THE CUTTING EDGE

Jul 01, 2001 9:30 PM  By

If you were a doctor treating the human body, you would try, as far as possible, to save a diseased limb, not hack it off with abandon. But if you were a business manager facing a massive cost-cutting campaign launched by a panic-stricken CEO, you would readily axe any function not deemed essential.

Logistics has often fallen victim to this mentality in the past few years. The most important tool in the hands of the logistics manager is the ability to manage — in fact, almost manipulate — a sensitive combination of functions, operations, policies, and practices. Recently, this approach to logistics and supply chain management has been replaced by necessity with expediting, firefighting, head-count slashing, ERPing, and Y2King. It’s time to call for a move back to logistics management: to a process whereby managers plan, evaluate, decide, arrange, and act to achieve the best possible level of logistics costs.

Following a tremendous increase in volume a year or so ago, the faltering economy has resulted in surges in demand — one month customer orders are up, another month they are soft. As companies look for ways to improve quarterly or annual earnings, logistics becomes a target for cost cutting.

Truly managing logistics means providing service to operating business units and customers, planning and solving logistical problems, and, of course, controlling costs. And why not? Last year logistics costs made up 9.44% of sales. Of course, the most difficult time to control spending on logistics is during an economic downturn. What usually happens in a downturn is that production has made it, we’re stocking and storing it, but customer demand is, at best, steady — or more likely, declining or stagnant.

So, what to do? First, let’s take stock of the costs.

What costs are incurred? Because logistics includes everything in the part of the supply chain that moves goods, services, and information, total logistics costs as used in industry typically include the costs of transportation, warehousing, logistics administration, customer service, and inventory carrying (see the sidebar on page 20 for definitions of the major cost components of logistics). Supply chain expenses tack on the costs of the departments and management involved in production planning, inventory control, forecasting, demand planning, deployment, purchasing, and sourcing.

Many companies do not track costs in this way. Warehousing of finished goods at the point of production is often a part of the plant or production cost. Transportation — is that our cost, or does the customer or vendor pay that cost directly or as a part of the purchased price? Inventory — who takes responsibility for that in the company? Sales? Production? Inventory planning? Finance? Pulling together the real costs of logistics frequently requires a non-partisan, all-encompassing examination to truly represent the actual total costs incurred.

Tracking the full logistics cost picture is important because optimizing only one cost component usually results in a shift of costs from one type of expense to another. You must work on the whole to accomplish real control or reduction; otherwise, a reduction in transportation may just lead to more warehouses. A reduction in warehousing may lead to more expediting cost in production planning and customer service. A reduction in production planning or customer service management may lead to an increase in inventory. A decrease in inventory may lead to an increase in premium transportation. You’re getting caught up in what might be called the logistics mismanagement cost increase cycle (see diagram below).

So managing logistics means more than tracking and benchmarking processes. It means controlling those processes and driving the total logistics costs to a minimum. But it all starts with knowing your costs and how they compare to industry standards. The Establish, Inc./Herbert W. Davis and Company Logistics Cost and Service Database has been tracking these industry standards for over 25 years. Costs are tracked as a percentage of net sales and per hundredweight by cost type and industry. Industries covered include consumer and durable goods manufacturing, in addition to distribution and retail. For a complete list, see the sidebar below.

Variations on a theme

Overall, costs across all industry groups average 9.44% of net sales and $57.24 per hundred pounds delivered to customers. But by industry, logistics cost as a percentage of sales ranges from 1% or less to 15% or more. What causes such a large variation? To begin with, the cost measure — dollars of expenses as a percentage of net sales dollars — is tremendously affected by the sales value of the products produced, stored, handled, and shipped. So logistics expenses for high-cost products, like pharmaceuticals, circuit boards, and other replacement parts, with their high value, are typically quite low as a percentage of sales. Logistics costs for lower-value products, such as non-durable consumer goods or industrial supplies, are much higher when calculated and expressed as a percentage of sales.

Costs are also determined by the buying and negotiating power of a company — essentially the economy of scale. However, this effect is not as simple as large companies paying less. That works up to a point. Companies beyond the size of being able to manage effectively can actually incur a lack of economy of scale — their costs as a percentage of sales can be higher than those of smaller, better-managed operations. The data from 2000 shows a significant economy of scale without a distorting effect, but this varies year by year and industry by industry.

This mix of costs is represented in the pie charts on page 20. Transportation has traditionally been the largest cost component and averages 37% of total logistics costs. Warehousing is the second largest component, averaging 25%. Inventory carrying cost — the cost incurred by the company as a result of having money invested in finished goods — is, at 21%, the third largest component. The costs of logistics administration and customer service/order entry are smaller in size, but have been increasing as companies add computer support and try to manage information and plan more effectively.

