Explicit and Implicit Costs

Many opinions exist about how to calculate total cost. For example, how should we calculate the cost of capital in order to recognize the opportunity costs of holding inventories? Cost of capital will not show on a logistics manager’s financial statement, so managing and including this aspect of the equation is troublesome. How many organizations are so progressive that they increase spending in transportation in order to offset a higher corresponding cost of holding inventory? To complicate this situation even further, the actual cost of holding the inventory may not even be visible! Because a cost is not visible does not mean that it does not exist. We need to recognize and understand the difference between implicit and explicit costs.

Explicit costs are defined as historical costs or actual costs that are tangible and visible on a firm’s financial statements. With respect to logistics, these costs can be seen in items such as storage, transportation, and material handling costs including personnel, warehouse, and explicit freight costs. Explicit costs associated with holding inventory include those related to scrap, rework, shrinkage, obsolescence, taxes, insurance, and damages to the inventory.

Although many of these costs should be explicit and visible, in many organizations they are not. Even though firms recognize that explicit costs exist with inventory, many companies rationalize these costs as necessary for doing business. Even though reducing these explicit costs appears daunting, doing so can separate the top performers in a competitive industry.

Implicit costs are those costs that do not involve actual payment by a company, but do represent lost opportunity that results from allocating money in one area, thus abandoning other potential investments and projects. The opportunity cost of such decisions results in lost profits that an abandoned project may have returned on the invested capital. There are many schools of thought on how to calculate the cost of lost opportunity, but most financial managers will agree that the financial losses fall somewhere between the actual cost of capital and a firm’s required risk-adjusted rate of return on its equity (the weighted average cost of capital). Regardless of how a firm calculates the opportunity cost of holding inventory, there is no doubt that the cost exists and must be taken into consideration when making strategic decisions. For example, what is the cost of setting a target of a 100 percent fill rate? Would 98 percent suffice? How much safety stock will be required to move from a guaranteed 98 percent fill rate to 100 percent? It certainly is a lot more than 2 percent! What is the overall or total cost to the firm in making this strategic decision?

As you can see, explicit costs are not reflective of the whole story relative to inventory. Implicit costs of holding inventory tell the true story of how inventory can have significant financial implications on a firm. As we can see from the inbound cost driver example presented earlier, it is essential for a firm to understand its total cost picture relative to these logistics activities. To this end, the goal must not be to optimize each activity individually, but rather to optimize the entire system using the sum of all costs together in reaching strategic decisions.

In order to do this, each activity driver must be analyzed relative to the cost drivers within the relevant system. To exemplify this philosophy, a firm can choose some of these logistics cost drivers to analyze and understand their interrelationships. One difficulty is that it requires cross-functional cooperation and high-level understanding of the issues because there may be instances where one area should increase its costs in order to reduce overall system costs. For example, even though many companies are aware of how much it costs to carry inventory, they continue to optimize transportation costs and try to move raw materials in truckload quantities. This is shortsighted, backward logic because the costs associated with holding the inventory will most likely exceed the savings achieved from optimizing transportation costs. For example, Figure 18.1 shows us that total logistics costs will far exceed just transportation costs.

Consequently, the valid challenge for companies is to develop an algorithm or management method that focuses on optimizing (i.e., minimizing) total cost.

Figure 18.1. Total Cost Is Considerably More Than Transportation Alone!

To manage total cost will require excellent coordination and horizontal integration inside the firm. For successful completion, someone must take responsibility for the total logistics system. This person will be a vice president of logistics or supply chain management or someone higher in the organization and, in fact, may be the CEO in many companies.

Perceived Difficulty and System Constraints

Many organizations have opportunities for horizontal integration relative to aggregating shipping volumes. It is the challenge to cooperate and collaborate that is seldom met. While the primary hurdle is commitment to get the job done, there are practical challenges to meet. The main challenge is system constraints and the perception that they are impossible to overcome.

