CSCMP's Supply Chain Quarterly
Procurement
October 22, 2018
Procurement

Planning for the unexpected: How "what-if" costing reduces global risk

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Cost simulation can help retailers and others that source internationally to reduce unpredictability in their landed costs.

Before a product reaches a customer's door, there are countless factors that could affect its cost. Even when these variables are relatively predictable, it's still a complicated equation, as organizations need to weigh the cost of everything from product manufacture to packaging to tariffs. Mix in the unpredictable nature of the real world, and companies can lose millions of dollars due to unanticipated elements that impact the landed cost of a product.

The global business community is more closely connected now than ever, thanks to technologies that enable buyers in California to quickly communicate with manufacturers in Bangladesh, customs officials in Saudi Arabia, and designers in Madrid. In this intertwined ecosystem, it's easy for the proverbial flap of a butterfly's wings at a point in the value chain halfway across the world to cause some destructive winds elsewhere. In other words, in today's supply chains, the smallest, seemingly insignificant event could have very important consequences. Even in the face of uncertainty caused by changing trade policy, shifting geopolitical landscapes, natural disasters, and more, companies must continue to meet the demands of their customers. Whether a labor strike makes it twice as expensive to source from a specific country or a mudslide ruins a factory that is critical to production, consumer demand doesn't let up, and business leaders must be prepared to make quick decisions to keep the wheels turning.

For most organizations, it's likely that actual landed costs will fluctuate (sometimes greatly) due to circumstances beyond their control. But that doesn't mean they are helpless when it comes to dealing with uncertainty. In fact, they can mitigate cost-related risk by more effectively planning for the unexpected.

Risk factors: Beyond natural disasters
Businesses around the world are more reliant on foreign partnerships than ever before, and the entangled network of buyers, suppliers, and customers further magnifies exposure to risks and the potential effect of the shockwaves crises could send through the supply chain. Industries that rely on speed—like retail—are particularly vulnerable to the impacts of unpredictability. It might be easier for retailers to respond to changes if they could somehow silo, or isolate, themselves, but there are too many participants and stakeholders that depend on each other to bring a product to market. From sourcers and designers to manufacturers and distributors, there's a complex network that is vulnerable to disruptions at every stage. According to a recent survey we conducted, 93 percent of major retailers work with more than 500 new vendors a year, including new suppliers in each department.1 The idea of siloing oneself to minimize risk simply isn't feasible with this much supply chain connectivity.

Disaster can strike at any time, so retailers must be ready to shift strategy at a moment's notice. In 2013, for example, a building that housed a garment factory collapsed in Savar, Bangladesh, killing more than 1,000 people. A gas leak in a manufacturing complex killed more than 8,000 people over two weeks in Bhopal, India, in 1984. Tragedies like this have happened since the beginning of industrialization, yet too many companies still fail to grasp the importance of preparing for the worst.

Retailers must also be prepared to address risks associated with economic and political change. Highlighting the growing degree of uncertainty, the professional services firm Deloitte recently reported that the U.S. economy is "heading into unknown territory with a new party in control of the White House, putting regulatory reform, trade policy, and the tax system on the table." Deloitte's analysts also pointed to slowdowns in international economies, thanks to the United Kingdom's planned departure from the European Union (popularly known as "Brexit") and negative interest rates in some countries, as additional sources of risk.2 Indeed, Brexit has already thrown a wrench into economic, political, and social systems across the globe, even though the U.K.'s departure from the EU won't be final until April 2019. While the full impact of Brexit remains to be seen, the possible outcomes—including changes in consumer behavior and as yet unknown trade agreements—have retailers struggling to accurately navigate uncharted waters and assess any need for change to mitigate risk before it occurs.

The International Monetary Fund (IMF) cited similar concerns around uncertainty in the United States that could impact businesses both at home and abroad. Among the risks that have the potential to harm companies in the near future, according to the IMF's July 2017 "World Economic Outlook Update," are a more protracted period of policy uncertainty, financial tensions with emerging economies, and inward-looking policies that could lead to disrupted global supply chains, lower global productivity, and less-affordable tradable consumer goods. "Despite a decline in election-related risks, policy uncertainty remains at a high level and could well rise further, reflecting—for example—difficult-to-predict U.S. regulatory and fiscal policies, negotiations of post-Brexit arrangements, or geopolitical risks," the IMF report said.3

Risk assessment done right: "What-if" costing
The sources of risk cited above are just some of the issues retailers must prepare for; the list of potential scenarios that can impact the landed cost of a product is too lengthy to fully cover here. This makes the idea of accounting for every possible situation seem like a task too monumental to tackle. However, it's critical that businesses not be put off by the scale of the challenge and decide to take only cursory steps to combat uncertainty, or to not do anything at all. There are some tempting reasons to take a "do nothing" approach. For instance, even with all the variables in play that could impact a company, it's possible that none of them will happen. A chief executive who plans for the best-case scenario will be very successful if everything plays out exactly as expected. This approach, however, simply increases risk that could introduce cost uncertainty across international supply chains.

