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The Little Black Book of Supply Chain
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Logistics and the Total Cost ConceptDiscussion
Crossing Boundaries of Get, Use, and Dispose
In his 1975 doctoral dissertation, Doug Lambert focused on inventory carrying costs, but he
put them in the context of other logistics costs like warehousing, lot sizing, transportation, and
customer service (Lambert, 1975). Later, in a top-selling textbook, Lambert and Jim Stock
assembled a more detailed total cost model. Discussion  It showed the links to marketing and added order
processing and information systems to the logistics portion of the model (Stock and Lambert,
2007). We take a similar approach in our overview here of logistics.Discussion
You should not consider costs in one logistics category without considering the others.
In the opening vignette, the issue was trading off transportation costs for inventory carrying
costs. As Lambert’s dissertation pointed out, you can’t consider that tradeoff if you don’t
know your inventory carrying costs (Lambert, 1975). Inventory carrying costs tend to be
higher than most people think they are. Second, the relationship between logistics cost categories is not always a tradeoff. Sometimes the categories move together.Discussion
Let’s take the relationships between five subcategories in logistics. Each of these gets a
chapter later in the book: customer service (Chapter 6), Inventory (Chapter 8), transportation
(Chapter 9), warehousing (Chapter 10), and information systems (Chapter 11). Those chapters
look at how to manage those functions. This chapter concentrates on costs and the relation-
ship between these functions. The chapter is partly an introduction to logistics and partly an
analysis of cost tradeoffs and relationships.Discussion
We examine these categories as cost centers, but each is also host to activities. We
briefly covered the total cost concept in Chapter 2, but we expand on each area here. This
chapter uses the term ‘warehouse’ to cover a range of facilities—fulfillment centers, distribution centers, and warehouses. We use it to mean any facility used to store goods for use or sale,
even if the storage period is short.
Customer Service
We can measure the financial impact of customer service failures. We have the financial
models that let us calculate the cost of a lost customer, the cost of a lost sale, and the cost of a
backorder. The problem is that we often don’t have the data. We could use a seven-year win-
dow in the model for Net Present Value and come up with a dollar figure for a lost customer.
That is, we could if we knew that we lost the customer. In some B2B settings, customers tell you without hesitation. “We are leaving. We won’t renew the contract. You missed Discussion  too many delivery times.” Since you probably have data on this former customer, you could
project the numbers for their hypothetical future sales. This knowledge might give you a
workable estimate of the cost of the lost customer.Discussion
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The Little Black Book of Supply Chains
Often companies don’t know that they have lost a customer. The customer just quits
showing up. They stop placing orders. They no longer stop in the store. The company doesn’t
know why or when. This lack of information means that companies measure customer service
costs indirectly in logistics. They calculate or choose an in-stock or out-of-stock percentage.
For example, they might use a 5% out-of-stock goal for a specific product. This measure
assumes that 95% of the time, a customer would find the product on the store shelf.
The company then tries to meet this goal while minimizing the total cost of the other
dimensions of logistics. For this overview, we start with inventory. Supply chains for physical
goods need inventory to exist.
Modern information systems help keep better track of customers. We can know more
about our customers than ever, but the systems fall short of perfection. The indirect measures
still work, and we still need them.
Inventory
Inventory ties up a company’s money, or it ties up someone’s money. If you pay $20 for an
item in inventory, that item should be worth at least $20 to you. If it isn’t, you made a bad deal.
To understand what inventory costs you, you should first think about what else you might
have done with that $20. This second choice is the opportunity cost. Your company mightDiscussion
earn a 25% pre-tax return on investment, so the $20 in inventory should earn something close
to that percentage.
As a rule of thumb, we’ll assign 25% as the opportunity cost for inventory. That’s 25%
of the average annual value of the inventory.
Inventory also carries risk. There’s the risk that it will go bad, the risk that it will be
stolen, and the risk that it will be in the wrong place and need to move. “Going bad” is obsolescence cost. We tend to think of obsolescence as something that happens to technology. Last
year’s iPhone is worth less when this year’s iPhone comes out. Yet you can have an obsolete
or rotten banana.
In this cost category, obsolete means that you can’t sell it or that you can’t sell it for
the same price as before. You buy one too many boxes of bananas for your grocery produce
department. Then you must cut the price or throw the leftover bananas away. If you overstock,
you may lose money on a product. Or, you might have a creative deli department manager who
could use the overripe fruit in a banana pudding to sell and recover some of the sunk costs.
