Monday, July 26, 2010

Cost of Sales and Supply Chain Competence

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Supply chain competence affects your bottom-line in more direct ways than you might realize. In an earlier article, I covered the role of inventory and how the ability to define and control inventory in the supply chain affects your financials. In this article, let us review the role of controlling cost of sales through supply chain competencies and its effect on the corporate financial statements.

The cost of sales appears on the income statement right below the revenues. The difference between the revenues and the cost of sales is the gross profit. Therefore, the cost of sales directly determines the gross profit of a firm and that is directly responsible for the firm’s bottom-line. It has several aliases: it may be called cost of goods sold, cost of products, cost of products sold or something else similar in connotation. That is not important. What is important is what constitutes the cost of sales. Typically, for manufacturers and retailers, it is also the second biggest number on the income statement after the revenues. In fact, for the financial year 2009, the COGS was 50% of 2009 revenues for P&G, 76% of the total revenues for Wal-Mart, and 70% of sales at Target for FY2009. Therefore, if one had to start looking at reducing costs, COGS fits the bill nicely. This is the largest pie of expense in an organization and even a small reduction in this will naturally generate a large impact on the firm’s bottom-line.

What does cost of sales consist of?

Cost of sales generally includes all direct expenses related to the products or services that a firm sells. For manufacturers, this typically includes the cost of raw materials and purchased sub-assemblies, cost of conversion to the finished goods like the direct labor used to run a plant, depreciation of the plant and machinery, or things like the coolant oil needed to cut metal on the turning centers, cost of freight to transport raw-materials to its factories, warehousing costs to maintain the finished-goods stocks and shipping costs to ship them to their customers. In a retail scenario, the cost of sales will include the cost of merchandise and the cost of freight from its suppliers to its warehouses, and the cost of distribution from its warehouses to its stores. In summary – include all direct expenses related to the value-adding activities of the firm in the cost of sales.

So how can supply chain competency affect the cost of sales?

Almost all expenses related to the value-adding activities are controlled through the supply chain processes and the efficacy of these processes determines the cost basis of the activity. Take the warehousing costs, for example, automating the warehouse planning and execution activities through a warehouse management & execution system can increase the number of cases handled on inbound and outbound shipments for every labor-hour employed. The freight costs can be reduced by employing a better process for planning shipments – that can reduce the miles driven, enhance the equipment utilization rates, or consolidate shipments to reduce freight. Any way you look at it, developing supply chain process competencies affects the process efficiencies that in turn, affect the cost of sales and hence your profitability.

Following are some of most common expenses included in the COGS and the supply chain process that can potentially optimize it.

Cost Component of COGS

Supply Chain Process Managing the Cost Component

Financial Metrics Affected

Direct Materials and Supplies, Cost of Raw Materials and Inputs (for manufacturers), or Merchandise (for retailers), etc.

Forecasting, Replenishment, Inventory Management (raw materials), Sourcing, Purchasing

Gross Margin, EBITDA, Inventory, Inventory Turnover, Current Assets, Working Capital, Return on Assets.

Direct Labor, Cost of Transformation (production, manufacturing, processing, etc.), Depreciation, Direct Manufacturing Overheads, etc.

Production Planning, Factory Planning, Resource Planning, Inventory (work-in-progress) Management

Gross Margin, EBITDA, Working Capital, Return on Capital Employed.

Cost of Freight (all inbound, outbound, and intra-facility transfers of material)

Transportation Management

Gross Margin, EBITDA, Working Capital.

Cost of Warehousing, Inventory Shrink, Obsolescence, Mark-downs, Handling, Inventory Carrying

Warehouse Management, Labor Management, Inventory Management (finished goods or merchandise)

Gross Margin, EBITDA, Working Capital.

As the Table 1 shows, the major components that constitute the cost of sales are the cost of merchandise or raw materials, cost of distribution, cost of manufacturing, and the cost of labor. The supply chain capabilities that can help reduce these costs are as follows.

  • The cost of materials, whether raw materials or merchandise, can be reduced through strategic sourcing, bid optimization, and supplier contracts-based optimization. Good demand and supply management practices also help in reducing the cost of materials by reducing obsolescence. Obsolete inventory typically results in merchandise clearance and write-offs both of which increase the total costs of materials.
  • Distribution costs primarily consist of warehousing and transportation. Supply chain processes that can help reduce these costs are network planning, warehouse management, and transportation management. The warehousing management capabilities reduce the warehousing costs through better use of space, better inventory management in the warehouse, automation, and optimized labor scheduling. Network planning can reduce the cost of distribution through optimal positioning of the distribution centers with respect to the suppliers and stores. Transportation management capabilities help reduce the distribution costs by optimizing shipments that reduce the total miles driven and enhance the container and trailer volume utilization. Better fleet management capabilities can increase the efficiency of the fleet and freight invoice automation can reduce the expenses related to validating and paying for freight.
  • Manufacturing costs can be reduced through better scheduling and factory planning processes. Supply chain optimization solutions that allow modeling of the demand, available inventory, available resources, operations, and sequencing constraints are typically used to produce feasible manufacturing schedules that can optimize the usage of assets and resources to produce manufacturing schedules that drive most profitable product-mix for the given demand or maximize the demand fulfillment for given orders. Increasing the asset utilization reduces need for investing in capital assets thus reducing long-term debt used to finance capital investments. In turn, it positively impacts return on capital employed by reducing the total current liabilities.
  • Major labor costs for the retailers occur in the warehouses and the stores, and for manufacturers, they are in the factories. Warehouse management processes can help directly reduce the labor costs in the warehouses, by better labor planning, scheduling, and task tracking. Better demand forecasting in the stores helps in streamlining the labor plans in the stores. Manufacturing labor costs are minimized through better scheduling and factory planning capabilities that can model the material and asset constraints to produce feasible labor plans.

Any reduction in the cost of sales directly translates into increased margins assuming the other factors remain constant.

© Vivek Sehgal, 2010, All Rights Reserved.

Want to know more about supply chain processes? How they work and what they afford? Check out my book on Enterprise Supply Chain Management at Amazon. You will find every supply chain function described in simple language that makes sense, as well as see its relationship to other functions.