- Long, cross-border supply chains often introduce vulnerabilities and may necessitate securing larger inventories to safeguard against potential disruptions like transportation cost fluctuations, currency exchange rates, or logistic uncertainties. This is especially true in a world of "just-in-time" production.
- The cost savings from offshoring may need to be larger than expected to make up for longer lead times and resulting stockouts or salvage costs.
- Inventory carrying costs include both direct expenses and the opportunity costs associated with decreased cash flow and working capital.
- Competitiveness requires a high degree of supply chain flexibility. Strategies for ensuring that flexibility are essential.
Companies, regardless of whether they manufacture or source inside or outside the United States, must consider the costs and risks associated with the lead times between ordering new products and receiving those products. Many companies that outsource production or sourcing need to maintain larger domestic inventories in the United States to meet short-term demand surges and buffer against delayed, defective, or incomplete deliveries.
According to a 2013 study by Accenture, about four in ten manufacturers surveyed reported that they had relocated production facilities to new locations since 2011. Of those firms, nearly one-third listed reduced transportation costs as one of their top three reasons. One quarter cited increased responsiveness or reduced lead time. Nearly half of all firms surveyed had started new operations since 2011, and one in four cited reduced transportation costs and lead time as top-three factors.
These considerations become more complex for "lean" firms, whose "just-in-time" inventory approach ensures that production inputs are available only when they are needed. "Just-in-time" practices minimize or eliminate storage costs and bring components directly from the source to the destination. In order to fulfill customer demand in a timely manner, even lean firms may find it necessary to carry larger inventories to safeguard against supply chain vulnerabilities. Lean and other firms also may decide to identify alternative domestic suppliers should critical shortages arise.
Valuing Lead Time
Companies are increasingly interested in putting a monetary value on the lead time between ordering and receiving components from suppliers. How much is it worth to them to reduce the lead time? In an ideal world, of course, there is no lead time between a company’s needs and the delivery of products or components. If there is no lead time (that is, we know what our demand or our customers’ demands will be with absolute certainty), then a firm can produce exactly the quantity demanded. In the real world, however, orders for parts or products need to be placed before demand is known. If a company predicts that it will need too much product, then demand uncertainty will result in excess inventory (salvage). When a company under-predicts demand, stockouts occur. These mismatch costs reduce—often substantially—the cost savings offered by remote suppliers with longer lead times.
Although managers are aware that extending the supply chain—with the substantial increase in lead time associated with such an extension—increases mismatch costs, they have not had tools to estimate how much costs could increase. Put another way, they have not known how much savings they would need to get from offshoring to compensate for the added uncertainty and risk.
Innovative work from the University of Lausanne in Switzerland draws insights from the complex field of quantitative finance to provide a tool that makes such calculations relatively straightforward. Starting with company data on demand volatility, including how large demand peaks are and how frequently they occur, the tool then also incorporates the price, cost, salvage value, and target demand for the product.
Let’s consider a scenario where price is $100, the make-to-order cost is $44, and the salvage value is $20. Suppose that the distant supplier offers a 20 percent cost reduction. The “cost-differential frontier” generated by the tool shows how much cheaper the product needs to be to compensate for mismatch costs as lead time increases from 0 (representing make-to-order production with full demand information) to 1 (representing make-to-stock production with the lead time that results from a fully extended supply chain):
The cost-differential frontier in the figure shows that, if a firm sees its weekly demand double for only two weeks a year, a 22.5 percent cost savings is required to make up for mismatch costs. So, if an overseas supplier offers only a 20 percent discount compared to a domestic supplier, it does not make sense to offshore the supply chain.
The University of Lausanne has also produced a video presentation that further elaborates these concepts.
Long lead times between the initial order of new products or components and receipt of those products in the United States create challenges for inventory management.
Because of the long lead times associated with transporting products from a foreign destination to the U.S. market, companies must usually maintain larger inventories at their facilities within the United States. They must ensure that they will not run out of stock while waiting for a new shipment, but they must also ensure that they have enough stock to meet changes in demand, higher-than-expected scrap and rework, or any other unforeseen changes in circumstances. It is difficult to assess how lead times affect inventory for any particular business without knowing the precise operating conditions in which that business operates.
According to The Economist, companies importing from abroad may have to hold up to 100 days of inventory in the United States. Authors of another academic study calculated that, when companies in their dataset increased the international share of their supply chain by 33 percent, it corresponded to an average increase of 23 percent in their inventory investment costs. This drives up not only the cost of acquiring the larger inventory of goods, but the carrying costs as well.
Inventory carrying costs include myriad factors:
- Warehouse space
- Administrative management costs
- Scrap, sorting, and rework
- Obsolescence and deterioration
- Cost of capital
The last of these factors, in particular, can be easily overlooked. The cost of inventory is not solely determined by the direct expenses associated with storing, managing, and maintaining the goods, but also by the opportunity costs that arise when money is tied up. Goods represent a store of value; keeping resources tied up in products or components that are not being utilized or sold immediately restricts a company's overall cash flow and may reduce the amount of liquid capital available. Inventory management requires a careful balancing of all these costs against the benefits of having more goods or inputs available on demand.
As a rough rule of thumb, many sources, including the Reshoring Initiative, use 25 percent of a product's unit price as an estimate of annual carrying costs per unit. However, the actual number for any specific company, product, or component may be considerably higher.
In addition to the costs of carrying inventory onshore in the United States, companies must also consider the carrying costs of inventory in transit. It is easy to overlook the carrying costs associated with these products because they are not sitting in a warehouse, but they form part of a company's overall inventory and represent money that is tied up in goods. They also require the payment of insurance, consideration of the ultimate need for scrap and rework, and so on. Companies must be mindful not to disregard the cost of carrying inventory that has not yet arrived at its final destination, especially given the amount of time this inventory will spend in transit and the associated financing costs.
Supply Chain Flexibility
In competitive markets, being the first to offer a new product secures important market share before similar products are offered by competitors. Sourcing goods close to their final markets allows for new products to have smaller production and transit cycles. For some products, it also allows firms to design, modify, and adjust products almost at will, while also enabling them to scale production according to demand and to avoid waste. Longer supply chains can decrease this flexibility. Companies can expect to wait a month or more between the time components are shipped from foreign factories and the time they arrive in the United States. For high value consumer items, this is often an uncompetitive strategy. According to one study, each day a desired consumer product is stuck in transit is equivalent to an ad-valorem tariff of 0.6 to 2.3 percent. This means that domestic competitors with even moderately more expensive production costs can win market share by bringing products to market faster.
Lean inventory management and supply chain flexibility have become key components of the modern business environment. Companies choosing to produce or source abroad must carefully consider the costs of increased inventory and the risks associated with a longer supply chain.