These cost levels have changed over time. Overall logistics costs are most affected by ideas of control and management, as well as significant slowdowns in demand. The organization of physical distribution (as they were then called) departments in the early 1970s and the deregulation of the motor carrier industry in the 1980s are responsible for the largest declines in logistics costs since they began to be tracked. The largest increases have occurred as a result of the oil embargo and skyrocketing interest rates in the ’70s and the sluggish demand associated with the economic slowdowns in 1981 and 1991 (see graph on page 22). Remember, during large downturns, you still have the inventory stored in warehouses and must continue to pay for storing and carrying it while waiting for sales volume to trickle in.

Since last year, some companies have reduced their costs, while others have experienced cost surges. Twenty-three percent of companies cut their logistics costs, with an average reduction of 11.5%. On the other hand, 46% of companies experienced a cost increase — and that increase averaged 26.6%. This means that two companies, both averaging 10% of sales in logistics costs last year, now have logistics expenditures of 8.5% versus 12.6% of sales. The difference is a whopping 4.1% of sales!

How did the companies that reduce their costs manage to do so? Costs for a particular firm are driven by logistics management, policies, and operating practices. In other words, the costs incurred are determined primarily by the policies and by what is actually being done in the logistics operation. So benchmarking what a company spends may be interesting but becomes an effective tool for cost reduction only when coupled with a review and rationalization of policies and activities, and the identification of opportunities for improvement.

Prix fixe menu

Once a company has determined its top 40 to 50 distribution policies, logistics costs can get fixed in a tight range until policies and strategy are reexamined. Examples of distribution policies include establishing one-call-does-it-all customer service; encouraging electronic data interchange; forming supply chain partnerships; using unique transport networks for different businesses; and setting up uniform operating methods in all corporate warehouses.

Logistics cost improvement seems to come in two flavors:

  1. General improvement of logistics procedures and operations frequently yields reductions in logistics costs because changes in sales patterns, customer requirements, physical product characteristics, vendor offerings, or even internal organization take place constantly, and yet logistics operations and techniques change infrequently. These improvements generally affect 5% to 10% of total logistics costs — 0.5% to 1% of net sales. Nothing to sneeze at — this improvement alone is one of the most easily obtainable cost reduction methods available to many companies.

  2. Breakthrough cost improvement takes the form of deciding to manage and perform logistics differently — changing some policies that have been established for a number of years, changing the responsibilities of vendors or customers, changing the service offering significantly, or changing the method of handling logistics for different channels of distribution. This is made possible by thinking about the supply of goods and services in a new light, handling or performing them in a new way, or using newly available technology to work smarter rather than just harder. Enhancements of this type can equal 20% to 25% of logistics cost, or about 2% of sales or more, as a contribution to the bottom line. In these times of ever-increasing demands for better financial performance, this can be a powerful technique.

Too often logistics managers constantly hit up for cost reductions come to think of themselves as cost controllers. As can be seen from the impact of company size, product value, and sudden increases and decreases in sales demand, logistics costs as a percentage of sales and dollars per hundredweight are not completely controlled by the logistics or supply chain manager. One of the biggest opportunities for cost reduction and process improvement — and one of the hottest topics in logistics — is e-business. No, we’re not just talking about consumers buying books and CDs over the Web. In logistics and supply chain management, we’re talking about online, real-time sharing of information with vendors, suppliers, co-packers, 3PLs, carriers, and customers. In procurement, the best opportunities are frequently found in traditional MRO material, like production parts and supplies, and non-traditional material, like the shipping and packaging supplies that logistics operations use up at such a great rate. Focus on these areas may produce some of that return on investment that top management is always seeking.

Pie in the sky

Although most companies state that they plan to use the Internet to improve logistics, a third still have not addressed this issue (see pie chart on page 22). Some of those that claim to have online strategies in fact have only fancy presentations that do not result in action-oriented programs for this year or next.

It is difficult to separate the real from the imagined in this area. Web sites that promise the stars are hard to distinguish from those that have real applicability to a specific problem. But there are a number of useful, easy-to-implement Web services that offer immediate benefit for inbound and outbound transportation, warehousing, and procurement, and that managers can use to achieve benefits within this fiscal year. For many companies, the Internet may be one of the fastest ways to apply technology to logistics operations for cost control and reduction.

