Innovative Distribution Company A Total Cost Approach to Understanding Supply Chain Risk

2010 ACADEMIC CASE STUDY SERIES

Innovative Distribution Company

A Total Cost Approach to Understanding Supply Chain Risk

An Academic Learning Case Study written for the

Council of Supply Chain Management Professionals

Dr. Ted Farris University of North Texas [email protected] (940) 565-4368

Dr. Ila Manuj University of North Texas [email protected] (940) 565-3131

Council of Supply Chain Management Professionals

333 East Butterfield Road, Suite 140 Lombard, Illinois 60148 USA

+ 1 630.574.0985

[email protected]

cscmp.org

Innovative Distribution Company

A Total Cost Approach to Understanding Supply Chain Risk

CASE OVERVIEW:

This case illustrates the use of the total cost of ownership concept to analyze two supply chains, one international and one domestic. Students must calculate economic order quantity and safety stock quantities, then combine purchase price, shipping costs, and inventory carrying costs to quantify the differences between the two supply chains.

The domestic vs. international aspects of the case allow the instructor latitude in discussing:

1. Differences in labor rates driving outsourcing
2. Use of exchange rates
3. Contrast INCO terms versus FOB terms
4. Understand the economic development of inland China and their developing infrastructure
5. In-transit carrying costs and on-site inventory carrying cost
6. Economic order quantity
7. Safety stock
8. Total cost of ownership

Learning Objective and Appropriate Audience

The case addresses many activities in supply chain management that may be quantified to help assist a lowest total cost of ownership decision. It has been effectively used with the intermediate to advanced student in a senior-level capstone course to synthesize the many trade-offs which should be considered in supply chain management. It may also be effectively utilized within a junior-level international logistics course.

“Arrrgh!” exclaimed James L. Heskett, President of Innovative Distribution Company (IDC). “Pirates have struck again off the coast of Somalia. It seems like every time we turn around there is another piracy on the High Seas.”

“Unfortunately that is nothing new,” replied John L. Hazard, VP of Supply Chain Excellence. “Piracy has been going on for centuries and is still going on today. Did you know piracy has been dramatically increasing?  In 2005 there were 276 piracy incidents1 and in 2009 there were 406 incidents

worldwide?”2

“Wow! That has got to cost someone a bundle.  Who pays for that?” asked Heskett.

“I read a segment on MSN about that,”3 responded Hazard, “the cost of insuring ships has gone up. Insurance premiums increased by 10 times in 2009. Some companies are spending more time training their crews, others are avoiding the area altogether — taking long trips around Africa’s southern tip adds 2,700 miles to each trip and increases fuel costs by $3.5 million annually—and, since the ships can only make 5 round trips per year instead of 6, delivery capacity has dropped by 26%. Who pays? The customer!”

“Gee, I never thought of those costs. The supply chain really takes a hit. It is a good thing we do not ship anywhere around Somalia,” exclaimed Heskett.

“But there is risk everywhere,” challenged Hazard, “Piracy occurs around the world. They have piracy problems in Malaysia and off the coast of Brazil as well. And there are lots of other risks in the supply chain that need to be mitigated. We have embraced off-sourcing because of lower unit prices but we need to consider the total cost of ownership of the supply chain. Longer transit times, fluctuating exchange rates, uncertain delivery schedules, disruptive weather patterns, multi-language requirements, political turmoil, unique tariffs and duties, all add to the cost of doing business internationally. I’m not sure we understand the true cost of our supply chain.”

“You have a great point. We ought to take a look at all the costs of sourcing IDC’s next new product, Schachtel Schmuggel Bannware, and consider the entire supply chain costs,” pondered Heskett. “See what numbers you can gather and we’ll take an all-in look at the numbers.”

A few days later Hazard and Heskett met to review all of the information they had gathered about the new product.

New Product Sourcing Details

“What did you find?” asked Heskett.

“There are only two possible sources of supply for IDC’s new product.  We cannot buy or hold fractional units of a product and we have a projected annual demand (based on a 365-day year) of 21,500 units with a deviation in daily sales of 11 units. Our goal is to maintain an in-stock probability of 97.7% for our customers” replied Hazard.

