Cost Drivers in Supply Chain Management

Most supply chain managers spend a lot of their time looking for ways to reduce costs. But one of the big challenges with supply chains is that things are often interconnected, so making a change in one area to lower costs can cause a change somewhere else that actually increases the cost. That's not to say that you shouldn't look for cost-savings opportunities, but you need to understand how the system works to ensure that you aren't creating new problems in the process.

There are four decisions areas that drive most of the costs in any supply chain. Thinking about all these items together can help you find true opportunities for savings.

Procurement costs

One of the most obvious costs for any supply chain is the amount that you pay for the products you buy. Some common ways to reduce procurement costs are to negotiate better prices from your suppliers, agree to buy larger quantities over a longer period or switch to a supplier that agrees to accept lower prices. Also, each supplier that you maintain a relationship with costs you money, because someone has to find the supplier, sign all the contracts, keep track of the supplier's performance, and make sure the supplier gets paid. So the cost for procurement also includes the salaries and overhead for your procurement team and the information systems that they use. Reducing the number of suppliers and streamlining your procurement processes can often reduce procurement costs.

Transportation costs

Moving a product from one place to another costs money, and different modes of transportation have different costs. These modes have different speeds, which can be just as important as transportation cost. For example, a faster and more expensive transportation mode might actually save you money by decreasing the amount of inventory that you have in transit. It is also common to use more than one mode of transportation to move a single product through a supply chain. Changing from one mode to another using multi-modal transportation can optimize transportation costs. Another common way to reduce transportation costs is to pack more products into each load, thereby improving capacity utilization. The important thing to remember is that choosing a transportation mode that is slower and less reliable may reduce transportation costs, but it will increase your inventory and consume working capital.

Generally, when you rank transportation methods from least expensive to most expensive, the order is this: pipeline, sea container, full truckload, less-than-truckload, and parcel.

Inventory costs

Keeping products in inventory costs money. Of course, the products that you are storing in inventory cost money. If you're borrowing money from the bank to pay for that inventory (which is often the case), your inventory costs you whatever interest rate you're paying to the bank. Other costs include paying for a building to keep the inventory safe and paying people to move the inventory around inside the building. You also run the risk that products could be lost, damaged, or stolen. This problem, often called shrinkage, also incurs a cost to your company. Finally, products can expire or become obsolete if they sit in a warehouse for too long.

Quality costs

Any time you buy a product, you expect it to meet a certain level of quality. In some cases, you may need to have formal inspection and quality assurance processes in place to make sure that the products you receive from suppliers, and the products that you send to your customers, meet these requirements. Any product that doesn't meet these standards costs you money, and the more closely you have to look for quality problems, the more money you spend. Reducing the variation in manufacturing and distribution processes through techniques such as Lean and Six Sigma can reduce the quality costs in a supply chain.

You can see in the figure how these four supply chain cost drivers are interdependent, and how changes in any one of the buckets can affect the others.