One strategy that is better than doing nothing—but is still deeply flawed—is to implement a blanket markup that will help ease the burden of disruption should anything go awry. As it stands, retailers focus too much on the initial cost when purchasing goods from abroad, and as a result, they don't have visibility into the full cost until after the deal is done. Markups may prevent underpayment to suppliers, but initial estimates often don't match the actual costs. A markup will also achieve the goal of mitigating risk of loss, but the impact it eventually has on price accuracy could cause later problems—such as maximized budgets, incomplete future projections, and potential supplier distrust—that a more scientific approach would have avoided.

Each of the approaches discussed above has the potential to create problems rather than solve them. In the face of the rapid and successive geopolitical and economic changes we are seeing more regularly, a better choice for reducing cost-related risk is "what-if" costing that models the impact of numerous variables on landed costs by simulating various cost scenarios.

While many organizations appreciate the importance of what-if costing, they don't always implement it in the most effective ways. For example, they might try to set up formulas in Excel with the expectation that it will help them manage complex situations and flexibly simulate various scenarios. As useful a tool as Excel is to us every day, it's not the most effective way to calculate hundreds of thousands of variables at a moment's notice. Furthermore, some organizations only commit to reviewing cost data no more frequently than once a year. The problem is that cost factors can change quickly and unexpectedly, and while analyzing cost information once or twice per year might be convenient, it isn't practical to act only on historical data when dealing with massive uncertainty. Ideally, what-if costing should be refined in real time, but if that's not feasible, then at least every month or so is recommended.

The most effective way for retailers to conduct what-if costing is with cost-simulation software that helps to calculate accurate landed-cost estimates. The most robust what-if costing tools for U.S.-based retailers are integrated with the U.S. government's Harmonized Tariff Schedule (HTS) and are updated regularly with data inputs from third-party companies such as financial institutions and agencies like the U.S. International Trade Commission. These tools get updated information into the hands of retailers as soon as it's available.

Cost simulation allows retailers to view the financial impact of executing an assortment against a plan, and to calculate margins at the item, class, department, season, or channel level. A platform with what-if costing functions can aggregate the potential costs and margins and compare the results to original forecasts to ensure accuracy throughout the product life cycle. And by delving deeper into the link between merchandising and product development, what-if costing-capable software allows users to adjust schedules and timelines to achieve overall margin targets. All of this gives companies new access to insights that account for every conceivable contingency, allowing them to predict, control, and manage their risks. This predictive ability allows executives to make strategic business decisions by considering various cost-disruption scenarios, which can help them achieve greater accuracy, justification, and confidence in their decision-making.

What-if costing alleviates the pain of change for suppliers, buyers, manufacturers, and distributors because it offers a picture of the international distribution of demand and provides increased transparency. With all parties involved in the product-development process well-informed, suppliers are in a better position to provide recommendations to retailers and form a mutually beneficial relationship. Additionally, retailers that employ what-if costing will place more accurate orders, reducing errors and simplifying supplier relationships. At the same time, the ability to calculate and mitigate risks allows retailers to expand their supplier base; they can engage in relationships that previously were too risky because it was difficult to accurately predict an outcome.

What-if costing can offer additional savings for some retailers. With the data provided by a cost-simulation tool, retailers no longer need to rely solely on industry experts for analysis and in some cases could eliminate these middlemen and their expensive fees. By automating the analysis of information from past deals and transactions, retailers also minimize opportunities for human error and can reallocate funds toward more beneficial projects or processes.

No longer a luxury
Business leaders are much more likely to bank on an assumed outcome if they don't have good data to examine. Unfortunately, it often is difficult to cultivate and analyze the data that can identify what the most likely scenario might be. When that's the case, many might assume that it's not worth it to allocate financial and human resources to making complex, arduous costing contingency plans, especially if a company has been existing and even thriving without them for years. Even more shortsighted, retailers that are hyperfocused on bargaining for the purchase of goods across the globe might forget that profit doesn't come until after the product is on the shelf. By making assumptions about every step in between purchase and the shelf without the data to predict various scenarios, they may find themselves unable to make cost adjustments in the event of a disruption.

With today's complicated global economy and endless points of exposure to risk, what-if costing isn't a luxury. In fact, the retailers that seem most poised to weather any storm that arises and to gain advantages over their slower competition are those that are committed to consistent, comprehensive what-if costing. There are many benefits to be gained by taking innovative approaches to calculating landed costs based on fees, services, geographies, markets, and other unique conditions in real or near real time. Retailers that use this strategy to stay ahead of disruptions will be the ones that emerge as leaders in a changing global landscape.

Notes:
1. Bamboo Rose, "Digital Sourcing in the New Retail Economy."
2. Deloitte, "Insurance Outlook 2017."
3. International Monetary Fund, "World Economic Outlook Update," July 2017.

Sue Welch is the Founder and CEO of Bamboo Rose, a collaborative B2B platform that combines intelligent product life-cycle management, sourcing, and global trade management.

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