When was the last time you looked at your small business' spend and broke it down by category? If you've got employees, you might find out that they cost you more than almost any other category of spend. Unless you're working out of your kitchen, rent might also rank up there. But one of the most costly — and necessary — parts of your business is your supply chain.
How do reduce the costs in your supply chain, while at the same time keeping that supply chain up and running? (Because without that supply chain, well, you likely wouldn't have products to supply to your customers, i.e. you wouldn't have much of a small business.
The quickest wins when it comes to supply chain cost reductions include:
- Cost of Goods Reductions
- Logistics Costs Reductions
By driving savings across cost of goods and logistics — you can achieve measurable savings at even larger businesses. Small businesses can definitely benefit from focusing on these cost savings drivers.
Cost of Goods Reductions
When it comes to cost reductions, the only way to reduce your human capital costs (i.e. your employees) is to cut someone's pay, cut someone's hours or cut someone from your payroll. A decision to take that kind of action is highly emotional.
Likewise, if you want to cut another high cost area — your rent — you can move to a smaller space or a cheaper neighborhood or share your space with someone. These are also highly emotional decisions to make.
And if your small business is a sole proprietorship and you're working out of your garage — you may not be able to do anything about cutting employee cost and lowering your rent.
But the driving cost of goods reductions is a tool that doesn't have to be emotional and can be highly effective.
We'll talk about some effective ways of driving your cost of goods down, but first, let's make sure we're aligned on how you define what your cost of goods are.
The cost of goods is defined as the total cost to you of the goods you sell. The cost of goods can consist of the following elements:
- Your purchase price of all components and raw materials
- The logistics and shipping costs of getting those components and raw materials to you
- Your material, labor and overhead costs of turning those component and raw materials into the product your small business sells
The first bullet point — the purchase price of all your components and raw materials — is pretty straight forward and easy to calculate. If you sell Product A and you have to buy Components X, Y and Z to make, build, assemble or cook Product A — how much to you pay for Components X, Y and Z? Look at your invoices from your suppliers. If you bought Component X from two different suppliers and their prices were different, use the higher price as your cost of goods price.
The difference between a "component" and a "raw material" is ambiguous. Some people use them interchangeably, which is fine. Some people saw that a component is something that you use as-is, while a raw material is something you change before you use. That definition works, too.
Logistics and Shipping Costs
As far as the second bullet point above is concerned, sometimes the logistics and shipping costs are categorized separately — and not part of your cost of goods. But you should be sure that you're aware that those logistics and shipping costs are a critical part of where your money is spent. (And are negotiable, see below.)
Material, Labor and Overhead Costs
The third bullet point is the one that many small businesses don't think about when they calculate their cost of goods.
I recently asked a small business owner how much it cost him to make a key chain pendant that he was selling. He told me that the blank metal cost him a dollar, so he was going to sell the key chain for two bucks.
I asked him about the nylon cord and the ring that were also a part of the key chain. “Pennies,” he said.
And what about your time to assemble the finished product? “I can do that really fast,” he replied.
And the blank metal — the centerpiece of the key chain — how long does it take you to make it and how much electricity are you consuming with your milling machine? And what about the time to wipe it down and make sure all sharp edges are filed away? He told me, “I’m not counting that.”
His real cost of goods wasn’t a dollar. When you started to add up the other material cost, his labor cost and the overhead cost (that electricity that he needs to pay for) — his real cost of goods was close to his two-buck sales price.
Make sure you’re capturing your actual cost of goods by including everything it costs you to make the product you’re selling.
Okay, Mr. Supply Chain Dude, now I know how to calculate my actual cost of goods. What can I do about it?
How to Approach Cost of Goods Reduction
So your cost of goods is comprised of the prices you pay your supplier plus your own internal costs to make and ship a product.
The prices you pay your suppliers are subject to pricing negotiations. That’s the simplest and lowest hanging fruit in the cost of goods reduction process model.
