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August 22, 2014
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Strategy

How volatile oil prices will rock the supply chain

In this excerpt from the book Operations Rules: Delivering Customer Value through Flexible Operations, author David Simchi-Levi explains why unstable fuel prices should lead companies to rethink the way they manage inventory, production, customer service, and supply chain integration.

Excerpted and adapted from Operations Rules: Delivering Customer Value Through Flexible Operations (The MIT Press, 2010). Reprinted by permission of the publisher.

Since the mid-1990s, many corporations have tried to reduce operational costs and achieve a lean supply chain by emphasizing manufacturing outsourcing, offshoring, plant rationalization, and facility consolidation. The underlying rationale behind these trends was cheap oil. Indeed, in many industries transportation costs accounted for just a few percentage points of total operational costs. Hence, more emphasis was given to reducing manufacturing costs through offshoring or outsourcing, rationalizing plants to take advantage of economies of scale in production costs and reduce capital investment, and consolidating distribution centers and warehouses to reduce inventory levels and fixed facility costs.

Article Figures
[Figure 1] Offshoring versus nearshoring: the effect of infrastructure and transportation
[Figure 1] Offshoring versus nearshoring: the effect of infrastructure and transportation Enlarge this image

The recent increases in oil prices are starting to reverse this trend. Indeed, as crude oil prices increase, transportation costs become more important relative to inventory, production, and facility fixed costs. Thus, three trade-offs emerge:

Regional distribution centers are more attractive. As oil prices increase, outbound transportation costs become more expensive, and as a consequence, it is increasingly more important to minimize the distance of the final leg—from distribution centers to retail outlets. This can be achieved by establishing more warehouses, each responsible for a specific region. Of course, more warehouses imply more safety stock and hence higher inventory levels. Finally, the increase in transportation costs will force companies to ship large quantities to take advantage of economies of scale. Therefore, larger warehouses will be needed.

Sourcing and production move closer to demand. As cheaper manufacturing costs (frequently associated with offshoring) are offset by higher transportation costs, more and more manufacturing and sourcing activities will move to "nearshoring." This is nicely illustrated by total landed costs, which include unit costs, transportation costs, inventory and handling costs, duties and taxation, and the costs of finance. Landed cost, which represents the effective cost of sourcing or manufacturing in one location and serving customers in other locations, should be used when evaluating sourcing and manufacturing decisions. Evidently, as transportation costs increase, the role of sourcing and production costs in determining total landed cost diminishes.

The need to move manufacturing facilities from low-cost countries to locations closer to market demand in the United States is exacerbated by financial pressure to reduce time to market. These two forces—the effect of transportation on total landed costs and the pressure to reduce time to market—have motivated some industries to move manufacturing facilities from Asia to Mexico.

Supply chain flexibility becomes the focus of the organization. As oil price and volatility increase, it becomes more important to serve demand from the closest manufacturing plant. However, this is not possible if each plant specializes in producing just a few products, a strategy known as dedicated manufacturing.

A dedicated manufacturing environment often reduces manufacturing costs because economies of scale come into play and fewer setups are required to switch between different products. Unfortunately, such a strategy may result in long delivery legs to reach market demand and hence higher transportation costs. By contrast, a "full flexibility" manufacturing strategy, where each plant is able to produce all (or almost all) products, increases production costs (due to frequent setups and smaller lot sizes) but reduces transportation costs.

The implications are clear. The higher the price of a barrel of oil, the more important it is to invest in a flexible strategy because it reduces transportation costs.

Impact on transportation
Many current transportation strategies, including just-in-time delivery, quick and frequent shipments, and using a dedicated fleet, are based on cheap oil prices. For example, transportation strategies such as quick and frequent deliveries were designed to reduce inventory levels by decreasing lead times and increasing the frequency of deliveries. As oil prices increased in 2008, transportation became more expensive relative to inventory, and as a result three important trends emerged:

A shift from just-in-time delivery to better use of transportation capacity. With this trend, larger lot sizes are shipped less frequently, and efficient packaging is used to improve truckload utilization.

A shift from quick delivery to cheaper and sometimes slower transportation modes. As oil prices increase, more shipments will move from air to ground and from trucking to rail to cut fuel consumption and reduce transportation costs.

