Recently, I had a North American client who decided to move their supply chain requirements to an overseas manufacturer and supplier. In doing this, they envisioned a situation where the lower cost from the overseas manufacturer would allow them to both grow their existing gross profit, and possibly grow their market share by securing new customer accounts.
Granted, the price was much better, but there were a couple of things they completely ignored. It was unfortunate, because not only had they already made the decision, and signed a supply agreement, but they also severed their relationship with a supplier and manufacturer in North America who had been their source for well over 10 years.
Suffice it to say, it was the wrong decision, and both their overall costs for the product line, and their gross profit, took a huge hit by moving to the overseas supplier. Their costs went up, their gross profit went down, and they lost clients. So, what went wrong?
Based Their Decision On Price Only
The biggest mistake they made was to base their decision on price alone. This isn’t to say that they didn’t look at other factors. They did, they just glanced over them, and concentrated solely on their purchase price. Sure, the pricing from overseas was far cheaper, and the products were of relatively good quality. Customers approved the samples, liked the product, and were genuinely interested in buying. However, while the price itself was good, they ignored several important factors.
1. Per-Unit Freight Cost & Duties Increased
Amazingly, they completely ignored the total cost of the product once it arrived in their North American warehouses. Their total cost of ownership of the product actually went up because the duties and freight was much higher than anticipated. The situation only got worse as the more they lost customers, and the less demand they had for the product, the worse those costs became. They didn’t take the time to properly calculate their inventory cost of going to a new supplier. Basing their decision on price alone was their first mistake, but it only got worse.
2. They Didn’t Understand Their Costs of Inventory
Inventory costs are often misunderstood. This company in particular did not understand inventory costs at all. They assumed that the costs for the product on the shelf extended only to the purchase price, and how long that product remained in inventory. However, per unit freight costs are an extremely important cost of inventory. Some companies take their entire freight bill and do some funky calculation to figure out their per unit freight costs of parts coming into their warehouse. This was one of those companies. They did not properly track the specific duties and freight costs for this particular product.
There are two main costs to managing inventory: Lost sales and high carrying costs.
3. Didn’t Have a Pulse on the Market and Demand Dropped!
They also did not anticipate a sudden and drastic drop in demand. The reason being? They did not have good knowledge of their customer requirements and the market they serviced. They were completely caught off guard by the drop in demand. This sudden drop caused their per unit freight costs and duties to go up for every product coming into their warehouse. In addition, because they signed a supply agreement, with specified volumes, they were purchasing more than they needed and this only added to their costs. The products stayed in their warehouse longer and their holding costs of inventory went up. Going back to their overseas supplier didn’t help, because as they lowered their volumes per order, their price went back up as they were buying less!
Vendor consolidation is one way to reduce inventory costs. It allows you to amalgamate volumes in order to reduce your prices, reduce your costs of incoming freight and reduce your inventory skews. To learn more, please go to: What is Vendor Consolidation? Strategies to Reduce Inventory Holding Costs
4. Service Times for Customers Went up, and Product Damage in the Warehouse Became Commonplace
Because they had a drop in demand, and were buying more than they could sell, holding inventory for longer periods posed a number of problems.
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Inventory Holding Costs Increased: This is usually 3%month of the value of the product. As their inventory turn over rate went down they held inventory for longer periods. Essentially, with less demand their inventory stayed in their warehouse for months.
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Damage to Inventory Increased: The longer the product remained in their warehouse the more likely it became damaged.
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Unable to Respond to Poor Quality: Every company, regardless of how good their product is, will from time to time, have some bad production batches. However, when your entire inventory is made up of product from a bad batch, and your supplier is on the other side of the ocean, how can you possibly address customer complaints? You don’t!
This customer of mine learned the hard way. The end result was that they not only lost customers, but they eventually had to terminate their supply agreement with the overseas supplier and move their supply demands back to North America. What do you think happened when they went back to their old North American supplier? Exactly, they got a price increase!
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