As a small manufacturer, you know that eliminating downtime will help to increase your production throughput. Unfortunately, there are multiple causes of lost time and to eliminate them all is much easier said than done. However, there is one cause of downtime that your company can have an immediate impact on. What is it you ask? It’s the issues caused by a lack of available parts and materials, or more commonly referred to as stock outs. So, what vendor strategies should your company adopt to eliminate the issues caused by a lack of material and parts?
The Dangers of Running a Tight Inventory!
Like most manufacturers, you’ve probably pursued strategies to mitigate your company’s inventory costs by minimizing how much you carry in your warehouse. The intention is a good one. Minimize your inventory counts and your company won’t incur high holding costs. It's a strategy that will help you avoid the costs of obsolescence and damage. However, have you ever tracked the impact of material shortages and stock outs? Better yet, have you ever tracked the costs of urgent shipments from vendors when you encounter a material shortage?
The questions above are meant to explain the importance of eliminating work stoppages resulting from a lack of inventory. While every small manufacturer understands this, very few are able to ensure they have material when they need it. Instead, most small manufacturers run extremely tight inventories, ones where material shortages are addressed by paying high expedite fees, and incurring high freight costs to rush material and parts into their warehouse. They save money in the short-term, but they lose in the long-term. However, contractual agreements can not only protect against shortages, but they can also lower your material costs.
The above video explains how to measure high volume purchases against the costs of holding inventory for extended periods. To read more about the strategies outlined in the above video, please go to: Inventory Carrying Costs Versus Higher Volume Purchases
The Importance of Multiple Vendors & Contractual Supply Agreements
The following concept is fairly straightforward, and it's one adopted by the majority of manufacturers I work with. It’s predicated on ensuring your company has a steady supply of parts and materials by having access to multiple vendors. Ultimately, you need to have contractual agreements with each of these vendors. However, these contracts will allow your company to adjust to any unforeseen spikes in customer demand by being able to rely upon guaranteed sources.
While most small manufacturers may be able to call on other vendors, they still incur significant costs when they do. This is because they don't have agreements that protect their costs and mitigate their per-unit freight costs on incoming shipments. Using vendor agreements will mean you share in your vendor's holding costs. However, by guaranteeing supply, you'll avoid those instances where stock outs force you to expedite shipments from your vendors. In the end, it will reduce your costs.
Scenario #1: Company Uses Contractual Supply Agreements
In this first scenario, a small manufacturer has decided to use supply agreements to guard against shortages. They purchase 20,000 widgets from three vendors and have supply agreements with all of them. The majority of their volume goes to the first vendor. As such, this vendor doesn’t charge the small manufacturer any holding costs because they never retain inventory for too long a period.
However, vendors number two and three not only charge a higher price per-widget (because of lower volume), but they also charge quarterly inventory holding costs of 3%. This amount is actually 1/3 of the vendor's monthly inventory holding costs as most companies will apply 3% to hold inventory on a monthly basis. In this case, the vendor is only charging the small manufacturer 1% a month to hold product for them. It's a small price to pay to guarantee supply.
Because the small manufacturer has entered into these supply agreements, and because inventory is readily available at each of their vendors' locations, the manufacturer's per-unit freight costs on incoming shipments for the widgets are the same ($0.02 per widget). Ultimately, the small manufacturer pays to have parts held for them, but saves money by avoiding the high costs of urgent and rush orders.
The “total expenditures” portion is calculated by taking the “price” multiplied by “volumes purchased” multiplied by “holding costs per quarter”. This sum is then added to the per-unit freight costs.
Example of Total Expenditures Calculation for Vendor 2
- $2.10 x 5000 = $10,500
- $10,500 x 3% = $315
- $0.02 x 500 = $100
- Total expenditures = $10,915.00
Scenario # 2: Company Doesn't Use Contractual Agreements:
In this second scenario, the manufacturer doesn’t use any contractual supply agreements. In this case, the company hasn't guaranteed its supply. Vendors don’t charge the company any inventory holding costs because no inventory is being retained. However, the prices charged by vendor two and three are much higher, as is the per-unit freight costs on incoming parts.
Again, the vendor will likely have to charge the manufacturer a higher price for rush orders. In addition, rushing parts always coincides with expedited delivery, and that means higher per-unit freight costs. These are the ultimate costs of running too tight an inventory, and not having agreements in place to protect supply only exacerbates these costs.
When small manufacturers look to eliminate material shortages, they must be willing to evaluate the costs of rush orders and high freight costs for expedited deliveries (when they run tight inventories) from their vendors. In this case, it’s essential they use contractual agreements in order to protect against these sudden cost increases. While there are inventory holding costs associated with these contractual agreements, in the long run, they lower the average price by mitigating the costs of rush orders and high expedite fees.
In our example, we’ve merely compared average prices between two scenarios. This doesn’t take into consideration the savings the small manufacturer accrues by avoiding material shortages and their impact on production throughput.
Make sure to track your costs for rush orders and expedited deliveries from your vendors. Afterwards, compare those costs against the costs of running a contractual supply agreement where you agree to quarterly inventory holding costs, but have a guaranteed source of supply.
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