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My Introspective

by Laurus Nobilis
My BrainCast

Case Studies

Ultimate Cost: Purchasing an Item at the Ultimate Cost (E)


Ultimate Cost




What is the Ultimate Cost? Is the Cost Saving always what is meant to be? How to avoid buy cheap-sell cheaper traps?


Posted: Mar 2008

It is well known fact that one of the goals of the trade is to buy an item at the lowest possible cost and then to sell it at the highest possible price. That sounds simple and obvious. The same stands for every other activity within the company. Every activity that can be done with less expense can increase profitability of the Company by reducing input costs.  

But when the organisation is large, or when people are not aligning between each other, then the "Silo" thinking syndrome occurs. The Silo thinking is typical for the bigger organisations, but it can appear in every organisation. The Silo or Functional thinking is looks productive at first glance, effective or cost efficient from perspective of a single function/department, but is totally opposite for the common benefit of the whole organisation.

Example 1:

Beverage Company is importing sugar in a quantity and shipment dynamics that is larger than usual. As we know, the sugar is one of the main ingredients of the soft drinks.

The annual quantity of sugar ordered is 12% larger than planned annual production. The Quarterly dynamics of production and shipment dynamics is as follows:

                                            Q1                 Q2              Q3                Q4

Sugar in Production:        14%             26%            33%            27%

Sugar Import:                   16%            33%            32%           19%

What is the real landed cost of some activity? What are "hidden cost", and why are they hidden?

The Sugar is bought at this quantity and shipment dynamics, since the price was more favorite for this quantity. Also, the sugar is more expensive in stock market in Q3 than in Q1 and Q2. So the plan is obviously OK.

But, in this situation there is the surplus of sugar in stock that needs to be placed in warehouse. The usual warehouse space dedicated for sugar is up to 1.000 metric tons. With the new setup, the company will have stock average quarterly surplus as it is shown:

                                           Q1               Q2                 Q3               Q4

Sugar on stock ( mt ):   1.050            1.850            1.550            1.250             

Obvious that the Company needed to rent extra warehouse for surplus sugar, what created additional costs. In fact this situation depicts what is usual Postponement of cost in the company that is Silo-Thinking oriented. Fortunately, the saving on sugar was significant enough to cover extra warehousing space. The saving on sugar was €80 per metric ton, while warehouse and additional cost per excessive ton was €12. So, the ultimate saving per sugar metric ton was not €80, but it was €68.

In this case the company was still making more money than before, even after a lot of internal conflicting who should pay for the warehousing cost. Should the Supply Chain pay the extra warehousing cost, or Procurement that bought cheap sugar?


Example 2:

Another Soft Drink Company after analysing different options in production cost saving decides to use thinner ( and cheaper ) wrap film for packaging. The pallet of product is composed of certain number of cases ( 6 bottles wraped with a film ) placed on a wooden pallet. Everything is then fixed by wrapping the plastic film around.

Of course, for the company that sells a millions of cases annually the decision to use 45 nm wrap film is €1,2 cheaper per pallet than with 65 nm wrap film. This initially meant to be a perfect example of a clever saving.  

Case Study: Ultimate CostUnfortunately, the problems in warehousing appeared soon. The pallets in warehouse are placed one on top of the other. There are other methods ( racking ), but this method is the cheapest, since it not requires any investment. Usually, the pallets are stored in 3 layers. But, with this weakened wrap film the pallets lost some stability. This was reflected by the sporadic collapsing of lowest pallets. This was a problem from many perspectives: safety, cost ( € 400 per pallet ), customer satisfaction, ... Afterward, the decision was made to store pallets in 2 layers only. After this situation is settled, there were no more pallets collapsing.  

But, on the other side the problem appeared. As the season was approaching, the warehouse was quickly become full, since the capacity was reduced by the decision to store pallets on 2 instead on 3 layers. The solution was to rent an extra seasonal warehouse. Finally, someone asked about what caused this problem in first place.

Indeed, what was the cause? It was the new wrap film that changed procedure in storing the pallets. And what was the result? The warehouse "shrinked" by loosing the 3rd layer of pallets.

The Analysis of problem showed the following facts:

- New Wrap Film saving is €1,2 pallet

- Warehouse cost per pallet is €3 per pallet

So, at the end the Company was loosing money by introducing cost saving in production, because that caused increase of warehousing costs. Saving of €1,2 caused additional €3 through Postponement of cost. The solution was to use old Wrap film for those products whose stability on pallet was jeopardised by thinner film.

Note: These two examples are essentially authentic, but figures are somewhat changed and company names are disclosed for reasons of confidentiality.



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