“All product (regardless of supplier) will be shipped by rail utilizing twenty-foot equivalent units (TEUs) to IDC’s distribution center in Alliance Fort Worth (AFW) where we will service all of IDC’s customer’s needs. A single TEU container can hold up to 600 units of Schachtel Schmuggel Bannware. Due to the nature of the product, no other product may be loaded into the same container. IDC’s inventory carrying cost throughout the supply chain is 32.2%.”

Hazard and Heskett recognize it will cost $105 to place each order with the domestic supplier, and due to the complexity of international trade, will cost $182 to place each order with the foreign supplier.

Domestic Supplier Details

One of the possible sources of supply is CousinsAg, located in Wahoo, Nebraska. The US Department of Labor reported that in 2002, 88,000 of Nebraska’s wage and salary workers are members of unions.4 CousinsAg is a union shop with an average labor rate in their facility of $25.30 per hour. In responding to IDC’s Request for Quote (RFQ), CousinsAg’s price is $85.00 per unit.

As 

shown in Figure One, when an order is placed with CousinsAg it will take 10 days for them to process and manufacture the order, and an additional 5 days to ship it FOB Origin Prepaid to IDC’s Alliance Fort Worth (AFW) Distribution Center. Rail shipping cost from CousinsAg to AFW is $1,850. Based on similar rail shipments from that part of the country, Hazard assumes the standard deviation of the shipping time from Wahoo will be 1.14 days.

Global Supplier Details

The other possible source of supply is Dong Hai Supply, in Chengdu, Sichuan, China. Over the past decade, China aggressively developed their transportation and logistics infrastructure inland from the coast. As shown in Figure Two, the Chinese government is now actively promoting trade in areas such as Chengdu. Located 2,107 kilometers from the port of Shanghai, the Sichuan Administration of Price Control, Sichuan Department of Finance, and the Sichuan Labor Department have maintained strict wage controls to help develop manufacturing for export. The average labor rate in Chengdu

is 10.36 Yuan per hour. The current exchange rate is 1 CNY China Yuan Renminbi (¥) = 0.14646 US Dollar.5  In responding to IDC’s Request for Quote (RFQ), Dong Hai Supply’s price is 547 ¥ per unit.

The 

global supply chain is shown in Figure Three. When an order is placed with Dong Hai Supply (EXW Chengdu, China) it will take 15 days for them to process, manufacture, and stuff the order into a TEU container. Dong Hai Supply will use the Interface Exporting Company (IEC) to ship the container FCA Long Beach.

As a part of China’s aggressive development in infrastructure, the high-speed Shanghai-Chengdu Railroad has recently been completed,6 and will take IEC one day to move the container by rail from Chengdu to Shanghai. It will wait four days at the Port of Shanghai waiting to be loaded onto a ship, 16 days to cross the Pacific Ocean to the Port of Long Beach, and three days waiting to clear customs and be unloaded onto a dockside rail spur in Long Beach.

IEC charges ¥ 12,414.5 for each TEU shipped. Import tariffs and duties are $325 per TEU are incurred at Long Beach U.S. Customs and charged separately to IDC on a monthly basis. Once the shipment clears customs and is offloaded to railcar in Long Beach it will take an additional 4 days to ship it FOB Origin Prepaid to IDC’s Alliance Fort Worth Distribution Center. Rail shipping cost from Long Beach to AFW is $2,250. Based on similar mini-landbridge shipments from inland China, Hazard assumes the standard deviation of the shipping time will be 3.45 days.

Faced with this information Heskett has asked Hazard the following questions.

QUESTIONS:

Q1:

Using the current exchange rate, what is the INITIAL PURCHASE COST PER UNIT (in US

Dollars) paid to Dong Hai Supply? (Do not include transportation costs).

