Two Important Ways to Control Operating Costs

Operating costs are on the rise driven by energy prices and interest rates. Here are some suggestions that can help mitigate the impact on your business.

Energy pricing

Who would have thought we would be dealing with oil prices of $80/barrel. The most obvious impact has been the rapid rise in transportation costs reflected in freight rates and surcharges. Those of you who were on my distribution list in January received an article written by Chuck Buben that addressed cost savings opportunities for truck load transportation. If you want a copy of that article, let me know by return e-mail. Chuck would also suggest focusing on making your business as carrier-friendly as you can, because for the time being, the power is with the carriers. In addition, you should be checking the competitiveness of the rates and surcharges you are receiving. Even in a tight transportation market, your business may be attractive to a carrier that you are not currently using.

Another important activity is to monitor the impact of oil prices on any of your purchased materials that are oil-based or contain a significant percentage of oil based or high energy content processes. Typically suppliers will add some version of an energy surcharge or escalator to their base pricing. You must calculate the percent of your component cost represented by oil or energy and then verify that the surcharge or escalation factor makes sense. For example, if the “oil content” of your purchased material or item is 20% of the item’s cost, then oil escalation should be applied at the rate of 20% to your price. If you don’t check the math, you may be overpaying!

Another opportunity may be to negotiate the timing of the escalator or surcharge. Your supplier’s costs may not be impacted immediately when oil prices change. If that is true, you can delay the timing of the price change.

Finally, do not accept “form letter” price increases. Your purchasing people should be actively resisting every announced price increase. This means having a discussion with the supplier, doing the “math” I referred to above, and asking for some concession, perhaps not price related, before you accept any increase. Last year I wrote a newsletter that included some specific tactics for dealing with announced price increases. If you want a copy of that newsletter, let me know by return e-mail.

Inventory carrying cost

Here are the components of inventory carrying cost:

  • Interest expense
  • Obsolescence
  • Warehousing
  • Depreciation
  • Taxes
  • Insurance

All of these may increase for different reasons, the focus here is on interest expense. The Fed has raised its lending rate to banks which has resulted in borrowing cost increases for everyone. Since most of us cannot negotiate the cost of borrowed capital, the best way to control inventory carrying cost is to have less inventory. That saves money not just on interest expense, but on all the other elements of carrying cost as well. If you can improve inventory turns, you will generate more cash and reduce carrying costs relative to total performance. Here is the equation for inventory turns:

Inventory turnover =
Average annual cost of sales
12 months average inventory dollars

If your business’s sales are increasing it may not be possible to reduce the level of inventory in absolute dollars. But if you hold the dollar amount of inventory constant, turns will improve as you can see from the equation. With the economy performing relatively well, longer lead times, and supply chains that are becoming increasingly global, inventory levels have been rising in total in the US. Carrying cost can be 20-30% of the value of the inventory for many companies. This equates to the fact that if you hold $100 of inventory for a year, it has cost you $30 in addition to the original $100. There is a big opportunity to save money in this area.

Benchmarking against the total economy

One final way to measure your company’s performance is to benchmark against industry averages. The Council of Supply Chain Management Professionals has been tracking logistics costs as a percent of GDP for many years. Over 95% of logistics costs are in the two of the areas discussed above – transportation and inventory carrying cost. In total, logistics costs are about 10% of GDP. If your number is significantly higher, that is an indication that you have got issues in one or both areas.

If you want to act on any of these suggestions, I can help. Give me a call at 847-498-9510 or reply by e-mail to herb@hshieldsconsulting.com.

Thank you for reading this newsletter. If you know of someone in your company or in another company that would find it of interest, please forward it to them. For more information regarding purchasing, inventory management, and logistics education, visit my web site: www.hshieldsconsulting.com. If you do not want to receive future newsletters, you may reply and indicate that.

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