Total cost analysis

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Russian: Анализ общих затрат

Total cost analysis represents the concept that the sum of the functional costs within the firm should be managed in addition to managing the individual costs independent of one another. The functions included in a total cost analysis include transportation, warehousing, order processing, inventory management, production, and purchasing. The linking of functional costs into a total cost perspective allows the firm to make functional trade-offs in aligning functions in a unified and integrated fashion. The unifying objective should be to minimize total cost subject to meeting a prespecified customer service level. Without the customer service constraint, a trivial solution to minimizing cost is to minimize operations. In some cases, the functional trade-off may be relativgely straightforward. For example, transportation mode selection may require a trade-off of mode speed (with faster modes charging a higher rate per relevant weight unit) against the transit time inventory carrying cost. A fast mode (e.g., air) will have a high freight rate and a low in transit inventory carrying cost rate, while a slower mode (e.g., rail) will have a lower freight rate and a higher in transit inventory carrying cost rate. In other cases, the trade-offs are relatively complex. For instance, the network design problem seeks to solve the issue of the number, location, and capacity of production and warehouse facilities, the modes to be used when servicing flows from production facilities to warehouses and from warehouses to customers, and the assignment of customers to warehouses and of products to be manufactured at production facilities. The costs being traded-off in this instance include those related to transportation, production, and warehousing. When a solution to the network design problem is sought for a global business, the processes involved including data collection, model verification, and model analysis are not trival and generally require sophisticated software packages.

Example

A practical example of total cost anlsyis is found in the case of Hewlett Packard (HP) and production of a specialized laptop[1]. In the baseline or current network configuation, a number of regional facilities were utilized where final laptop configuation was undertaken. This final configuation included features related to the power system, the keyboard, the language of materials and of the software, and regional or local packaging requirements. The production of the base product for the entire globe was undertaken at a single location in the United States. This configuation took advantage of form postponement (see order penetration point), as final configuration was only conducted at regional faciilities after orders were recevied, and of geographic speculation, as HP speculated on the quantity of the base product required at each regional facility based on forecasts. Since larger scale bulk shipments could be ultilized when shipping from the U.S. production facility to the regional facilities, outbound freight costs were effectively managed. However, HP was not taking advantage of risk pooling effect across space and found itself holding significant safety stocks at each regional facility. This network configuration traded the high cost of the inventory carrying cost against the low cost of freight. An alternative configuration that HP considered and eventually adopted was that of centralizing all production in the U.S. Under this configuration the level of form postponment would not change as the firm would continue to wait for orders before completing the final configuration. The level of geographic postponement would change as HP would not longer specualtion on where inventory was needed before the arrival of orders. The Table shows the percentage cost change for several functions in a shift from the current configuration (geographic speculation) to the proposed configuration (geographic postponenment). The centralization of production would result in some production savings, presumably from a scale effect. The freight cost were expected to increase dramatically, by +56.8%. This is the result of the displacement of bulk shipments from the production facility to the regional facilities with small lot (or express) shipments from the production facility to final customers. HP recently had expanded and clarified the fashion in which it measured inventory carrying costs. Three such costs are provided in the table: (1) an inventory fincnace cost; (2) an inventory devaluation cost, which represents write-downs on inventory; and (3) an inventory obsolescence cost, which reflected inventory write-offs. As seen in the Table, proposed configuration would result in a dramatic reduction of inventory cost. This is primarily a function of the the risk pooling effects across space - less safety stock is required. Thus the proposed network configuration would result in higher freight cost, but lower productoin and inventory cost. Both systems configurations were expected to maintain similar service levels. The total cost of the proposed solution was 28.3% less than the current configuration. The proposed configuration was eventually adopted.


Total Cost Analysis: Comparing Two Network Configurations
Cost Current Configuration: Use of Regional Facilities Proposed Configuration: One Centralized Facility
Production 100% -21.0%
Freight 100% +56.8%
Inventory finance 100% -51.9%
Inventory devaluation 100% -63.5%
Inventory obsolescence 100% -58.1%
Total 100% -28.3%

References

  1. Callioni, G., X. de Montgros, R. Slagmulder, L.K. Van Wassenhove, and L. Wright (2005), "Inventory Driven Cost," Harvard Business Review, 83 (3), 135-151.
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