improves a company’s ability to manage aggregate profitability across existing and potential portfolios of products and customers. For example, when a large-volume
customer is threatening to walk away during tough price
negotiations, the real decision for the seller usually is not
what will happen if all that volume is lost, but rather how
it will impact the business if that volume (or capacity) is
sold to a different customer. Having that product/customer
level of detail allows the seller to develop a pricing strategy
informed by a set of alternatives across the entire network,
thus it will be able to forecast the impact of a potential
change like the one just described.
CALCULATING TDC: DO'S AND DON'TS
As is true with all things measured, precision is overrated,
accuracy is essential. Such is the case with computing TDC.
Calculating TDC is not a precise science, because there are
too many fixed costs involved in the manufacturing and
delivery of products that need to be allocated to products
and customers. That is no excuse, however, for avoiding
the work required to ensure that a TDC calculation is sufficiently accurate.
The consequences of not doing the necessary work are
clear. Many companies find it too difficult to get accurate
costs or to implement a sound costing methodology, so
they end up using oversimplified proxies for TDC that
more often than not lead to faulty decision making that
is based on sloppy data and/or analysis. Almost unbelievably, we have seen companies build up a “cost to serve” by
applying a single average freight rate for all of the products
that are sourced from a given plant to any of its customers.
Likewise, we have seen many instances when the “average
manufacturing cost” is used across all products, regardless
of significant differences in processing times or manufacturing difficulty.
There is no question that accurately calculating TDC is
challenging. It’s even harder to make sure the analysis produces data that will be useful for planning future business.
To help in this regard, the following sections outline the
key components of TDC, some common pitfalls associated
with each one, and suggestions for the best way to compute
each component. Following these recommendations will
provide the forward-looking estimate of the TDC that is
necessary to make the best supply chain planning decisions.
Manufacturing, packaging, warehousing, and distribution
costs: Financial systems often store some form of variable and
fixed costs for manufacturing, packaging, warehousing, and
distribution operations. Typically these are based on some
sort of averages and/or standard costs that do not reflect the
true marginal cost of incremental activities. For example,
consider a 10-truck distribution fleet that is expected to log
400,000 miles in the coming year. If the combined cost of
the truck leases, maintenance, fuel, drivers, insurance, and
other factors is budgeted at US $1 million, then the average
projected cost would be $2.50 per mile. However, assuming
the fleet could serve additional customers, which would
require another 50,000 miles, without adding more trucks
or drivers, the actual added cost would be significantly less
than $125,000 ( 50,000 x $2.50).
Thus, it is important to properly split the fixed and variable costs in a supply chain to provide the best information
to develop future plans. People tend to use the same basic
approach when calculating the appropriate planning costs
for manufacturing, packaging, warehousing, or distribution operations, but the unique characteristics of those
activities should be taken into account. For example, to
appropriately capture the TDC of manufacturing activities,
it is best to determine which costs are truly variable in the
manufacturing operations across the volumes that are “in
play” in the analysis; that is to say, costs that would not be
incurred if the manufacturing operation does not occur.
These are the volume-related variable costs. To illustrate
this, let’s look at two different examples.
Plant A has three production lines, each capable of
producing 1 million units per month. The decision has
already been made to operate all three production lines in
the coming year, so there is some level of expense for items
that typically are categorized as “variable” in accounting
analyses—personnel, maintenance, utilities, supplies, and
so forth—that will be incurred just because each line will
be in operation. There is also likely a minimum volume
level under which a given line cannot be run efficiently.
Thus, the total cost to run the line at its minimum volume
should be thought of as a fixed cost when it comes to deci-
sion-making. Then, the projected variable cost per unit
becomes the incremental cost to produce each additional
unit on the line over the range from the minimum volume
to the maximum capacity of the line. Therefore, we suggest
that the variable operating cost should be calculated as:
(total cost to operate at maximum volume – total
cost to operate at minimum volume) / (maximum
volume – minimum volume)
Depending on the operation, this calculation may be
