John Vogt on Management Through Measurement Economics
John Vogt, former Halliburton vice president of global logistics, presents the latest in his series on Incoterms, the internationally recognized set of trade rules that sellers and buyers must follow when devising a contract for the shipment of goods. New installments are published each month in our fortnightly online BreakbulkONE newsletter.
In parts 1 and 2 we explored the concept of a calculation which combined accounting costs, capital, time, and inventory to arrive at an Economic Value Added, or, for Supply Chain management, the Total Cost of Ownership. In principle we have the following:
TCO = Capital cost to purchase the asset,
and Expenses to deliver the asset,
and Cost to hold the stock in the warehouse(s) in the logistics chain to support a service standard,
and Cost while goods are in motion between seller and buyer.
To illustrate this concept, we will look at an example utilizing fictional data depicting the option of obtaining goods from three countries. It will be laid out in the simplest form, so the mathematics does not obscure what we are looking for – the correct solution for the total cost of acquiring or owning goods and supplying them to our customers.
For our example we have the following information, which is in units (units can be whatever you are selling). One aspect of this that needs to be carefully considered is whether the measurement is per day or per order period and so on. It is of great importance to use these calculations utilizing the same time span, and the simplest is per year. This results in the following assumptions:
Assumptions Common Data
Demand / day (units) 10
Demand variability (units) 3
Return Hurdle Rate (per year) 20%
Safety Stock Availability 1.77
Order is every (days) 7
Orders per year 52
Order quantity (units) 70
The ‘Common Data’ holds for all our options as they represent what a customer requires (the demand) when our cost of capital is 20% per year (Hurdle Rate) and our promise or service standard which is 95% or a statistical factor of 1.77. Obviously, a higher service standard will require far more inventory and vice versa.
The time and costs are different depending on where we source these units and the information needed to make these comparisons is as follows:
Scenario A Scenario B Scenario C
(US to domestic buyer) (China to US buyer) (Mexico to US Buyer)
Time Time from order to delivery 7 60 15
Time variability 1 14 7
Costs Purchase price / item 480 450 470
Logistics costs / order 350 2,200 800
Goods sold per year 1,752,000 1,642,500 1,715,500
Logistics cost per year 18,250 114,714 41,714
We can then calculate the portions of the formula we discussed previously in the detailed economic analyses! Remember the safety stock is carried all year, but the movement is the number of orders per period of movement, and the logistics costs are per order for the number of orders per year. Beware that the calculations need to show the annual costs. This ensures the calculations have the same period as is required to add them together.
It becomes evident that, in this example, the lowest cost producer is not the most economical. This is not obvious unless one does the full economic calculation as above. One can see why incorrect decisions are made when a focus on a single aspect of the total economic cost, such as just the purchase price or just the logistics cost is used. The differences for each of the sources between the four cost inputs of purchase price, logistics, movement value and stock holding are also interesting. In each case the total price has different proportions of these four contributory factors. This shows that all 4 factors need to be considered, and any decision based on less than a complete TCO will be flawed. As many decisions have been.
There is also the problem of accounting records as there are Assets and some as Expenses mixed into the economic cost. Remember that the cost of the goods will go to an asset account in the balance sheet with the working capital for the stockholding, while the logistics costs will go to the expense account. A company that is trying to reduce expenses will struggle to understand the increased logistics cost from China as opposed to domestic production. Equally the USA source will have low logistics costs, but higher Asset values. All these are merely aspects to note and understand, the correct answer is that economics should drive the decision-making.
What is interesting is the difference is very small between the USA and Mexico production. This is of interest as we will explore in the next article where we add risk to the discussion.
John Vogt has his own consulting company and, at the end of his 42 years in industry around the world, was the Vice President of Global Logistics for Halliburton. Thereafter he spent five years as a Professor of Record for the University of Houston-Downtown MBA for International and Supply Chain courses. He has experience as a Board Director and has travelled the world to improve trade. In his career, he has driven the correct use of Incoterms as part of the trade improvements he has implemented to drive efficiency and effectiveness.