Product manufacturing has never been as inexpensive as it is today. At the same time more money is spent on transporting those products than ever before. The main reason for the shift is the growth of mass importation from low-cost countries, particularly from East and South-East Asia.
There has long been a trade-off between distance and cost. When goods are purchased from half-way around the world, the factory-gate prices may be lower, but long and unreliable delivery times increase both costs and supply chain risks. At worst, delayed deliveries or inaccurate demand forecasting may lead to product shortages and stock-outs. When delivery schedules are extended and unreliable, safety buffers are required. This, in turn, increases the need for storage space.
There are running debates in supply chain management circles, sometimes quite heated, about the real costs of long-distance procurement for many trading businesses. But there’s no need to get hot under the collar. Instead I’d encourage companies to reap benefits from both short- and long-distance procurement by using them in combination. Manufacturing businesses already know how to identify and manage supply chain risks related to sourcing. Now it is time for businesses that are able to handle long distance/long lead buying to up their supply chain management game, improve their sales forecasting and buy better!
In this article, I will:
- compare the costs of procurement in relation to long and short delivery times and give guidelines for making comparisons
- present an opportunity to benefit from the best aspects of both procurement models, simultaneously
- discuss the requirements for utilising this combined operations model.
The Costs With Long Delivery Times
The main driver for using a remote supplier rather than a local one is usually the lower purchase price. If far-Eastern manufacturers or wholesalers sell goods for considerably lower prices than their European counterparts, the price difference could be crucial to profitability– and the difference is often enormous, even when the higher transportation costs are taken into account. However, long and unreliable delivery schedules add significantly to inventory management costs, as more storage space and capital is required, and the risk of receiving unsalable products is greater. Demand forecasting becomes harder the shorter the life-cycle of the product is and the more significant these additional costs can become. Even so, the total costs are very rarely taken into consideration when a source of supply is chosen, and they are seldom considered in assessment of the ultimate profitability of a product. However, an indicative cost can be calculated in advance.
Example 1: Long-distance Vs. Short-distance Procurement
As an example, let’s compare a product costing €100 in Europe, delivery paid for by the supplier, with one costing €60 in the Far East, with the delivery charges covered by the buyer. The product is not particularly large or heavy. When the goods are transported in full units, the comparable purchase price for the Far East is €67, translating into a difference of €33 in the procurement price alone.
However the minimum purchase batch sourced from the Far East covers six months demand while it’s feasible to buy just two weeks’ supply from the European source.
Let’s assume that a buffer stock of approximately 40% of the average sales per purchase cycle is needed (and maintained) to ensure availability. When one factors in storage space expenses, interest on capital, and the risk of being left with dead stock, the total costs for storage will come to 35% of the purchase price.
In these circumstances and with these prices, the storage costs for supplies from the Far East are ten times those associated with buying from Europe. When goods are purchased from Europe, the inventory turnover rate is slightly over 25, while the equivalent figure for procurement from Asia is only 1.7. Nonetheless, the total costs for procurement from the Far East are still 20% lower.
On the basis of costs alone, it is more profitable to buy a product from the Far East if the purchase price is at least 17% lower than the price offered by a European supplier. If the price difference is less than that, using the European supplier will eventually be cheaper.
The calculations are explained in Appendix 1: ‘Explanation of the calculation examples’. The explanation can be used to create a cost comparison spreadsheet for any business. I can also provide the example created for this article on request.
Long-distance purchases involve greater risks, particularly where sales forecasting has failed to predict demand with sufficient accuracy. If demand is higher than expected or delivery schedules slide, products may sell out before the next delivery arrives. This results in unhappy customers and lost sales. Moreover, if sales are lower than expected, products – especially items with a short life cycle – may have to be discounted or destroyed. This increases costs and decreases the margin for the product. In a fluctuating market, the risks of sourcing at long-distance are higher than usual. When a company buys enough products to cover six months’ sales, and keeps a regular buffer stock, it’s not beyond the realms of possibility that it could finds itself with enough stock for 300 days. If sales drop radically, that stock could hang around for years.
Because of the uncertainties inherent in long-distance procurement, I suggest companies take advantage of the best aspects of both long-distance and short-distance procurement.
The Best of Both Worlds: Using Both Long- And Short-distance Suppliers
Running long-distance and short-distance procurement in parallel results in improved delivery reliability, increased supply chain management flexibility, and lower overall costs.
In the combined operations model, the Far East acts as the primary supply channel for a product. However, to ensure more flexibility, an alternative supplier must be found more locally. The starting point needs to be projected sales. The next step is to decide what proportion of the estimated stock required should be purchased from the cheaper, but more distant supplier. The buyer will factor in considerations such as minimum order quantities, shipping consolidation, door to door delivery times etc and so forth. Then the more local supplier can then act as a buffer against unexpected demand surges when the dynamics of the tradeoff between a higher price but quicker delivery and smaller order quantities shifts in its favour.
