Wednesday, September 11, 2013

Effect of supply chain on the product cost structures

One of the greatest challenges faced by the companies in the retail business is defining the product cost structure. Should the supply chain costs be included into the product cost? Or should the customers be asked to pay according to the cost plus delivery structure? For some may feel the additional increase in cost may drive the customer away, others may feel that knowing the cost upfront will help them better plan out their supply networks!

There are various factors that come into play when deciding about the pricing strategy of a particular product. The ones that tie up to the supply chain systems involved will be the ones I will be talking about. What process the firm chooses to define its cost structure with, is largely dependent on four particular factors; process cost, process flow time, process flexibility and process quality. Out of these four attributes the ones that are value adding to the customer, i.e the ones for which the customers are ready to pay for,  form the basis of defining the strategy the firm adopts when defining its pricing structure. The firms like P&G, Nestle whose products can be bought of the shelf have a more focus on the attributes like quality and cost, because they are the ones that the customers are willing to pay for. Such firms have to keep the price low and still deliver a good quality product. The remaining two attributes are the ones that these firms focus on when deciding the supply chain networks. They choose the modes of transport that are cheap and are well defined. Most of these transportations take place either by sea or by land using trucks and goods carrying trains. Using predictive modeling techniques these firms can predict the demand for their products and thus reduce the high cost that would otherwise be incurred if there was flexibility in their demand. Also because most of the products have a pre-defined design therefore the low variability helps them maintain the right inventory needed to effectively meet the market demand. 

This is not the same for every firm in the business. For certain products the demand for any particular item and the urgency of delivery may vary. For most of the online stores that ship the product to your doorstep the model is different than that adapted by P&G and Nestle. Companies like Amazon, Zapoos allow you to choose your own delivery method. They can do so because most of their shipment operations are outsourced to firms like UPS, USPS and Fed-ex who have a well-defined supply chain network already in place. For the customers who are less sensitive towards price and care about the flow time, these firms provide faster shipment services at a higher cost. These firms primarily focus on adapting the cost plus model where they focus is on keeping the price low and thereby providing the customer the flexibility to choose for themselves the amount they are willing to pay for the shipments.
Sometimes companies choose to switch from one model to another because they feel that the other one is more profitable. When there is variability in the demand the firms cannot afford to have a fixed cost structure but have to tailor the network and ask the customer for a different delivery cost depending upon the urgency of their need.

This was one of the prime reasons for ‘Virginia Mason’ and ‘Owens and Minor’ to switch from using a cost plus model to a TSCC (Total supply chain cost) model.  V&M initially charged a fixed delivery cost for every order placed.  They realized the problem in their product cost structure and thus later decided to have a more comprehensive approach towards this problem. At this point the cost plus model was the only model that was being implemented in the industry. V&M and O&M i.e the customer and the distributor collaboratively worked on solving this problem and came up with the TSCC approach where the total supply chain cost of the product was tied in the product being delivered. To test the feasibility of the analysis, they ran the operations using the cost plus model but alongside also kept a track of the cost savings they would incur if they used the TSCC model. After careful analysis and examination they increased the firm’s profit margin by adapting the TSCC model and thus reducing the supply chain cost.
Jeff Bezos,the CEO of Amazon bought ‘The Washington Post’. When the newspaper industry is not a profit making business anymore, is he trying to use the well established distribution network they have to bring down Amazon’s operation cost? Is there another historic example of TSCC being created? We will just have to ‘wait and watch’!

Prateek Arora

HBR article : 9-110-063 : Supply chain partners V&M and O&M
Managing Business Process Flows, Principles of Operations Management : ISBN-10: 0-13-603637-6

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