A shift from dedicated resources to shared resources. In the new economy of highly volatile oil prices, the role played by shared resources—such as third-party logistics carriers and consolidated warehouses—will increase. Common carriers can consolidate shipments from many vendors and replace less-than-full truckloads with full truckload shipments. They are also in a better position to reduce deadhead travel, a source of transportation inefficiency. Similarly, large consolidated warehouses aggregate order quantities into full truckload shipments and reduce total shipping costs.

Supply chain strategies
Beyond their effect on network and transportation strategies, escalating and volatile oil prices also affect business strategies in general and supply chains in particular. Let's start by reviewing two important impacts.

More inventory. The analysis above suggests that higher oil prices will have two important effects—increasing total safety stock in the supply chain (because of the need for more regional warehouses) and increasing lot sizes (to take advantage of economies of scale). At the same time, the switch from quick and frequent deliveries to efficient, slow, and less frequent shipments will also drive up inventory. Thus, assuming that lead times remain the same and that there is no change in sourcing locations, supply chain inventory will increase as oil prices increase.

More push strategies. Today's supply chain strategies are often categorized as "push," "pull," or "push-pull" strategies. The appropriate supply chain strategy for a particular product depends on a variety of drivers, but the most important for this discussion is economies of scale. Everything else being equal, the higher the importance of economies of scale in reducing cost, the greater the value of aggregating demand and thus the greater the importance of managing the supply chain based on a long-term forecast—a push-based strategy. As oil prices increase, the importance of economies of scale (such as shipping large quantities) increases, hence the importance of a push-based strategy. Therefore, we expect that escalating oil prices will drive more supply chain stages toward a push strategy.

Of course, more inventories and a higher degree of push may not be appropriate in many industries. Thus, executives need to consider mitigation strategies such as the following:

Position inventory effectively. As oil prices increase, trade-offs between inventory and transportation costs become more important, and as a result, positioning inventory correctly can have a dramatic impact on logistics costs. For example, in a hub-and-spoke network, items are shipped from manufacturing facilities to primary warehouses (hubs), and from there to secondary warehouses (spokes), and finally, to retail stores. In such a network, high-volume/low-variability products must be positioned at the secondary warehouses because of the need to take advantage of economies of scale in transportation costs—safety stock is not an issue since forecasts are accurate for products with these characteristics. By contrast, forecast accuracy is poor for low-volume/high-variability products, thus these products are positioned at primary warehouses to reduce inventory by taking advantage of the risk pooling concept.

My experience is that many companies are not very good at positioning inventory in their supply chain. They try to keep as much inventory close to the customers as possible, hold some inventory at every location, and store as much raw material as possible. In such a strategy, each facility in the supply chain optimizes its own objective with very little regard to the impact of its decisions on other facilities in the supply chain. This typically leads to:

  • High inventory levels and low inventory turns,
  • High transportation costs because of the need to expedite shipments, and
  • Inconsistent service levels across locations and products.

Emphasize better service. An important driver of transportation activities is typically the need to expedite products across the network due to poor service levels. When oil is cheap, this is not necessarily a huge problem. But under the new reality, there will be a significant pressure to reduce expediting costs by improving service and by better positioning inventory in the supply chain. This is also critical in the direct-to-consumer business model that is employed by many online retailers. In this case, there is continuing pressure to increase the probability of success in first-time delivery to the customer.

Push for tighter supply chain integration. An important driver of inefficiencies in the supply chain is the "bullwhip effect," which suggests that variability increases as one moves up the supply chain. That is, variability in customer demand is smaller than variability in retailers' orders for the same products over the same period. Similarly, variability in retailers' orders to the distributors is smaller than variability in distributors' orders to the manufacturers. This increase in variability causes significant operational inefficiencies. For example, it reduces the ability to employ transportation capacity efficiently. This is true because high shipment variability makes it harder to plan transportation capacity. Should it be based on average or maximum shipment size? Either way, transportation cost increases. Thus, as oil prices increase, it becomes more important to reduce the bullwhip effect—that is, to reduce supply chain variability. This can be done by reducing lead times, sharing information across the various facilities in the supply chain, or strategic partnering such as vendor-managed inventory. In short, the importance of tighter supply chain integration increases with escalating oil prices.

Rethink offshoring strategy. Depending on the industry and product characteristics, more and more companies need to reconsider their production-sourcing strategies and even suppliers' footprint, as is discussed in the next section.

Offshoring versus nearshoring
In some industries, escalating and volatile oil prices are more likely to force changes in production-sourcing strategies. The objective of this section is to identify product characteristics that will motivate companies to move manufacturing from offshore locations in Asia to "nearshore" locations that are closer to market demand—such as Mexico for demand in North America and Eastern Europe for consumers in Western Europe.

