting, and inventory problem resolution more quickly and make the results available to users in time to avoid outcomes that increase costs.

Streamline inventory performance

Although this may be viewed as an oblique line of attack on costs, it’s certainly true that increasing sales without applying more resources to do so is attractive. If you reduce cycle time from receipt to availability for sale, you can generally improve your fill rates and reduce the amount of inventory kept on hand. Clear the inbound dock every day as a matter of policy. Inventory control may be regarded as an indirect cost of processing orders, but it affects direct costs in powerful ways and can involve some very large numbers.

Solicit input from “users.”

Distribution and fulfillment operations remain heavily dependent on people rather than machines to do the work. But the collective wisdom of the DC labor force is often underestimated or just plain overlooked.

Look for help from vendors and customers

Likewise, solicit the help of your other relevant constituencies. Both vendors and customers work with those same products that may be causing you a problem. See how they’ve addressed any issues. Maintaining and nourishing good communications on both ends of the supply chain can sometimes have surprising consequences from the cost perspective.

One wholesale supplier to a major retailer was struggling over a growing chargeback problem. The supplier was selling two brands of goods to the retailer — one with price stickers and the other without (the manufacturer forbade it). While the retailer was getting good, reliable service and highly competitive pricing from the supplier, it was also issuing recurring sanctions for nonstickered items. Only when the two parties sat down face to face did issues become clear. On top of the price-sticker prohibition, it came out that the supplier was defined in the retailer’s purchasing system only as a provider of priced goods, not of items without price stickers on them. When the retailer changed its system records, chargebacks plummeted by more than 80%.

If requested, vendors may be able to change unitizing to reduce inbound handling, or to use carriers that are more satisfactory. There are often many such cost-reduction opportunities available for the taking.

Motivate workers to improve

Warehouse employees make discretionary decisions every day. If they’re making decisions that result in lower costs, everyone wins — customers, workers, management, and investors.

During a five-year period, a wholesale distribution center for a well-known company used incentives to improve productivity, with dramatic results. It enjoyed a 71% gain in productivity, enabling a workforce reduction, mainly through attrition, of 144 full-time equivalent (FTE) employees (a 60% reduction) and taking more than $5 million out of the cost equation annually.

Rusty may not live happily ever after, but if he acts on Woody’s advice, he’s bound to make AAA Widgets Corp. more profitable. And surely Woody’s advice can help you too.


Ron Hounsell is director of logistics services at Cadre Technologies, a Denver-based supply chain consulting firm.

Order-processing costs

Annual volume Full-time equiv. $/hour loaded Annualized
Order taking Phone 50,000 2 $17.50 $72,800
EDI 25,000 1 15.00 31,200
Fax 3,750 0 0
Mail 18,750 0 0
Online 275,000 1 22.00 45,760
Total volume 372,500
Order prep Printing, sorting, distrib. 1 12.00 24,960
Wave prep, printing, distrib. 1 25.00 52,000
Fulfillment Picking 10 17.50 364,000
Checking 1 17.50 36,400
Packing, consolidation 2 15.00 62,400
Shipping 0 15.00 0
ASNs, EDI 0 0 0
Error handling Customer service time 1 18.00 37,440
Inventory loss $2,500 30,000
Packaging, shipping $1,000 12,000
Annual overhead Catalog $3,000 3,000
Web access $10,000 10,000
Credit-card processing $55,875 55,875
$837,835