Variable vs. Fixed Costs for the Supply Chain: A Sound Approach to Future Growth

As the economy begins to improve, a myriad of benefits can be gained with a strategic 3PL partnership to facilitate upticks in demand and volume

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By Antony Francis and Irv Grossman

Cutting costs without compromising service is a standing challenge for any manufacturer, regardless of industry. While the economy has been challenging, to say the least, in recent quarters, there are glimmers of hope that the beginning stages of a potential recovery could be on the horizon. Even though there is still caution, experts from the Manufacturers Alliance (MAPI) stated in their June industrial production analysis that "we believe a turning point is near for the beleaguered manufacturing sector." In addition, the Institute for Supply Management's "Manufacturing Report on Business" cited encouraging trends, with seven of 18 industries reporting growth in June 2009.

While firm indicators of a recovery remain somewhat elusive, there are promising indications of a reversal of current trends. The state of the economy, and potential rejuvenation, presents an opportunity for manufacturers to be well positioned when markets return to full strength. Beyond recovery, the challenge remains to keep costs lean, even with an uptick in demand.

With the lessons learned from recent hardships, now more than ever, manufacturers should look to outside relationships for non-core operations to reduce costs and increase cash flow. This is especially true for companies that have reduced expenditures on personnel and resources because of shrinking demand. Scaling back might have saved money in the short term, but when consumers begin to reengage the marketplace, some companies might be left behind without the capacity to meet this surge.

Even so, enlightened companies should seek to keep costs low going forward while still preparing to meet demands. This can allow manufacturers to weather storms without enduring harsh reductions in force or "fire sales" of assets to generate revenue. To become market leaders, companies need to keenly focus on improving core capabilities, such as research and development, managing sales channels and maximizing customer loyalty. Committing resources beyond these core areas can serve as a distraction from the most critical operational issues.

Supply chain management is an extremely complex function that commands a significant amount of resources, requiring sophisticated equipment and technology processes, backed by skilled labor that is cost prohibitive for many organizations to retain internally. In order to have a strategic supply chain operation that is cost effective, a qualified third-party logistics (3PL) partner with specific industry expertise should be closely considered by forward-thinking organizations.

With a 3PL partner, the supply chain cost structure can be transitioned from primarily fixed to variable, avoiding the fixed investment in material handling equipment, real estate and IT systems that are inherent to an "in-sourced" operation. Plus, the expense of labor, along with overhead, can be reduced without compromising the ability to fulfill customer obligations.

Leveraging a 3PL for expert workforce, equipment, facilities and advanced technologies can eliminate fixed costs and dramatically reduce variable operational expenses, thus vastly improving a manufacturer's bottom line. This cost transition can increase shareholder value and offer a company the flexibility to react to a dynamic economy and consumer demand.

The Variable Model Defined

Implementing an advanced closed-loop supply chain operation mandates an extensive time commitment, coupled with large CAPEX that can take months to realize ROI. As such, corporate supply chain executives should embrace an "outsource vs. build" mentality that places the investments required for this infrastructure squarely upon a 3PL. A well-suited partner will have the capacity to offer workforce, equipment, facilities and technology that can be almost immediately available, when compared to instituting these resources internally. This allows for all the benefits to be gained without the time and capital outlay.

Two Views of the Supply ChainThe "two views of a supply chain" as shown in the illustration at right demonstrates this concept, featuring two approaches to the same project. The first is the variable cost model approach, featuring the capabilities offered by a 3PL, including labor, facilities and technology. The second option represents the same functions performed internally. The merits of the concept are clear. A 3PL offers all the benefits of a comprehensive supply chain operation in a far condensed timeframe, with less investment, to preserve cash flow.

Reliable Labor and Knowledgeable Leadership

Highly skilled supply chain professionals from the distribution center to the executive suite require extensive overhead investment to retain, from recruitment, to training, to salaries and benefits. This spending is typically not cost effective for manufacturers to maintain on a full time basis. Supply chain expertise may only be necessary on a periodic basis. When demand and volume inevitably fluctuate, the reduced capacity and associated downtime can lead to a drain on operating costs.

Rather, a 3PL offers the ideal amount of labor based on current market conditions, allowing workforce to be utilized only when needed. The 3PL also provides qualified management oversight to maximize production and output, while keeping the operations as lean as possible. In addition, labor resources of a 3PL can provide manufacturers with capacity in the event of internal reductions.