Q2:

What is the AVERAGE TIME for an order filling a TEU container to come from Dong Hai Supply in Chengdu, China to IDC’s Alliance Fort Worth Distribution Center? From CousinsAg in Wahoo, Nebraska to IDC’s Alliance Fort Worth Distribution Center?

Q3:

Using the current exchange rate, what is the COST (in US Dollars) to ship a TEU container from Dong Hai Supply in Chengdu, China to IDC’s Alliance Fort Worth Distribution Center?

Q4:

What is the ECONOMIC ORDER QUANTITY (use unit price only, do not include transportation costs) if we purchase everything from CousinsAg? From Dong Hai Supply?

Q5:

How many units of SAFETY STOCK will we need to hold if we purchase everything from Dong Hai Supply? From CousinsAg?

Q6:

Inventory Carrying Costs are based on the value of the product at the time it is held in inventory.

What is the IN-TRANSIT CARRYING COST PER UNIT (in dollars and cents) if we purchase

everything from Dong Hai Supply? From CousinsAg?

Q7:        

What AVERAGE INVENTORY LEVEL (in units) will we hold at the IDC’s Alliance Fort Worth Distribution Center if we purchase everything from Dong Hai Supply? (Be sure to consider both safety stock and cycle stock) From CousinsAg?

Q8:         Inventory Carrying Costs are based on the value of the product at the time it is held in inventory. When the product is sitting in the IDC Alliance Fort Worth Distribution Center, its value is a combination of purchase price plus any transportation costs to get it from the supplier to the DC plus in-transit carrying costs. What is the TOTAL ANNUAL INVENTORY CARRYING COST (in dollars) for the safety stock and cycle stock inventory held at the Alliance Fort Worth Distribution Center if we purchase everything from Dong Hai Supply? From CousinsAg?

Q9:         Inventory Carrying Costs are based on the value of the product at the time it is held in inventory. When the product is sitting at IDC’s Alliance Fort Worth Distribution Center, its value is a combination of purchase price plus any transportation costs to get it from the supplier to the DC plus in-transit carrying costs. ON A PER-UNIT BASIS (in dollars) what is the total inventory carrying cost for the safety stock and cycle stock inventory held at IDC’s Alliance Fort Worth Distribution Center if we purchase everything from Dong Hai Supply? From CousinsAg?

Q10:       Let’s put it all together to determine the total cost of ownership. We have determined the unit price, the in-transit carrying cost, the transportation costs, and the IDC Alliance Fort Worth Distribution Center’s inventory carrying cost. If we also consider the Annual Ordering Cost, what is the TOTAL COST OF OWNERSHIP PER UNIT (in dollars) if we purchase everything from Dong Hai Supply? From CousinsAg?

Q11:       After you incorporate all the risk costs, which supplier is the LEAST TOTAL COST PROVIDER of Schachtel Schmuggel Bannware?

Q12:       There are additional risks which must be considered to better evaluate IDC’s decision for the two supply chain choices, CousinsAg, and Dong Hai Supply.

1.            Identify two additional risks which should be considered, and

2.            Provide at least two realistic quantitative measures for each risk that you would use to evaluate that risk

Q13:       Recommend improvements to the supply chain process to reduce total landed cost.

1 “Modern High Seas Piracy,” 20 November 2000 presentation by Michael S. McDaniel to the Propeller Club of the United States At Port of Chicago with November 2005 update. www.cargolaw.com/presentations_pirates.html accessed 8 February 2010.

2 International Chamber of Commerce International Maritime Bureau (IMB) Piracy and Armed Robbery Against Ships Annual Report 1 January – 31 December 2009. p. 6.

3 “Pirate attacks drive up the cost of shipping: Companies face higher insurance rates or taking longer, expensive routes,” April 12, 2009, www.msnbc.msn.com/id/30180080/ accessed 8 February 2010.

4 www.city-data.com/states/Nebraska-Labor.html accessed 8 February 2010.

5 Exchange rate as of 8 February 2010.  The instructor may wish to update the rate by accessing www.xe.com/

6 www.chinapage.com/road/shanghai-chengdu-railroad.htm accessed 8 February 2010