Cost Reductions Have Hidden Costs

Cost Reductions Have Hidden Costs

In my previous edition of The Daily Reckoning Australia, I listed a variety of techniques to optimise efficiency.

These concepts all involve planning the supply chain itself, sourcing inputs and raw materials, making the product in the most efficient manner possible, delivering finished products with optimised transportation lanes, allowing for the return of defective products or the disposal of any waste, and enabling people with the right skills to carry out these tasks.

Looking over these techniques and tools, one is not surprised to learn that there are hundreds more supply chain management techniques. Without getting into details, some of these other techniques include master scheduling, inventory planning, total quality management, continuous improvement, warehouse management, material requirement planning, cross-docking, vendor-managed inventory, and many more.

All of these supply chain management models have one goal in common: to reduce costs. For example, cross-docking is a method invented by Walmart where goods arrive at a distribution centre and are moved immediately from an arriving vehicle to another vehicle that’s headed to a particular store. The goods never enter the warehouse and are never included in distribution centre inventory.

It’s as if the goods were shipped directly from the cargo ports to the individual stores; the distribution centre is just a place to change trucks, not a place to stack inventory. This process saves time and money and lowers costs to the consumer. It’s one of many ways that Walmart keeps its promise of ‘Everyday Low Price’.

And these supply chain tools have been greatly enhanced by computers, algorithms, and artificial intelligence. A company receiving inputs from 10 countries through four US ports, distributed to 10 warehouses using seven major trucking companies has 2,800 possible transportation lanes.

Computers can be used to optimise these lanes in ways that reduce the actual routes to perhaps the 40 that make the most sense in terms of time and money. The manufacturer will select from among these 40 options while using the computer to update the optimisation software with new inputs and continually searching for the best routes.

The downside of cost reductions

Why does cost reduction weaken supply chains and lead to breakdowns? The answer is that cost reductions have hidden costs.

When you increase the length of a supply chain to reach lower labour costs in Asia, you also increase the number of things that can go wrong along the way. When you reduce your trucking providers to the two offering the lowest rates, you increase your vulnerability if one of those two suffers a strike or is disrupted by a natural disaster. If you route all of your inbound cargo to the Port of Los Angeles (instead of Houston, New York, or Tacoma) in order to be close to your distribution centre, what happens when the Port of Los Angeles becomes a global bottleneck — which it has?

Put differently, the hidden cost of efficiency is vulnerability. It might be more costly in the short run to use multiple ports of entry, multiple trucking companies, and widely separated distribution centres. But those redundancies can produce great savings in terms of keeping manufacturing processes running and avoiding lost sales if one of those ports, truckers, or distribution centres is disrupted by pandemics, weather, natural disasters, or power outages.

The best way to think of how the added costs of redundancy can produce savings is to think of it as insurance. When you buy insurance, you hope that you will never need it. When you pay your insurance premium, you consider it money well spent, even though it has no immediate return. When you have an insurance claim, you receive great value. The insurance can save you from financial ruin, even though the premium is a short-run cost. Redundancy or resilience built into supply chains can save your business from ruin.


Jim Rickards,
Strategist, The Daily Reckoning Australia