Higher oil prices call for flexible supply chains

As companies wrestle with rising energy costs, they need to need to know their "tipping point"—the level at which higher prices will necessitate changes in their supply chain strategy. So said Massachusetts Institute of Technology Professor David Simchi-Levi in his presentation at CSCMP's Annual Global Conference in Denver, Colorado, USA.

Traditionally, Simchi-Levi said, cheap oil prices and low labor costs in developing countries provided the basis for such strategies as lean manufacturing, outsourcing and offshoring, just-intime (JIT) production, and smaller, more frequent deliveries. But when crude oil prices rise to a certain level, transportation costs start to assume greater importance to companies than do production, inventory, and facility fixed costs, he said.

Many companies already have reached that point. In the United States, for example, every US $10-per-barrel hike in crude oil prices raises transportation rates by 4 cents per mile, he said. In Europe, a US $10-per-barrel hike raises rates by 7 to 9 cents per mile, depending on the country.

To cope with higher fuel prices and the resulting rate increases, companies must re-think their manufacturing and distribution strategies, said the MIT professor of engineering systems. In an era of high energy prices, he argued, enterprises need to develop flexible supply chains that take into account the trade-offs between higher transportation expenses and inventory, facility, and manufacturing costs.

An analysis of those trade-offs might, for example, prompt a company to add warehouses to its distribution network in order to shorten delivery distances and lower transportation costs. Companies might also consider placing less emphasis on JIT and more on optimizing transportation capacity by shipping larger lot sizes less frequently.

As for manufacturing strategies, companies might have their plants produce multiple product lines rather than a single product. Although a plant making multiple product lines generally has higher manufacturing costs than a factory that makes just one or two, a multiple-line plant could provide a full complement of products for customers in nearby regions, thereby resulting in lower shipping costs. "As crude oil prices increase, [manufacturing] flexibility becomes more important than efficiency," Simchi-Levi said.

With transportation rates escalating worldwide and labor costs in developing countries on the rise, companies will also have to re-examine where they source both parts and finished goods. In particular, Simchi-Levi recommended that companies producing heavyweight items, like refrigerators and televisions, consider making and sourcing those products closer to the point of consumption in order to reduce transportation expenses.

In short, Simchi-Levi said, higher oil prices are leading companies to reassess the conventional wisdom that has shaped their supply chain designs so far. In his view, this change is not a one-time occurrence: "Higher transportation costs will force companies to continuously evaluate their networks and make adjustments," he said.

Editor's Note: To view a video interview with MIT Professor David Simchi-Levi, visit our web site: www.SupplyChainQuarterly.com.

[Source: David Simchi-Levi, "The Impact Of Oil Prices On Supply Chain Strategies," 2008 CSCMP Annual Global Conference, Oct. 6, 2008.Click here to view presentation slides on cscmp.org.]