Many organizations have grown by way of mergers and acquisitions. Consequently, these organizations have a plethora of different processes, operational techniques, and computer systems. These constraints alone are used as an excuse summarily to dismiss any idea of horizontal integration. Survival of the corporation dictates integration. Combining and leveraging logistics activities simply makes sense; it is unequivocally the correct thing to do. It is helpful to avoid thinking of integration as a larger than life initiative. Computer systems do not need to be integrated, and all processes do not need to be identical. Although this would be ideal, it is not crucial to early integration initiatives. Simply commit to getting volumes in a standard format, and have logistics engineers analyze the data for possible integration opportunities. When opportunities arise, they can be executed operationally, one small event at a time. For example, you do not need to combine entire corporate volumes overnight, but you can implement one milk run or one less-than-truckload consolidation at a time.

Compensation and Incentive Programs

Poorly designed incentive programs could be the leading cause of logistics operations failure. There is no incentive for people to make changes based on horizontal integration. In fact, in many cases, people are financially motivated to do the opposite of what is smart or best for the organization. For example, why would a traffic manager reduce lot size and increase frequency of delivery if a bonus is based on transportation cost? Clearly, a traffic manager would want all shipments to move truckload. Or, for instance, why would warehouse managers want to reduce inventories to free up space when their bonuses are based on warehouse utilization?

Incentive programs need to be based on the total cost concept. The total cost algorithm needs to be completed, and incentives need to be linked to the goal of the total cost drivers. This will result in multiple people, from multiple functions and departments, all being responsible for a common goal. The common goal will be to increase operational efficiencies and optimize overall total cost. This results in doing more with less, eliminating inventories, and driving waste out of the system. Even under these circumstances, basic human nature will create walls that need to be broken down.

Teamwork, Imperfection, and Defensive Behavior

Organizational teamwork has become the fashion over the last decade. Many companies embrace the theory and wisdom of teamwork, yet true teamwork is often hard to find in mainstream industry. When one reviews the main points of teamwork, it makes sense. Consider working as a high-functioning group trying to reach a common goal through synergy, collaboration, and more. Indeed, teamwork could help us bridge core processes with enabling processes. Often, one functional area recognizes the weaknesses in another functional area of the company. That is, the employees from one area often see and recognize what needs to be corrected in other areas of the organization. Yet, communicating these weaknesses and solving problems in a team environment remains a difficult task. Why? The answer rests in the concepts of human imperfection and defensive behavior.

No human being is perfect; on this we all agree. Therefore, no CEO, vice president, or manager is perfect. As professionals, if we are not perfect, then we know that some areas in our jurisdiction need improvement. In a perfect world, we would embrace critical and constructive feedback from colleagues who more easily recognize our division’s weakness. Alas, it is not a perfect world, and logical, effective implementation of cross-functional, horizontal feedback remains a challenge.

The irony here is that defensive behaviors exist because of the exact reason we need to overcome them. That is, because we are not perfect, as professionals, there are always areas in our span of control that can be improved. Our co-workers recognize these areas because they are not as close to the situation as we are. This describes the quintessential “fresh set of eyes” concept that is the winning formula for most consulting companies. However, our natural defensive behaviors do not allow us to be open or receptive to the feedback from our imperfect co-workers. Put another way, we are not willing to accept critical feedback from colleagues who may have many issues within their own departments. So, we think, “How dare you recommend improvements in my department when your department is a wreck!” Colleagues’ comments about areas for improvement are probably accurate, and, in fact, their observations of our weaknesses have no relationship to how well they manage their own areas. They may be incompetent in their work, but from a distance they could be accurate in their assessment of another department.

For these reasons, it is crucial to embrace feedback in a positive manner. Getting over this destructive cycle requires a mutual understanding that we are not perfect, that others see the imperfections in our work, and that critical feedback is not necessarily negative, but rather constructive and can be valuable in reaching the combined goals of the company. That would be teamwork!

