Saturday, 26 March 2011

Fuel for thought

With the struggle for a more democratic regime in Libya and other North African countries and the debate on nuclear power given the trouble in Japan, oil prices have risen in the last couple of months to the highest values since august 2008. To illustrate; a barrel of North Sea Brent has gone up from about $80 per barrel in March 2010 to about $110 per barrel today. That’s an increase of nearly 40% in just one year. How does this rapidly increasing oil price effect supply chains and their operations? Should companies just endure this increase in transportation costs, or are there alternatives?

Since the mid-1990’s the focus of many companies has been to lower operations cost, focussing on off-shoring and consolidation of production capacity. As a result many of them set up large plants in countries like China and India because of the low cost of labour and low cost of transporting the finished goods to Europe and the US. Also just-in-time inventory and continuous replenishment strategies emerged, especially in retail (causing inner-city areas to get congested). This was all possible due to low oil prices and therefore low transportation cost. With oil prices rising, things become different. A straightforward analysis of changes in Brent oil price versus changes in diesel price shows that a 10% increase in crude oil price will result in an increase in diesel price of 8.7%. The increase of the past year therefore resulted in 36% diesel price increase, or a € 0.12/km cost increase (assuming 3 km to 1 litre fuel consumption, current diesel price €1.329/litre). Although labour cost is still the highest cost component in transportation, the relative part of cost of fuel has risen drastically.

This increase in transportation cost is significant enough to rethink supply chain strategies especially for makers of products with low profit margins and long product life cycles. Think of consumer packaged goods and chemicals. Higher transportation costs will reduce their profits significantly. So what can they do? Without changing supply chain infrastructure, transportation cost will go down when shipping larger quantities and therefore achieving more economies of scale, but inventory costs will go up. Transportation costs will also decrease when using slower modes of transport; from air to road and from road to rail. This will however increase lead time and inventory. Math modelling can make the trade-off clear and lead to the optimal choice. Using 3rd party logistics providers will potentially reduce cost, because they have better consolidation possibilities. Last but not least better utilisation of truck capacity using efficient packaging, load and pallet building capabilities will decrease cost. A nice example is the improvement E-Logistics Control (part of Ewals group) was able to achieve. They managed to increase the truck utilisation by 10%.(Dutch) This was not easy, remember playing 3D-Tetris? Special optimisation models and software, like LoadDesigner, is required to get the best possible truck utilisation. It is not only stacking the goods as efficient as possible on the truck, you also have to think about the order in which the goods will be delivered. Otherwise you have to completely rearrange the truck at each stop. It is a combined routing, packing and stacking challenge.

As transportation costs continue to rise optimisation of the supply chain infrastructure might be interesting. Reducing the length of the final leg in the supply chain and consolidation of shipments will reduce transportation cost but will require additional and larger warehouses, which implies more stock, hence higher inventory levels and costs. Deciding on the number of locations to add, requires finding a balance between transportation costs, inventory cost, handling cost and warehouse costs. The best supply chain design can only be found with the use of a supply chain infrastructure optimisation models. Using these models different supply chain designs can be modelled, evaluated and optimised, taking into account not only the costs involved but the impact on lead times and inventory levels as well. So oil price increases are fuel for thought. Supply chain managers have all kinds of options to deal with oil price induced cost increases. Operations Research can assist them, whether a complete supply chain redesign is considered or just better using the available assets.

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