Industrial Strength

Industry groups previously tracked in the Logistics Cost and Service Database include:

Industrial replacement parts
Building supplies/hardware products
High-value industrial durables
High-value consumer packaged goods
Low-value industrial durables
Low-value consumer packaged goods
Computers
Grocery
Peripherals
Produce and fresh foods
Telecommunications
Meat and fish products
Frozen food
Chemicals
Beverages
Industrial supplies
Consumer household products
Consumer replacement parts
Health and beauty aids
Small appliances
High-value pharmaceuticals
Large appliances
Low-value pharmaceuticals
Publishers
Industrial and consumer wholesalers
Tires
Apparel retailers
Consumer packaged goods
Drug chains
Mass merchandisers

Source: Establish, Inc./Herbert W. Davis and Co. Logistics Cost and Service Database

TO HAVE AND TO HOLD

Some companies hold logistics or supply chain managers responsible for the levels of finished goods and the costs of maintaining the inventory. Other firms hand over those duties to sales, manufacturing, finance, or corporate management. But no matter who does the job, inventory is one of the pieces of the logistics puzzle, and it can be minimized at the expense of higher transport and management expenses, or used to offset those charges. Therefore, in many companies, inventory ownership needs to be in the hands of the logistics manager.

The true cost of carrying finished goods inventory can be calculated in either of two ways: (1) by adding up the components of the cost of money, insurance, obsolescence, damage, and so forth; or (2) by using a company’s internal ROI hurdle rate — essentially what the money would be used for and earn for the company if the capital were freed through a reduction in inventory, or what return-producing projects would be shelved because of a need to invest in an increase in inventory. Over the past 20 years, we have collected data on the carrying cost used by our database participants and have found that it consistently averages 18%. That is, the logistics cost component of inventory carrying costs is best calculated as 18% of the average inventory level in dollars at standard cost.
WHD

Data Mart

Average Company: 2000 Database
Logistics Cost
(% of Sales) $/CWT
Transportation 3.54% $28.42
Warehousing 2.39 18.41
Order entry/customer service 0.76 5.59
Administration 0.85 2.84
Inventory carrying 2.03 20.18
Total Logistics Costs 9.44% $57.24
Source: Establish, Inc./Herbert W. Davis and Co.

DEFINE YOUR TERMS

Transportation

  1. Primary transportation. Finished goods movement to the warehouse from plants and vendors. Replenishment movement from plants to DCs or other plants, or between DCs; inbound freight on purchased finished goods moving to plants or DCs for resale.

  2. Secondary transportation. Finished goods delivery to customers. Costs of payments to carriers, pickup allowances given, truck or rail equipment and operations, and freight allowed. Freight origin may be plants, DCs, or terminals. All modes are included.

  3. Total transportation. Finished goods total; that is, the addition of (a) and (b) above.

Warehousing (finished goods). Plant, DC and public warehouse costs for storage and handling of finished goods. Owned or leased operations, including space cost of rent/depreciation, taxes, utilities, maintenance, operating costs for personnel (along with benefits), direct shipping and packing supplies, equipment amortization or rent, supervision, and management. Warehousing includes the cost of bulk terminals, consolidation points, transfer operations, estimates of plant space used for shipping finished goods, and the operating costs incurred in storing and handling finished goods.

Order entry/customer service. Costs include order taking and inquiry handling, staff supervision, communication, equipment, computer time and services, and space allocated to the order entry/customer service function.

Administration of distribution. Generally, this includes personnel and support costs for indirect management, including the distribution central staff, inventory planning and analysis staff, and the traffic department. Note that computer software and hardware cost allocations are increasingly important as a distribution expense. Include them in the appropriate cost category, with any remainder in administration.

Finished goods inventory carrying charges. Our database calculates annual cost at 18% per year (see sidebar on page 18) to obtain a uniform comparison and continuity over the years. This charge is to cover cost of money (opportunity or interest), ad valorem taxes, insurance, and shrinkage. We established this level of 18% very carefully in 1974 when we initiated the database. It still represents a reasonable measure of the cost to carry inventory, although we hear many arguments for both lower and higher figures. The point is not significant for the database, however. If you prefer a different number, simply divide our inventory cost statistic by 18 and multiply by the desired value. The entire database comparison will then be on your preferred level. By continuing to use the same inventory value each year, we switch the focus to transportation and warehousing costs plus other important cost factors, and we report a measure of inventory turnover.

Other costs. This item includes other cost categories not covered in the classifications above that relate to the sales income and/or weight. Very few companies report anything in the “other” category, so we do not analyze it or include it in the reported total. If you have a cost and don’t know where to put it, use “other” and describe it. We will transfer it if necessary.
WHD

William H. Drumm is executive vice president of Establish, Inc., which merged with Herbert W. Davis and Company in 2000. Drumm is responsible for supply chain management strategy, logistics improvement programs, and the practical use of e-business. He can be reached by phone at (201) 944-5580 and bye-mail at william.drumm@establishinc.com.


You are invited to participate at no charge in the Establish, Inc./Herbert W. Davis and Company annual survey of logistics costs. For more information and to complete and submit a simple one-page questionnaire, visit the company’s Web site at www.establishinc.com.