03 August 2011

The Dangerous Dichotomy—Part 3


The conclusion of the preceding article was that, without doubt, reducing out-of-stock occurrences will tend to increase revenues. Increasing revenues will certainly satisfy the sales and marketing team, who have been mandated by the firm’s executives with doing that very thing. But, the question remains, can actions be taken to reduce out-of-stock occurrences in such a way that will satisfy what should be everyone’s goal of helping the business make more money tomorrow than it is making today?

We believe it can.

Consider a distributor that buys products from Pacific rim suppliers. One line of products produces gross profits of about 80 percent. Of the costs associated with this product line, about 15 percent are the actual product cost (including any taxes and duties). The remaining five percent are the costs per unit of shipping the product by ship from its source to the firm’s distribution centers.

Like the product in the example provided in the preceding article (see “The Dangerous Dichotomy—Part 2”), this line comes in an array of styles (or color or sizes). Some of these variants sell better than others, naturally. However, because the distributor (wrongly) believe that they are stuck with a three-month or longer lead-time to get these products, they feel that they must forecast demand well in advance and place their orders based solely on this forecast.

The three-month lead time consists of the time it takes to produce enough product to fill a container (or meet some other policy-based “cost-saving” arrangement), plus the time for ocean-going transportation, and the time to get it takes to get the items through customs and provide land transportation to the destination distribution centers. But, because the forecast is always wrong, the firm inevitably finds itself in the situation we described in “The Dangerous Dichotomy—Part 2”; that is, they experience out-of-stocks on several of the variants while being overstocked on several other varieties of the product.

The firm is aware that they can ship these items by air—in much smaller quantities, of course. However, doing so doubles the per-unit cost of shipping these products.

When managers hear that simple phrase: “Shipping by air doubles our freight costs,” that is usually all they need to hear. They think of those “slashed margins” and “higher costs” and that is where the conversation ends.

But, consider this: Doubling the per-unit cost of shipping on this product line reduces the margin from 80 percent to 75 percent. Sure, that is, in fact, a reduction in profit margins on this product line.

Now, consider this: Shipping by air forces shipment in smaller batches. The smaller batches in the shipments mean that the manufacturer can produce the batches for shipment in less time—perhaps as short a time as a few days. Shorter lead times mean the original forecast and the original order need only cover the starter stock—the stock to be sold while the firm figures out what styles or colors are going to be the “big-sellers.”

When the “big-sellers” are known, replenishment stock can be ordered and shipped by air, but the firm is likely to actually make more money than they did when they were paying lower shipping costs.


The reason is simple: At a 75 percent gross margin and a five percent increase in shipping costs—between multi-mode sea-land transportation and air transportation—every additional sale (resulting from reduced out-of-stocks on the popular models) covers the difference in shipping costs for 15 units (i.e., 75 percent gross margin divided by the five percent increase in shipping costs).

Besides the obvious advantage found in the extremely high likelihood of increased profits—despite “doubling your shipping costs” and suffering “reduced margins”—this thoughtful approach has all of the following advantages, as well:

  1. Happier and more satisfied customers
  2. Less likelihood of customers being lost to competitive sources
  3. Fewer lost customers means the firm is more likely to be able to sustain revenues with lower marketing costs
  4. A happier and more productive sales and marketing staff—able to spend their time capturing new customers and markets instead of appeasing disgruntled customers who could not buy the product they wanted
  5. A happier and more productive organization overall—with less in-fighting and a real sense of success and accomplishment
  6. More satisfied management and executive team
  7. A far greater opportunity for success in the future

All of these benefits accrue to an organization that discovers “system thinking” (i.e., seeing their organization as a whole, rather than as disconnected pieces and departments). Meanwhile, the firm still caught in “the dangerous dichotomy” is still fighting fires day-by-day and trying to keep the smoldering animosity between the factions from breaking out into open warfare.

Makes you want to give “system thinking” a try, doesn’t it?

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