‘Shrinkage’ is a common term in inventory management. The computer record shows
more inventory than you find on the shelf or in the storage bin. The inventory ‘shrank.’ One
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Logistics and the Total Cost Concept
reason that inventory might shrink—it gets stolen. It could be shoplifting or employee theft.
A second reason is poor record keeping or inventory counts.
Some years ago, a consumer products manufacturer included batteries with some of its
products. Let’s just say that its inventory security fell short. At Christmas time, none of the
employees worried much about the toys that arrived ‘batteries not included.’ Some employees
were leaving the warehouse so loaded down with batteries that it seemed that their pants
would fall off.
For our rule of thumb, we’ll assign 10% of inventory value for a year in this category.
Inventory also needs to be insured. A firm that holds millions in inventory will ensure
investment against fire, flood, and other disasters. Inventory may incur taxes. However, most
firms have strategies to avoid inventory taxes when possible.
Combined, our rule of thumb will be 1% for these categories.
We will use this total, 36%, in an example at the end of this chapter. It will help to summarize the point of the chapter.
In his dissertation research, Lambert estimated the inventory carrying costs for six
large firms. He compared his calculations to the percentages that the companies were using
in their inventory models. The numbers differed by at least six percentage points in annual
inventory carrying costs. One of the companies had been using 9.5% for its inventory calculations. Lambert found its inventory carrying percentage to be 35% annually (Lambert, 1975,
p. 113). Lest these data seem ancient, current estimates of inventory carrying costs still range
between 15% and 30% on websites like www.investopedia.com and www.tradegecko.com.
(See https://www.investopedia.com/terms/c/carryingcostofinventory.asp)
Inventory alone requires analysis to improve performance, but it also needs work in the
context of other logistics operations. Procter and Gamble cut more than $1.5 billion from its
inventory carrying costs between 1999 and 2004 (Farasyn et al., 2011). They could only do
this because they used the available tools, including logistics-oriented information systems
and modeling.
Transportation
Transportation systems come in various modes and mixtures of equipment, people, I.T. sys-
tems, and infrastructure. Here, we focus on costs and not those mixtures but costs and timing.
Managing is for another chapter.
Transportation costs change depending on one critical decision. It’s a make-or-buy deci-
sion. A company can operate its transportation system. That’s a ‘make’ choice. A company
could hire another company to transport its goods. That’s a ‘buy’ decision. A company could
also do some of both, a ‘make-and-buy’ choice.
60The Little Black Book of Supply Chains
When a company buys transportation services, the costs tend to be straightforward. It’s
not quite paying the invoice for the transportation firm, but it’s close to that. There will be
some administrative costs, but most of the costs will be in the invoice from the carrier. When
a company does its transportation, the costs become a problem for the accounting department.
They must then be allocated according to the rules followed for any other operation in the
company.
Let’s look at a couple of examples. First, let’s look at Walmart as an example of a
large company. Walmart has a fleet of trucks. They use this fleet to haul goods from their
distribution centers to their stores. These are dense routes, so the cost per ton for the freight
is low. Walmart also hires trucking firms to haul goods, usually on the less dense routes or
with seasonal demand changes. It’s up to the external trucking firms to make their profits and
cover their costs, not just with revenue from Walmart but from all their customers.
A local furniture company might own a truck and hire a driver. A local soft drink or
beer distributor probably owns or leases a fleet of trucks and operates a full-time transportation operation. The same goes for local landscaping services, tree trimming, and similar
businesses. These businesses are in constant motion.
Some of these fleets deliver services, while others deliver products. We have firms like
Door Dash that deliver food as “for-hire” carriers for local restaurants, typically using their
personal vehicles for the deliveries. Fleets of smaller vehicles bring electricians, pest control
technicians, and landscape services to businesses and individual homes. The vehicles arrive
with service specialists, and they supply the tools they need to use to perform or “deliver” the
services.
For most freight carriers, the tradeoff is between speed and cost. Air freight costs more
than surface freight like motor carriage (trucks). Still, air freight allows for lower inventories
and smaller warehouses, so transportation costs can trade off with other logistics costs.
