Crude Calculations

Why high oil prices are upending the way companies should manage their supply chains
By DAVID SIMCHI-LEVI, DEREK NELSON, NARENDRA MULANI and JONATHAN WRIGHT

High oil prices are forcing companies to rethink long-held strategies they use to make and move goods to market.
Supply-chain tactics that in recent years were considered essential to success -- things like moving factories offshore where labor is cheaper and making quick and frequent deliveries to retailers to keep inventories low -- are losing luster in an economy where every $10-per-barrel increase in the price of oil results in a four-cents-per-mile hike in transportation rates.

Although the price of oil recently has retreated, some investment banks still expect it to be well over $100 a barrel next year. To maintain a competitive edge, companies will need to continually re-evaluate the design and operation of their supply chains, even if it means ditching recently adopted strategies.
This is especially true for makers of products with low profit margins and long life cycles -- things like consumer packaged goods and chemicals. Higher transportation costs have the potential to take a bigger bite out of their profits than they do out of the profits of companies that make things like cellphones and personal computers, which have shorter life cycles and higher profit margins.
Here is a look at some supply-chain changes already taking place, as well as trends we expect to take hold:
Higher Prices, Bigger Inventories
When oil was cheaper, the trend was to move factories offshore and keep inventories low because costs associated with manufacturing and inventory outweighed the cheap transportation costs. High oil prices are upending those strategies.
As transportation costs become more dominant, it becomes increasingly important to minimize the length of the journey from distribution center to retailer -- the final leg of the supply chain -- and to ship in large quantities to take advantage of economies of scale. To accomplish this, additional and larger warehouses become necessary, which implies more stock, hence higher inventory levels and costs.
Data from the annual State of Logistics Report, sponsored by the Council of Supply Chain Management Professionals, suggest this already is happening. The report found U.S. logistics costs, which include all the expenses associated with moving goods, rose 52% from 2002 to 2007, including jumps of 47% in transportation costs and 62% in inventory-carrying costs. Maintaining more inventory can be risky because products may lose value if demand or prices fall. But the benefits can outweigh the risks when transportation costs become a bigger burden than inventory expenses.

Some companies are trying to cut shipping times and costs by moving factories closer to the markets they serve. This generally makes sense when transportation expenses offset savings generated by making products in low-cost countries.
Manufacturers are more likely to move factories inshore when a product is bulky, hence expensive to transport, when factory equipment and infrastructure are relatively simple to move or when getting a product to market more quickly allows a manufacturer to charge a higher price for it. Examples include furniture, appliances, flat-screen televisions, car parts and toys. Sharp Corp., for example, started moving a larger portion of its flat-screen TV manufacturing to Mexico from Asia to be closer to customers in North and South America. Flat-screen TV prices typically fall quickly, so reducing lead time by 4 weeks has helped Sharp's bottom line.
A move inshore is less beneficial when factory equipment and infrastructure are expensive to move. Mobile phones and computers are good examples because components like chipsets require heavy infrastructure to produce.
Flexible Manufacturing Will Grow
As a growing number of companies seek to serve markets from the closest factory, we predict another trend will emerge: a switch from dedicated to flexible manufacturing strategies. In flexible manufacturing, each factory is capable of making multiple products; in dedicated manufacturing, each plant specializes in making just a few. While dedicated manufacturing reduces production costs through economies of scale and fewer assembly-line set-ups, it can result in higher transportation costs because companies can't always serve demand from the closest factories. The opposite is true with flexible manufacturing -- production costs rise, but transportation costs fall.

A switch to flexible manufacturing will help companies keep cost increases in check if oil prices rise dramatically. In a recent study performed on a European manufacturing and distribution network, we quantified the total cost increase associated with a jump in oil to $200 a barrel from $100 a barrel. We found that the potential 14% increase could be cut to a 3.5% increase with a switch to flexible manufacturing, combined with the addition of a single distribution center to the supply chain to cut fuel use.
Shipping Strategies Will Change
When oil was cheaper, many companies made quick and frequent deliveries to retailers and maintained a dedicated fleet of trucks to ship products. If oil prices stay high, we predict three transportation trends will gain popularity:
First, organizations will ship larger lot sizes less frequently or try to package products more efficiently to improve truckload utilization. As reported in CFO magazine, household and personal-care products maker S.C. Johnson & Son Inc. of Racine, Wis., last year saved about $1.6 million and cut fuel use by 168,000 gallons by combining multiple customer orders and products to load the fullest, best-configured trucks possible.
Second, companies will adopt cheaper and sometimes slower modes of transportation. Thus, we project more shipments will move from air to ground and from trucks to rail to cut fuel consumption. This trend also reduces carbon emissions, so as oil prices increase, environmentally friendly initiatives start making business sense.
Third, manufacturers may rely more heavily on third-party trucking services and warehouses. Third-party carriers can consolidate shipments from many vendors to ensure their trucks are full before taking off, resulting in lower shipping costs. Similarly, third-party carriers are in a better position to reduce "deadhead" travel, which is any travel by trucks when they are empty.
Push vs. Pull
There are other steps organizations can take to mitigate the impact of high oil prices, and we expect these strategies to gain traction, too.
Kinks in the Chain
The Situation: High oil prices are forcing firms to rethink supply-chain strategies.
The Details: To cut fuel use, firms are moving factories closer to the markets they serve, shipping larger lot sizes less frequently and adding warehouses.
What It Means: With transportation expenses now considered their biggest burden, some companies are allowing inventory levels and costs to grow.
Some manufacturers may switch to a "push-based" supply chain from a "pull-based" one, meaning they will base production and distribution decisions on long-term forecasts rather than simply responding to customer demand. A push strategy becomes more attractive when companies need to ship large quantities to take advantage of economies of scale. Shipping large quantities implies a company is covering demand for a longer period of time, thus the need to base decisions on long-term forecasts.
Companies also may try to cut back on expensive rush-delivery services. By better managing inventory to ensure they have enough supply to meet demand, companies can prevent shortages that might require them to rush in parts or products from distant plants or warehouses.
Similarly, tighter integration between various stages of the supply chain can help manufacturers utilize transportation capacity more efficiently. Sharing information about what products are moving off store shelves, what promotions retailers are planning and what volume discounts distributors are offering can reduce the likelihood that manufacturers will have to use rush deliveries to meet orders.—Dr. Simchi-Levi is a professor of engineering systems at Massachusetts Institute of Technology in Cambridge, Mass., and chief science officer at ILOG, a French business-software company. Mr. Nelson is ILOG's product-marketing manager based in Chicago. Dr. Mulani and Mr. Wright are partners at technology-consulting firm Accenture Ltd., based in Chicago and London, respectively. They can be reached at reports@wsj.com.