The High Cost of Getting the Lowest Cost

Most everyone understands that, if you order a lot of something, you can usually get a better price. That is pretty basic and it forms the basis of many of our purchasing decisions. We are encouraged to believe that this pattern of behavior saves us money and, if the only cost that we consider is the unit cost of the item, its absolutely true. If I buy 12 rolls of toilet paper at $.50 a roll, each roll costs less than if I buy just one roll for $1 – simple.

Beyond the compelling unit cost, we are further convinced that bulk purchases will save us time, because we’ll need to make fewer trips to the store and money in the form of reduced fuel use from those fewer trips. Again, simple. These ideas are so simple, and so obvious, that we almost never think about the effects of this pattern of purchasing and consumption. In fact, its so ingrained in our thinking, that we apply the same toilet-paper logic to almost everything we do; chores, work, shopping.

But toilet-paper logic is not just simple, it is simplistic and since we don’t question it, few of us ever conclude that it is deeply flawed. Some of the flaws of this thinking come in the form of real quantifiable costs that we incur to get that cheap price, but many come in the form of costly behaviors that are much harder to put a sticker on. To illustrate, let’s continue with and expand upon the toilet-paper example. Let’s say, we try to go to a wholesale club to get bulk prices on our household needs and we try to limit our shopping to one trip per week. We make a list of the items needed and head out on Saturday to pick them up.

So, we get the TP. And while we’re there, we get several giant boxes of cereal. We get a “club pack” of chicken, 36 cans of Pepsi, a 12 pack of Spaghetti Sauce, 8 pounds of pasta to go with it, 2 huge containers of laundry detergent, a 4-pack of toothpaste, a crate of our oranges, a mountain of garbage bags, 10 lbs of potatoes, 8 tubs of ricotta cheese…on and on.

We know that we regularly use all these items and we have at least a mental plan to use the perishables before they perish. We also know we’ve gotten a great unit price because we’ve done our homework and we know what the comparison prices would be elsewhere. Because this is our one trip for the week, it takes several hours. We also took a friend because we needed 2 carts to hold it all. We check out, proceed to load it into the car, the trunk and the back seat piled with fresh stuff.

Ok, here the costs have already started adding up. Despite getting a great unit price on every single item, the total bill is huge. Since you get the same amount in your paycheck every week, this would put a big, sudden dent in your available cash. So, to keep your cash flow more even, you decided to finance this with a credit card and pay it off over the next 2 or 3 weeks. As long as you do, it won’t cost you anything extra.

As you are driving home, something occurs to you “This is exactly like ordering large quantities of raw materials at work. I get a great price for a full truckload of stuff, but its still a big order and it lands like a bomb in my cash flow which I have to finance with my credit line.”

Cost #1 – costly cash flow due to a large purchase

So, you get home and start unloading the car. You block open the front door and unload everything at once into, let’s say the kitchen. In fifteen minutes 2 huges cartloads of bulk goods (at very good unit price) are heaped onto the kitchen floor and counter. Your son sees the million-pack of Pepsi, tears it open and grabs 2 cans, and then drives away in your car to his friend’s house (kids…am I right?). Your wife, who was only vaguely aware of your shopping trip at all, stops what she was doing (preparing a presentation for a client), and comes to help put the stuff away.

And it occurs to you “This is exactly what happens when that big order of raw materials shows up at the receiving dock. It gets handled once to unload the truck and lands in a huge pile that’s right in the way of everything. No one expects it, but they drop the valuable work they’re doing to put it away (non-value added work). And while it is sitting there, someone tears into it and consumes some of it.”

Cost #2 – large shipments take people away from ‘real’ work and invariably get double-handled

But you’re too busy to worry about that right now. You have to put this stuff away. Much of this involves repackaging the bulk items into consumable chunks. So, you break apart the big pack of chicken and place it in meal-sized quantities into smaller zip-loc bags, most of which you freeze, and one of which you place in the refrigerator for more imminent use. Of course, in the process, you exhaust the last of your zip-loc bags. So, with the mega pack of ground beef you wrap one pound portions in plastic wrap, which you have lots of.