The makers of smartphones ship their goods by air from Asia to North America and
Europe. An extra month of inventory carrying costs overwhelms the difference between air
shipping and ocean and surface shipping costs.
Warehousing Costs
Warehousing costs tend to vary with the number and size of the warehouses. The more ware-
houses and distribution centers you have, the more inventory you will carry. The larger the
warehouse, the more inventory you are likely to carry. So, inventory carrying costs and ware-
housing costs tend to move together. But the two should not be confused or conflated.
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Logistics and the Total Cost Concept
Warehousing costs include the cost of owning, renting, or leasing the facility. They also
include energy, labor, security services, maintenance, and administrative costs. These costs
vary little with the level of inventory. Inventory carrying costs should include only those costs
that change with inventory levels. The warehouse manager’s salary probably doesn’t vary
with inventory level, so it belongs in the category of warehousing costs.
Material handling costs tend to be associated with the warehouse to a greater degree
than with the level of inventory. If you own a forklift, the cost of ownership tends to be fixed,
although operating costs might arguably vary with the inventory level.
The number of warehouses in a network changes transportation costs. It may also
change customer service costs. The thinking is that customer service will improve if you add
more warehouses or “fulfillment centers,” to use Amazon’s terminology. You can promise
two-day delivery more reliably if you have more stock locations.
If you make promises like second-day delivery, you must keep those promises. Promises of this nature set customer expectations. If you violate those expectations, you may lose
customers or sales. More warehouses in the right places may help meet customer expectations, increase customer retention, and increase sales.
Transportation changes with the network of warehouses. If you examine an Amazon
fulfillment center, you see small vehicles loaded with small packages leaving the center
to deliver to homes and businesses. If you look at a Walmart distribution center, you see
18-wheelers leaving to deliver large quantities of goods to Walmart stores. This changes with
the type of distribution center in Walmart’s network. Their distribution centers for online
sales look a lot like Amazon fulfillment centers.
In many ways, warehouses define the logistics network and the supply chain. They are
destinations and points of interchange in the supply chain. Transportation goes to and from
them, carrying inventory. The information system follows and tracks the inventory, storage
locations, vehicles, and other information.
Information Systems and Order Processing
Inventory may be the key to a supply chain. Without an inventory, you do not need ware-
housing or transportation. You can provide no customer service. But the information system
offers the ‘start’ button for the supply chain, the order processing. This system connects the
functions of warehousing, transportation, and inventory to operations, supply management,
and customers.
Customers place orders in many ways. They may press buttons on websites, make
phone calls, or visit stores or factories. At some point, the order goes into the information sys-
tem. This move makes the order real to warehousing, inventory control, and transportation.
62The Little Black Book of Supply Chains
Data comes from the other areas of logistics into the logistics information system
through many routes. Warehouse Management Systems (WMS) seek real-time information.
This information may come from barcodes, radio frequency identification (RFID) chips, or
manual entry. Barcodes and RFID systems increase inventory accuracy from about 65% to
over 93%. The average barcode system has over 99% accuracy (Sangsane & Vanichchin-
chaim 2021).
You can use drones to gather data in large warehouses if the warehouse uses RFID
chips. The chips have become less expensive and more effective over time. The signals from
RFID chips now broadcast short distances, so people can’t just drive by your house and find
out what model of television you have. Neither can they easily fly past your house with a
drone and grab that information.
The average Amazon fulfillment center is about 800,000 different products. Drones
can speed up the process of data gathering in that context. The speed and accuracy of inven-
tory information have improved. Systems can now meet customer service standards with
less inventory, faster transportation, more efficient warehouses, and more reliable customer
service.
Materials Handling
Like information systems, materials handling crosses the boundaries of logistics siloes. Mate-
rials handling moves goods from operations into finished goods storage. It moves goods from
finished goods storage onto trucks and other vehicles and off of them at the destination. It
moves goods between machines, from raw materials storage to the operations floor, and from
inbound vehicles into raw materials, spare parts, and assembly storage.
Materials handling is also the source of data for the information system. The system
needs to know when inventory changes status from a work-in-process assembly to part of
finished goods or from raw materials to a product. As goods move through the system, the
system needs to know where they are, even in small steps. That can be important to opera-
tions, supply management, logistics, and customers.