Small business owners can take two approaches when negotiating prices with their suppliers. The first approach is a direct conversation related to the current pricing and what your intended price reductions are. In layman’s terms, this would be the “What is your best price?” approach.
But supply chain pro’s have a slightly more sophisticated approach than “What is your best price?”. By working with your suppliers to ensure you’re ordering within their standard lead times, you can mitigate the need for expedite costs. Often, suppliers will pass along expedite costs as price increases.
Do you even know what your suppliers’ lead times are? Are those their delivery lead times — and are those lead times driven by scheduling, raw material purchasing or other factors? By understanding the answers to those questions, you can help your suppliers manage their time and costs — and work to get your pricing down.
By giving your suppliers longer term financial commitments can also help drive their costs down — and in so doing, potentially lower your pricing. If you need 100 pieces every month from your supplier (and you’re sure you’re going to need those 100 pieces), you can help drive manufacturing costs down by ordering 1200 pieces. Your supplier may be able to hold the inventory and ship the parts to you 100 pieces each month. By doing so, your suppliers may be able to order raw materials in bulk and avoid the costs of multiple production set ups.
The risk in placing a long term (or blanket) purchase order is that you are financially obligated to the value of the purchase order. If you order 1,200 pieces but you get 900 pieces into the purchase order and realize you don’t need those last 300 pieces — you are legally obliged to pay for them.
By understanding your supplier’s supply chain and lead times and also providing your suppliers with a long term outlook of your needs, you can help their costs down and maybe drive your own costs of goods down, too.
Sourcing is a supply chain term that you may know as “shopping around.” A sourcing project is a project by which you look for suppliers to either help you with a new product or product you’ve been selling. When you launch a sourcing project for a product you’ve been selling, it makes sense — in most cases — to include your current supplier or suppliers in the sourcing project.
By including your current suppliers in the sourcing project for a product they current supply to you, you are sending multiple messages:
- You’re looking for better pricing, or…
- You’re looking for higher quality, or…
- You’re looking for product innovation, or…
- You’re looking for better service
In some cases, your current supplier may reach out to you and offer price reductions ahead of your sourcing project’s completion.
By reaching out to other suppliers, you’re doing important market research into the prices you are currently paying. If other suppliers are offering prices well below what you’re currently paying, the first thing you need to make sure of is that they’re offering the same product scope as your current supplier.
If that’s the case, then you likely have an opportunity to drive your cost of goods down — either by switching suppliers or using this new information as leverage in negotiations with your current supplier.
Logistics Cost Reductions
Whether you’re using trucks, trains, ships or airplanes to ship from your suppliers to your facility, you can use the same cost reduction strategies mentioned above with your logistics providers. Direct negotiations and sourcing projects can net you 5 percent-10 percent cost reductions pretty easily — especially if you’ve never tried to get those costs down before.
(If you try to do these cost reduction strategies regularly, you’ll see diminishing returns over time. I.e. you likely won’t see 5 percent-10 percent reductions every time you do this, if you do this every year or two years.)
Logistics cost reductions can also be achieved by planning. If you need a product delivered quickly, you typically have to pay more for it. By understanding your supplier’s lead times (see above), you likely will be able to plan your requirements so that you can engage the lowest cost delivery method.
Just remember the old logistics adage, “Put it on the ocean without commotion; fly it by air to give your CFO a scare.” Okay, that’s not really an old logistics adage. I just made it up. But — ocean and trucks are cheaper than air freight. Plan accordingly (unless you’re importing sushi).
Don't forget to consider the cost reductions strategies related to your own internal costs. I go back to the small keychain business. Even though it may only take a few seconds to assemble a key chain, those seconds add up. Are your materials within arm’s reach? How many can you make at a time, to optimize your speed and expertise? Are you buying any string or other low cost materials in bulk? Are you running high energy machinery at low-cost, non-peak hours?
The best thing about these costs is that they are controllable by you.
Reducing your supply chain costs is the first step to that “spending as little money as possible part.”