Figure 1 provides a framework for matching manufacturing and sourcing decisions with product and supply chain characteristics. The vertical axis provides information on the cost of moving infrastructure, including manufacturing and assembly. The horizontal axis represents the transportation impact—the product's bulkiness and hence cost to transport, the ratio of transportation cost to selling price, and the impact of delivery time on the price paid by consumers.

Everything else being equal, a higher cost of moving infrastructure leads to a preference for keeping manufacturing at current locations, while a lower cost leads to an interest in nearshoring. Similarly, everything else being equal, the higher the transportation impact, the greater the value of moving from offshoring to nearshoring.

In Figure 1 we partition the region spanned by the two dimensions into three boxes. Box I represents bulky products where transportation plays an important role in total landed cost. Examples include furniture, appliances, flat-screen TVs, and bulky parts for cars (such as engines). All of these products have already experienced some movement of manufacturing from offshoring to nearshoring.

Even when transportation costs are not high, some companies have started to move manufacturing closer to market demand if the cost of moving infrastructure is low (see Box II). This is particularly true for toys, footwear, and fashion apparel.

Finally, Box III represents industries where the cost of moving the infrastructure is high and the transportation impact is low. Examples include the supplier network of mobile phones and computers. In these cases, manufacturing of key components (such as desktop chassis, chip-sets, mobile phone keypads, and semiconductors) depends on heavy infrastructure, which is difficult to move. In these situations, companies will be slow to change their production and sourcing strategies.

Another equally important driver of the decision on whether to keep manufacturing offshore or move to nearshore production is changes in labor costs in different countries. Between 2002 and 2008, labor costs in countries such as Brazil and China have increased significantly, much faster than the increase in costs in the United States and Mexico. This implies that offshoring and outsourcing decisions that were made a few years ago may not be appropriate in the current environment.

As transportation costs and labor costs in developing countries increase, it becomes more attractive to move manufacturing closer to demand. In fact, such a move also reduces inventory levels, as it reduces lead time to key markets.

For some industries, these changes may lead to more distribution centers, with each responsible for a local market. Other industries may be forced to completely change their manufacturing strategies and establish plants closer to market demand.

Summary
Overall, the increase in oil prices and oil-price volatility will affect four important areas: business, consumers, the environment, and emerging technology.

Business. Rising oil prices are forcing companies to rethink many business strategies that have been implemented in the last two decades. Although the specifics vary from company to company, two things are certain:

  • The days of indiscriminate emphasis on manufacturing in low-cost countries and centralized distribution are numbered. In the new norm of rising oil prices, increased labor costs in developing countries, and moderate growth in the economies of developed countries, a more balanced mix between regional and global activities will emerge.
  • The days of static supply chain strategies are over. With increasing costs and changing markets, companies must monitor and re-evaluate their network and supply chain strategies on a continuous basis. Hence a switch to a more flexible supply chain strategy.

Consumers. With oil prices rising, business must consider whether to transfer the increased costs to consumers or to absorb the increase internally and face smaller profit margins. In some industries (such as tires and plastic), oil is such an important ingredient in the production processes that they typically are more willing to transfer costs to consumers.

The environment. As oil prices increase, environmentally friendly supply chain strategies coincide with economically effective business strategies. Increasing cube utilization, reducing deadhead distances, and decreasing fuel consumption improve the transportation bottom line and reduce the carbon footprint. Similarly, strategies that directly focus on reducing carbon emissions typically improve transportation efficiency.

Emerging technologies. The search is on for technologies that help industry reduce energy consumption and energy costs, including technologies that can reduce transportation costs. These include onboard global positioning systems with centralized information that allows for real-time monitoring of vehicle operations, aerodynamic tractor-trailers, kite-assisted ocean freight, automatic tire-inflation systems, and single-wide tires (replacing the traditional two-tire systems).

Investing in emerging clean technologies or implementing operational improvements and innovation to reduce carbon footprint are all part of corporate social responsibility—an area of focus for a growing number of firms.

Editor's note: Operations Rules: Delivering Customer Value through Flexible Operations, published by The MIT Press, sells for US $29.95 (20.95) and may be purchased at http://mitpress.mit.edu. It is also available as an e-book.

David Simchi-Levi is a professor in the Department of Civil and Environmental Engineering at Massachusetts Institute of Technology.

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