However to make this system work there needs to be continuous monitoring of actual sales against forecasts, of availability, stock levels, incoming and outgoing deliveries. Monitoring is the easiest if your procurement planning system is able to give you advance warning of possible availability problems. If sales are higher than your demand forecasting system predicted or deliveries are delayed, enough goods can be purchased locally to tide you through the expected shortage-risk period. Given that sea freighting items from China to Europe typically takes 30 days you know that if you have only two week’s stock in hand and your order from China only left Shanghai one day previously, that you will probably need stock to cover a minimum two week gap. Because such availability problems can be solved by means of a nearby supplier, the buffer stock level can also be optimised on the basis of delivery times.
Example 2: Combined Operations Model
Let’s assume that the product in the previous example is purchased primarily from Asia but unexpected circumstances necessitate backup orders for about 10% of the annual volume. In this case, the combined operations model would ensure better availability levels while keeping total costs 5% lower than would long-distance procurement alone. The inventory turnover rate also rises, from 1.7 to 3.7. This will soon be apparent in improved key figures for logistics and in decreased stock pressure. Also, with a slight delay, the amount of dead stock will decrease, as buffer stocks can be reduced significantly. The economic benefits are highest for products where sales are hardest to predict.
Assuming that the procurement and logistics expenses account for 65% of the company’s turnover and that 50% of the goods are purchased from long-distance suppliers, 5% cost savings for these products will translate into savings of 1.5% of the turnover, and thus a 1.5% increase in business profits.
The same model can be used dynamically in the course of the product life cycle or for a particular period. Fashion giant Zara does exactly that. For new lines Zara generally turns to nearby sources, because, in the more fashion-driven end of the apparel industry, sales forecasting has historically struggled to predict demand. If a product begins to sell well, it is then purchased in larger quantities from lower-cost sources. Supply channels with shorter delivery times are used once again at the end of the product life cycle, to avoid surplus stock. However for companies not working on Zara’s huge scale it may be rather challenging to create such a model, more or less so depending on their sector.
Simple in Theory…
Unfortunately, as with many other inventory management ideas, while the principle of using both long- and short-distance procurement is clear and even quite simple, making the supply-chain operations model work on a large scale is rather more challenging. However if you tackle the challenge systematically and with a will it is quite feasible.
The most fundamental practical issue is the increased inventory management work load, resulting from the necessity of finding alternative suppliers for products. An additional challenge arises from the fact that purchase volumes will still be uncertain during negotiations. In addition to realised sales, the volumes depend on the reliability of the primary source of supply. Therefore, various wholesale companies are generally a natural choice as secondary suppliers.
When product volumes are large, it is also essential for the data systems used to support the chosen operations model. Of course, every company operating in the field of trade looks for alternative suppliers for its products and makes backup purchases. However, in the target operations model potential shortages are identified in advance, and this triggers a pre-determined sequence of events. If the process can be implemented directly in the system, the only thing remaining to be handled is the selection of alternative suppliers and the maintenance of the supplier information.
Getting Started: Take Sure Steps at a Suitable Speed
The process of using two sources of supply should be started gradually. I recommend identifying and prioritising key products – those at the core of the product selection with large sales quantities. These are the products for which an existing backup supplier is most essential, both to manage risks and to ensure customer satisfaction. Nearly all industrial companies try to guarantee the availability of their key components by using several suppliers. In this respect, companies operating wholesale and retail are quite some way behind. Only when the availability of key products has been ensured is it time to start simply optimising costs. The cutting of costs should begin with products whose sales volumes cannot be easily predicted and which have a short life cycle, and the new model should be implemented first for the products with the largest sales volumes. The greater the unpredictability and the larger the sales volumes, the greater are the benefits.
Appendix 1: Explanation of the calculation examples
- For illustrative purposes, the annual demand has been stated at 1,000 items, but the relative difference between various sources of supply remains the same even if the demand is higher or lower.
- The buffer stock is a way of preparing for fluctuations in demand – predictions almost never match the reality exactly. The buffer stock is used to make up for fluctuation in demand during the period consisting of the delivery time and order interval.
- In the combination model, the buffer stock is needed only to cover the short-distance supplier’s delivery time and order interval, even if the majority of goods are purchased from the long-distance supplier.
- Average stock quantities (in items) have been calculated by multiplying the number of days the stock lasts by estimated daily demand (1,000 ÷ 360).
- The figures have been calculated on the basis of average purchase prices.
- Here, the long-distance procurement expenses have been compared to the costs for short-distance procurement (–20%), and expenses under the combination model with those of long-distance procurement alone (–5%).
- Usable stock is the portion of the stock that is needed for ability to cover the predicted sales quantities. The stock quantity depends on the order quantity – the average stock level is half that of a single order plus the buffer stock.