The benefits of a 3PL will differ based on the size and scope of a manufacturer. Smaller organizations, with a limited internal supply chain operations can potentially leverage a full suite of services, including order management, order fulfillment, inventory control, channel distribution, returns processing, planning, transportation, etc. Companies that are larger, with an existing internal supply chain resource, can selectively choose the exact services that complement current operations based on their unique needs, such as seasonal surges for situations such as "Black Friday." Mid-market manufacturers can use a mixture of both approaches. Regardless of the situation, there is a 3PL match that can benefit any sized company.

The Technology Backbone

Acquiring and implementing sophisticated IT systems hinge upon the investment of millions of dollars in equipment and the associated infrastructure. The integration process can also require an extended amount of time to achieve "go-live" status. Systems including inventory management, order management, warehouse management and transportation management can command, at a minimum, nine months to be operational, coupled with up to to a year for training and post implementation.

Trying to independently execute the implementation of technology systems can take years to achieve tangible ROI. However, a comprehensive 3PL can offer a complete technology solution and the ability to benefit in a vastly shorter timeframe. On a relative scale, the benefits that this strategy offers can be realized virtually immediately, without the wait or huge CAPEX. The process is greatly condensed, offering a distinct advantage to manufacturers. Best of all, the ongoing expense of maintenance, service and upgrades are left to the 3PL.

A 3PL will also offer the expert talent necessary to maximize these systems, with the ability to accurately decipher the voluminous amount of information they produce. After all, data are just data unless they can be effectively interpreted and applied to operational improvements. The expertise a 3PL can offer for this analysis is a circumstance where a best-of-breed 3PL provider should be sought. The lowest common denominator won't be able to provide access to this level of aptitude and won't be able to deliver the best results possible.

Leveraging Facilities and Equipment

As the needs of manufacturers tend to evolve based on new product offerings and market climate, it isn't advisable to build, lease or operate corporate-owned facilities. In addition to real estate, this approach commands sizable investments in technology hardware and software, along with materials handling equipment and other costly resources. Allowing a 3PL to assume these traditionally fixed costs can make a positive long-term impact while also allowing for far greater scalability and flexibility of operations as organizational needs change.

Being tied to long-term leases for real estate and the associated residual costs can limit a company's growth if a move to a new geography is needed. In contrast, entering new markets can be significantly accelerated by a 3PL with operations in place at a desired location. This can lead to lower transportation costs and more strategic proximity to customers that keeps expenses down.

Using 3PLs to Variabilize CostsIf a manufacturer is committed to a 3PL partner and vice versa, the relationship can still offer an advantage even when moving to a market where neither has a presence. A quality 3PL will usually have the wherewithal to enter a new market far more quickly than a manufacturer. Granted, it will require weeks or months to be operational, but the 3PL is better suited to make a move in a fraction of the time and produce dividends far sooner.

3PL Benefits

Transitioning from fixed to variable costs utilizing 3PL services can reduce CAPEX for facilities, technology, inventory and labor. Finding the right partner to support business objectives and current operations is key to success.

Engaging with a well-matched 3PL partner can yield significant benefits, but the right selection is crucial. When conducting due diligence, consider the following before making a selection:

1. Experienced, tenured executives and management, with limited workforce turnover.
2. Operations capable of adapting to market conditions.
3. Willingness to collaborate and exchange ideas to achieve mutual benefit.
4. Committed to ongoing improvement and refinement of processes.
5. Reliable organizational structure with sound finances.
6. Capacity and scalability to evolve as needs dictate.
7. Reliable references.

Looking Ahead

As the economy begins to improve, a myriad of benefits can be gained with a strategic 3PL partnership to facilitate upticks in demand and volume, as well as future growth that can lead to improved market share. While cautious optimism can dictate expanding output and thereby increase supply chain operations, thorough due diligence should be applied to select a suitable 3PL provider that can complement and enhance internal supply chain management with variable costs. Once the relationship is defined, manufacturers can enjoy a position of reduced investment of CAPEX and improved cash flow that can liberate them to focus on core competencies to pursue new opportunities and enjoy increased profitability.

About the Authors: Antony Francis is president of ATC Logistics & Electronics (ATCLE), a provider of third-party logistics (3PL) and supply chain services. More information at www.atcle.com. Irv Grossman is the managing principal with Chainnovations, a supply chain management consultancy. More information at www.chainnovations.com.

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