For-profit
businesses have a simple task – make profit. Well, maybe not that simple to attain,
but simply put for a business to make profit all it needs to do is to generate
revenues that are greater than its expenses (and if the business is interested
in sustaining the profit making, it needs to ensure that it grows, and therefore
that its revenues grow faster than its expenses).
The nature
of these two forces is quite interesting, and one of the characteristics they
have is absolutely opposite. While revenues generation is subject to high
uncertainty and somewhat out of the business control, cost is highly certain and
almost fully under the business control. This core difference leads to a fundamental
difference in the way management treats the two; we hope for revenues and we ache
costs.
Funny thing,
we tend to be much more attuned to our aches than to our hopes, and sadly we
tend to focus our managerial processes and tools on “optimizing” cost. You will
notice that I placed optimizing in quotes, as I do not believe the term is
relevant at all for the business world. And just for putting this argument
aside, if you accept that businesses must grow it will immediately mean that
there cannot be an optimum value for any of the relevant measures. But, let’s
go back to our tendency to focus on cost and try to better understand the
effect of that on our business overall performance. As this is a very large
subject, I chose for this article to discuss BATCHES and BATCHING.
Batching is
all around us, we use it everywhere in our business lives as well as in our
private lives. We were educated and we firmly believe that batches give us the
most cost effective approach. Please note the term – cost effective. Cost is
the leader, effectiveness follows. How do we measure this cost effectiveness?
Do we measure it by the effect the batching choice has on our overall cost?
Well, mostly we do not; we rather measure a different measure and believe it
gives us a good indicator to the effect on the overall cost. I am sure you are
familiar with this measure; it is called “cost per unit”. So we batch as
the cost per unit is lower vs. if we did not batch. And we believe (hope?) that
if the cost per unit is lower it will mean our overall cost will be lower too.
We have with this believe another, implicit, assumption – that our
effectiveness (making money) will not be affected negatively by this choice, or
that at least, the negative effect it will suffer is not high enough to justify
the additional cost of not batching.
There are
many areas in life we batch, and to further narrow down the discussion, let’s
review batching in supply chain environment and try to answer the following
question – Do we really get the lowest cost and is our choice really not
negatively affecting our effectiveness (or alternatively the negative effect on
effectiveness is smaller than the additional cost of not batching)?
OK, let’s check!
Where do we
batch in supply chain environments? Well, where not? We batch when we buy as
the seller often time will offer a discount (price per unit), we batch our
shipments, when we sell (both when we ship from suppliers as well when we ship to
our consumption locations), as the cost per unit of transportation is lower, we
batch our warehouse picking, as the cost per picked unit is lower, we batch
handling shipping documentation and invoices, as the cost per processed document
is lower (we call it efficiency). And let’s stop here. (However, there are many
other areas we batch that for the time being we will leave out. Still, I urge
you to challenge the validity of the cost effectiveness assumption. )
Before we
review each one of the above mentioned batching practices, please allow me to
review the mathematics behind the batching “science’ (quotes again, soon it
will be clear why). The following graph is the common way cost is related to
quantity:
The basic ingredients
are an ascending cost (red arrow) that grows as quantities grow
(like inventory handling cost), a descending cost (green arrow) that shrinks as
quantities grow (such as transportation cost) and their sum (the blue line),
which mathematically is curved and has an optimum. How lucky we are. The
calculation for the lucky optimal number (called EOQ – Economical Order
Quantity), is done using the following equation:
If you review
this beautiful mathematical equation you will see its components are:
- Annual usage in units – which is mostly an estimate
- Order cost – which is an estimate (and suspiciously related to the estimated annual consumption and the number of orders we are trying to calculate)
- Annual carrying cost per unit – which is again an estimate, and as suspicious as the previous number
However, the
beauty of a mathematical equation is that it results with a very accurate
number. So, we take estimates, guesses and highly dependent numbers and drive
out of them a perfectly accurate number. Strange, isn’t it? Please note one
more, extremely disturbing fact about this equation (and unfortunately this
fact is prevalent across most inventory management practices) – this equation
totally ignores the element of supply time, which is by far the most important
element in any such decision.
In case you
do not use EOQ (or any of its similarly dubious derivatives) the relevancy of batching
still calls for a review.
As the perceived
savings are resulting from similar considerations in all cases, we will start
with reviewing the cost savings. What are the cost savings we believe we
achieve by batching?
-
Purchasing price per unit,
which often time actually is lower for larger quantities.
o
However, often batching leads
to buying larger quantities vs. the quantities required within the time it
takes the supply point to deliver to the consumption point. In these cases
obviously the total cost goes up, as even though we pay less per unit, we pay
more for the full batch.
§
Example:
·
If a supplier can deliver
once a week, and the minimum batch is sufficient for one month, the minimum
order quantity is 1,000 units and price per unit if we buy 250 (which is what
we need) is $10 and the price per unit if we buy 1,000 (the “economical”
quantity) is $9. Then we pay $9,000 instead of just $2,500. In my mathematics
$9,000 is greater than $2,500, does anyone get it otherwise?