And it occurs to you “This is exactly like at work. We repack bulk raw materials into containers that fit our consumption needs. It creates extra processing work and we always run out of something – wrap, pallets, containers, tape, stickers…something…and we have to ‘make-do’ with what’s at hand”

Cost #3 – repacking, handling, and the shock to your supply system

Well, this stuff has to get put away, so, having dealt (poorly) with the meat and produce, you start dealing with the ‘non-perishables.’ When you designed your house, you knew you wanted to save money by buying in bulk, so you insisted on a huge walk-in supply pantry and you start putting away the toilet paper and other bulk packs. As you are putting away the toilet paper, you are reminded of why you decided to go shopping today in the first place: you had run out of toilet paper. This, despite the fact that you had bought 36 rolls the last time (so you wouldn’t run out). This time you REALLY saved money by buying 64 rolls. It seems impossible that you could run out now. Alas, the big pack won’t fit on your pantry shelves so you spend 5 minutes tearing it open and stacking individual rolls on the shelf. You take 4 rolls each to the “point of use – the bathrooms” and still find that you don’t really have anywhere to put the rest. So you set about 30 rolls, in torn-open plastic on the floor with the idea that you can store the extras in the garage. It comes as little surprise that, when you get around to heading out to the garage, you find 18 rolls of toilet paper already out there from the last time this happened. Luckily, your garage tends to be damp and these are swollen and discolored by moisture, so you can safely throw them away, and replace them with the new ones.

And it occurs to you “this happens all the time at work. We order more than we can store in the space designated for the material, so we put it somewhere else and forget about it. It invariably is of substandard quality when (if) we do find it and we throw it away, making an empty promise not to let that happen again”

Cost #4 – the cost of making a big space to handle lots of materials
Cost #5 – the cost of inventory damage due to age, environmental conditions
Cost #6 – the cost of inventory tracking to minimize costs #4 and #5

The more inventory a company has, the less likely they will have what they need.

-Taiichi Ohno

As you return to the pantry to put away the huge jugs of laundry detergent, you find that there is already a full one on the shelf. Now you have 3 full jugs and one 1/4 full jug in the laundry room.

And it occurs to you “this too happens at work”

Cost #7 – managing inventory

Okay, you get the idea. Non-perishable items are perishable and it’s costly to track them, even more so not to track them. But it gets worse. To your amazement, the 36 cans of Pepsi you bought will be gone in 3 days. Half the crate of oranges will be gone in 3 days, but the remaining half just sits there. Troubled by this (these are real perishables), you’ll load extra oranges into the kids lunches in order to use them up before they go bad. Then one day you’ll notice 6 oranges in your daughter’s backpack. Not wanting to waste food, you’ll pull one out to eat it. It’s dry and sour and hard to peel. When you question your daughter about it, she’ll say she felt guilty wasting it, but that they sucked, so she just kept them in her bag. Also, she’ll claims that she can only eat so many oranges.

And it will occur to you “this happens at work. When a new shipment of pleasing items comes it, like a giant box of new pens, markers, or warehouse supplies like tape and stretch wrap, everybody grabs a new one and probably an extra one. And for items that looked good when they arrived, but don’t work very well, like a component that is out of spec, or printing that doesn’t match a proof, people try to avoid saying anything about that. And because we ordered tons of it, we don’t find out about its poor quality until long after the order has arrived and been accepted and often paid for.”

Cost #8 – Convenience items go fast. Bright shiny tools make people feel good about their work, so they’ll grab a new one at every opportunity and discard old ones that are entirely serviceable. Consumption will always be higher than anticipated.

Cost #9 – Large-lot quality problems are much harder to pin on the supplier because a) some of its already been used b) much time has elapsed c) people tend to feel really bad about bringing a big problem to a supplier’s attention – they’d rather hide it or work through it – and really, are you going to try to return a half crate of week-old oranges?