Logistics, Supply Management, and Operations
The Total Cost Concept is tied to logistics, but logistics crosses into supply management and
operations. As with the logistics subfunctions, costs can trade off between logistics, opera-
tions, and supply management.
Consider car windows for automobile manufacturing. These windows could be stacked
one on top of the other. Stacking would save transportation costs. Slip thin foam pads between
them, and they suffer little damage. But that may make it difficult for workers on the assembly
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Logistics and the Total Cost Concept
line to separate the windows from one another. Instead, they are packaged in slotted pallets.
They stand up so workers can easily handle them. It may cost more in transportation, but it
makes operations work much easier and faster. So here is a connection between logistics,
operations, transportation, and materials handling. Materials handling is another boundary-
spanning activity.
One of the key activities in supply management is to oversee the delivery of purchased
goods. The delivery is a logistics activity. So, logistics and materials handling, a part of logis-
tics, connect supply management and operations.
Example of Trade-Offs
In this example, we put some numbers into a simple model. It’s a breakeven model that looks
at one supply chain logistics tradeoff. Should we ship from a port by rail or by truck?
To set up this example, we need to know a few things. First, how long does it take for
each mode to move from the port to the same destination? Second, we need to know how
much it costs for each mode of transportation.
These costs may be unrealistic, but they get to the general point that it costs about twice
as much to ship by truck as to ship by rail for this move. So, let’s say that it costs $3,000 to
move a container load by truck and about $1,500 to move the same shipment by rail. We will
also say that it takes 13 days to ship by rail and only three days to ship by truck. This is a
ten-day difference. It lets us keep the number in the calculation ‘round.’
Now we assume that inventory carrying costs are 36% of the value of the goods annu-
ally. This estimate allows us to set up a simple breakeven problem. It tells us the value of the
goods that choose between rail and truck a tossup.
The difference between the times is ten days, so the inventory carrying cost percentage
for those ten days would be roughly one percent (1%). The difference in transportation prices
is $1,500. We can set up a breakeven formula that looks like this:
.01x = $1,500
If we solve for x we get: x= $150,000. A container can easily carry that much in value,
so we find that the freight often moves by truck in those conditions.
Keep in mind that this only considers one of many tradeoffs. It also ignores variability,
which can be more of an issue with rail than trucking. Let’s say that rail might take between
seven and 14 days to arrive. You planned for a ten-day arrival time. If a railcar load shows up
early, you may not have space to store the goods, so you pay a demurrage fee to keep the rail-
car as temporary storage. In the long term, you might need a larger warehouse. If the freight
64The Little Black Book of Supply Chains
arrives in 14 days instead of ten days, you may run short on the product. In the long run, you
may need to increase your inventory levels.
The variability of the rail shipment is greater than the likely transit time for the truck,
so the low level of variability is another factor in favor of truck shipment. That choice does
assume that enough trucks will be available at the port for you and others who wish to ship
that way.
Air shipment, of course, is even faster—but also costlier. Some industries use air shipment for emergencies and expedited shipments. Others, like Apple, use it routinely to ship
high-value products.
The critical point is that you should evaluate each situation. You should consider costs
and activities in context. If you look at only one cost or one activity, you may make poor decisions on behalf of your company.
References and Additional Resources
References
Farasyn, I., Humair, S., Kahn, J. I., Neale, J. J., Rosen, O., Ruark, J., … & Willems, S. P. (2011).
Inventory optimization at Procter & Gamble: achieving real benefits through user adoption of
inventory tools. Interfaces, 41(1), 66–78.
Lambert, D. M. (1975). The development of an inventory costing methodology: a study of the costs
associated with holding inventory / [Doctoral dissertation, Ohio State University]. OhioLINK
Electronic Theses and Dissertations Center. http://rave.ohiolink.edu/etdc/view?acc_
num=osu1486998116224497
Sangsane, K., & Vanichchinchai, A. (2021, April). Improvement of Warehouse Storage Area and
System: An Application of Visual Control and Barcode. In 2021 IEEE 8th International
Conference on Industrial Engineering and Applications (ICIEA) (pp. 444–448). IEEE.
Stock, J. R., & Lambert, D. M. (2007). Strategic logistics management. Boston: McGraw-Hill
Irwin.
Links
www.investopedia.com
www.tradegecko.com. https://www.investopedia.com/terms/c/carryingcostofinventory.asp)