-
Handling cost per unit (Transportation,
Storing and warehouse operations, Administrative activities such as: shipping
documentation, orders, invoices, etc. and Overhead(
o
Handling cost per unit is a
calculation that allocates fixed cost of handling to units. We do not really
know this allocated cost before a period ends (as only then we know how many
units we actually handled). More than that, this cost does not change with a change
of unit, but more with leaps in units. You do not really lay off people, or
recruit them just because you have one more unit to handle (at lease for most
of the cases). So, often times the savings are fictitious, as many CFO’s know
when they ask – why can’t we see these saving in our bottom line?
o
Obviously when we have more
we need more space to store, more people to handle, we have more obsolescence and
scrap, we produce more, and we ship higher quantities. All of these could not
have a reduction effect on cost, do they?
Naturally evaluating
the effect on revenue generation is more complex as unlike cost, it cannot be
calculated, it can only be estimated (read again the difference between cost
and revenues explained in the beginning of this article). Therefore one should
ask himself what is the probability for the effect on revenues. Accordingly,
the next part is providing a glimpse into the lost revenue generation
opportunities, to their probable effect, and their probability of materializing.
And clearly, they do not always apply. Let’s review the effects of batching on
effectiveness:
-
Batching when we buy
o
When space is occupied with
inventory we do not need, we cannot hold inventory we do need (for example in
stores). Thus we are selling less.
o
As inventory and time are synonymous,
and forecast accuracy deteriorates with time, the higher the inventory the more
it is liable to misalignment with demand and more occasions of shortages
happen.
o
As long as some items have
large quantities of inventory, replacing them with others becomes an issue
delaying the generation of revenues from alternatives (new products).
o
Example:
§
A pharma retail chain. The
facts that help estimate probability:
·
53% of SKU’s have inventory
higher than their maximum level in the stores.
·
This excess inventory occupied
more than 30% of the stores shelves.
§
The effect of eliminating
batching
·
The overall cost went down
by 6% (even though transportation cost went up by 2%) and the revenues grew by
15%, resulting with increased profitability of about 10%.
-
Batching when we ship/ sell
o
When we have Minimum Order
Quantity (MOQ) we, at times, incentivize our customers to postpone buying (or not buy
at all)
o
When our customers buy
quantities larger than they need, they are not likely to buy again until they
use the quantity purchased resulting in delays in our ability to introduce new
products to the market
o
Example:
§
A Packed Consumer Goods
producer. The facts that help estimate probability:
·
About 25% of the retail
chain stores the company is selling to, do not hold the company’s products (and
obviously the company has zero sales in these stores, even though the chain as
a whole is a customer)
·
The company has a MOQ
policy that may represent to some stores inventory much higher than their
maximum targets
§
The effect of eliminating
batching
·
The overall cost of
shipping and producing went down by 4% and the revenues grew by 8%, resulting
with increased profitability of about 8%.
-
Batching warehouse
operations
o
Batching warehouse
operations means the warehouse refuses to service orders smaller than the MOQ,
thus these sales are either lost, or delayed.
o
Example:
§
A central warehouse of a
large retail chain. The facts that help estimate probability:
·
About 20% of the SKU’s in
the stores have no inventory while there is sufficient inventory in the warehouse.
§
The effect of eliminating
batching
·
The overall cost of warehouse
operations went down by 5% and the chain revenues grew by 8%, resulting with
increased profitability of about 3%.
-
Batching documentation
handling
o
Similar to the warehouse
operations, batching orders means the orders will not be released when
required, but rather when there enough of them (or when the fixed time for that
arrives). This means that sales that required the purchased items are delayed until
the processing of the documentation takes place, or lost.
o
And, for received orders
they will not be processed until such time there are enough of them (or when
the fixed time for that arrives). This means that even if inventory is in place
it cannot be used for its purposes as it is not available for that. Obviously,
it delays or even leads to lost opportunities.
o
Example 1:
§
Maintenance parts
distributor. The facts that help estimate probability:
·
With a policy of ordering
from suppliers monthly, about 24% of the SKU’s are either not available at all,
or insufficient for their demand.
§
The effect of eliminating
batching
·
Availability went up to 99%
plus, cost stayed the same, and sales grew by 15% leading to 6% improved profitability
o
Example 2:
§
OEM producer of sub-assemblies
for the defense industry. The facts that help estimate probability:
·
With a policy of processing
the receiving of purchased items once every two weeks, about 20% of the orders
are supplied in a delay even when the purchased items are in the plane
warehouse.
·
The Plant pays about 2% of
its revenues as late delivery penalties.
§
The effect of eliminating
batching
·
Delays went down to less
than 5% of the orders, and penalties to less than 0.5% of the revenues.
All of these
examples are demonstrating one crucial point – batching, more often than not, does
not result with the aspired cost savings and definitely results with the loss
of the hoped for revenues. It is not that the batching practice is insensible;
it is the policy that is. It should not be used automatically, and should be
reviewed on a per case basis, BUT through thorough evaluation of its full
effect on the total cost and the revenue generation (and not based on dubious
measures that may, or may not indicate it, such as cost per unit).
Do not be afraid
to assume effect on revenues, we do this with any new product we develop, with any
new market we enter too, with any price decision we make, with any promotion we
choose. And mostly, all of these are riskier, costlier and far less probable to
affect revenue generation vs. the elimination of batches in the appropriate
places.
Batches are
a meaningful, mean and well-disguised enemy of productivity, sales, service
and, surprisingly of cost too, so go to war, you can only win!
Very nice, Mickey! And so true. People have no metrics to tell them when their batching causes damage and so they prefer to believe that they made things better and some unknown factors are constantly working against them mitigating the expected bottom line benefits. It is quite hard to come to the realization that their work towards local efficiency is actually the cause of the damage.
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