Cost #10 – People like variety (especially customers) – if you don’t give them something new, you’ll end up throwing away a lot of oranges

Well, your pantry got loaded. You burned up most of a Saturday getting great prices on stuff. Sure, you financed it, spent money on space to store it, threw a bunch of it away and your family got bored with some of the rest. You got too much of some things, but you’ll use them, some day. After all, the family still uses toilet paper and still does laundry. So, you’re thinking on all this as you driving home from work. And as you’re thinking, you look out the window and notice that you are passing right by the club store where you bought all that stuff. And right next to that giant warehouse of goods is a supermarket. As you continue to drive home, you notice 3 other stores that sell the same items, and a farmer’s market, all of these within 5 minutes of you as you make this trip that you do twice a day.

And it occurs to you “by making one big trip to get great prices on bulk items, I didn’t save ANY transportation or fuel costs at all. All I really did was waste the trips I’m making to and from work right now”

Cost #11- increased transportation costs. Even when you save money shipping a ‘big shipment’ you often lose money by shipping more than you need, expediting, losing the ability to consolidate items in a single shipment, or making cheaper, more frequent pickups from local low volume suppliers.

You’re pondering this as you walk in the front door and your wife informs you that you’re out of AAA batteries, still don’t have any zip-loc bags, the kids have no fruit for their lunches, and somehow, you’re out of toilet paper. Also, there’s a huge bag of recyclable Pepsi cans that need to go back. On your immediate trip back out the door for this “milk run” you notice the garbage cans which your son has set at the curb (such a good kid). On the top of these is a half crate of oranges and some spoiled field greens in a big plastic club pack.

And it occurs to you “This happens at work all the time. We make a whole bunch of product at a great unit cost but then write it off when we make more than we need. At work though, the write-off happens so long after the actual production, that we don’t see it, and the only one we can blame for it is a customer who didn’t want it anymore, revised his order down,or  bought something else from us” You further think “I promoted the guy who ‘saved’ us costs on materials. I gave a bonus to the guy who scheduled those long runs that drove labor costs down. I gave another bonus to the sales department for beating their overall forecast. But the mix of those sales didn’t include the product we saved so much money on….hmmm…I encouraged this

Cost #12 – Over-runs – Big orders and big production runs can indeed drive unit costs down (though not really because of the length of the run…that’s another topic), but it hardly matters if you have to remainder a significant portion of what you made or throw away what you bought.

Cost #13 – Accountability – those goods written off, remaindered, closed out, or just kept, have less value. Savings 25% on production costs isn’t even interesting when you have to sell it for 50% off just to get it off your books. Who answers for it? Nobody. Everyone was just trying to reduce costs and grow sales just like you told them to.

Cost #14 – Data Quality – Until you really do those write-offs (and no one wants to do it, because it makes things look bad), your inventory looks just as valuable as it did, your COGS are down, and even your loser items seem profitable. When you look at this on a financial report and your bank throws money at you at the same time your warehouse manager reports that you’re out of space in your warehouse, you might think its time for a bigger one. Your decision making is clouded by the quality of the items in your warehouse and the data used to account for them.

…and a sinking suspicion should tell you that building a new warehouse is just like putting more junk in your garage.

Economies of scale are real. When a company grows to the size where every order is a large one, that company will likely get better prices from its suppliers (like Walmart does). Everyone wants a big order and is willing to give a better price to get it. However, there are pitfalls to single-minded pursuit of lower unit costs. All this is very fun to write about and maybe in some ways simplifies or exaggerates those pitfalls. Maybe not. In every company I’ve encountered, the term “economies of scale” is thrown around with abandon to justify long production runs and over-ordering of raw materials and basic supplies. That holds true in the office, on the production floor, in shipping, sales, and nearly every business function. For instance, I’ve never seen a company order fewer than 250 business cards even for employees who have almost no occasion to give them out. Why? Unit cost. Economies of scale. We would rather throw away extra than pay more for the right amount. It never seems to click that if you end up throwing away half of something, your costs just doubled.

So, before placing a big order or scheduling a long run, think about the high cost of getting the lowest cost. Incidentally, Lean Thinking will address all of these issues, balancing unit cost against these less obvious costs. The list above is by no means exhaustive and the point here is not to criticize the thought processes behind anyone’s actions. Sometimes the right goal though can lead to the wrong results.

 

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