Breaking Down the Walls

If the Berlin Wall can be broken down, we can dismantle the invisible walls within our own organizations. Without silos or functional barriers, an organization will make more effective decisions and positive results will grow exponentially. The beginning is to understand and respect our imperfections and, consequently, to encourage and embrace critical feedback from colleagues. The successful company will complement this increase in corporate self-confidence with a total systems approach to measurement and effectively bridge core and enabling processes. When this is accomplished, teamwork will thrive, costs will go down, revenues will grow, and customers will be in awe.

From Customer to Supplier

Vertical integration attempts to look at the entire series of business processes as one business. That is, from end customer to the highest level of raw material supplier, we attempt to build systems that optimize the entire supply chain. One fine example of vertical integration was when Henry Ford owned every aspect of the supply chain to build automobiles. From iron ore mining straight through to the car dealerships, every aspect was owned by Ford. The goal was to integrate each step in the process to synchronize flow in order to optimize the total system. Certainly, if you own all the operations in the supply chain, you can attain your goal. This is because the main elements of successful vertical integration are communication, information sharing, and trust. To support these ideas, Figure 18.3 shows a simple approach to getting started on vertical integration.

Vertical Integration and Information

The bullwhip effect is a well-known operational hazard. Rooted in the theory of Industrial Dynamics offered by Jay Forrester in the late 1950s,* the bullwhip effect teaches us that inventories grow inversely in the supply chain as a function of the amount of information that is shared among supply chain (vertical) partners. This relationship is reciprocal in nature; the less the information is

Figure 18.3. Vertical Integration: Steps to Success.

shared, the more inventories are created in the system. The information that needs to flow includes forecasting, demand planning information, and actual sales. Certainly, it would be easier to optimize the system if we knew the exact demand that would be directed to each supply chain level. Starting with the customer, we could work backward to calculate the requirements for the supply chain. Indeed, this is the heart of Lean and pull replenishment theories. This is the Lean model: build only what is sold and replenish only what is consumed.

Unfortunately, modern business practice does not allow for effective vertical integration implementation. This is in large part due to trust issues and ineffective communications. It is also caused by lack of knowledge. That is, most organizations would be happy to share forecasts and information if only they knew what was going to happen, but they do not. Inefficiencies in their internal systems and processes create an environment where workers are so busy fighting fires that proper supply chain management is still a dream. When this occurs, variability results, and it is this variability that creates vertical instability in the supply chain.

Variability, Leveled Flow, and Vertical Integration

Six Sigma teaches us to understand and manage variation. Lean teaches about flow and leveling of processes and demand on resources. Once again, we learn how Six Sigma and Lean interconnect to find solutions to serious operations management problems. In particular, variability and leveled flow play a significant role in vertical integration.

Take, for example, a tier 1 automotive supplier that is serving multiple original equipment manufacturer (OEM) customers from the same facility. Even though they are serving the OEM customers from the same plant, the supplier will likely have very different operations in place to serve each customer. For instance, maybe one of its OEM customers is a Lean manufacturer that has leveled its manufacturing to the beat of the customer. In this case, the tier 1 supplier should have little or no safety stock in place for the OEM, as the variability in the OEM orders will be minimal. This low-order variability allows the tier 1 supplier to plan and trust what the OEM will need. The supplier can then plan its own systems to build what is required to be ready just in time for the customer delivery.

Now consider a second OEM customer being served from the same plant. This OEM is not practicing Lean manufacturing and therefore has unleveled demand and many changes to its production schedule. Although the customer may be giving the tier 1 supplier a forecast, it will change. This change could be as much as 20 percent on the day before an order is shipped. How is the tier 1 supplier to manage its own business with this much variation in customer orders? The only way is to carry safety stock because safety stock is the only way to hedge against uncertainty. Yet safety stock results in significant costs that, at some point and in some way, must be passed on to the OEM responsible for the expense.

Vertical integration is about communicating expectations and needs so trading partners in the supply chain can plan better systems and maintain more effective operations. This means that information, communication, and material must flow throughout the whole supply chain. This requires commitment and trust — commitment to share and trust that data are used for honest purposes. Mainly, vertical integration requires recognition that supply chain partners are an integral part of our business. Successful vertical integration requires a supply chain strategy based on total cost and a systems approach to supply chain management.

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