Supply chain sustainability:
The concept of risk management under the conditions of the new reality
– Six months ago, I could not have imagined the reality in which we have to work now, — admits Kseniia Valieva, director of the supply chain management department of the UPECO representative office in Ukraine. — But it’s time to put aside fears and resentments and take a new look at the conditions in which we have to survive, live and even develop, no matter what.
A new reality
The current crisis, in addition to the natural increase in logistics costs in similar situations against the background of falling sales, is characterized by the emergence of a number of completely new, unusual risk factors.
Of course, the growth of logistics costs affected almost all market players. In the field of transport, it was caused by the increase in fuel prices (by 50% since the beginning of the year). Fluctuations in exchange rates affected the cost of warehouse logistics, because most contracts provide for either the price to be tied to the dollar or the corresponding coefficients. Due to the instability of the market, companies have to negotiate and renegotiate with their partners, and not everyone and not always succeed in reaching a compromise. As a result, losses can reach 30% of the estimated cost of logistics costs.
The increase in the cost of production was no less noticeable. Depending on how the logistics chain was built and what the company imported (raw materials, finished products or packaging), the increase in the cost of goods was from 10% to 30%.
At the same time, there was a noticeable drop in sales, against the background of which logistics budgets appear in an increasingly unfavorable light. After all, the growth of logistics costs in percentage ratio due to the drop in sales looks even more tangible.
A factor such as overdue receivables has a serious impact on the entire supply chain. The scale of this problem during the crisis has become so significant that it forces logisticians to comprehensively change their approaches, in particular, to procurement and inventory management.
Among the specific signs of the current crisis, we can also name the risks of spoilage and loss of cargo, which have increased sharply, during delivery to the southeastern regions of Ukraine and Crimea. In the same row, there is a decrease in the volume of exports to Russia, which hurt many Ukrainian and international companies, which traditionally built their business and supply chains, relying on close economic relations with the northern neighbor.
Such companies have to constantly keep in mind the risks of imposing sanctions on imports from Russia. To date, it is almost impossible to predict how the further political situation will develop, in particular, the confrontation between Ukraine and the Russian Federation, therefore any agreements, preferences and benefits currently in force are under threat. And this, accordingly, threatens significant losses for businesses. Thus, the cancellation of provisions that completely exempt Russian-made goods imported from Russia from customs duties will automatically lead to an increase in the cost price of such goods by 5–10%.
Suddenly, the possibility of removing goods with a Russian barcode from retail networks became a real risk, which is especially relevant for Western Ukraine. Companies are already losing sales. At the same time, it is impossible to explain to consumers that a Russian barcode does not necessarily mean that the product is made in Russia. As a result, a product that was imported, for example, from Italy and packaged in Ukraine (for which people who are officially employed in Ukraine received salaries, and all taxes were paid to the Ukrainian budget), may fall into “hot hands” and be removed from the network without consideration.
From insurance to sustainability
— Left without intervention, events have a tendency to develop from bad to worse, K. Valieva quotes Murphy’s law and emphasizes that the only way out in the current situation is to take risks under reliable control. — Without managing these risks, our losses will grow exponentially, and as a result, we can simply “fly into the pipe”.
Of course, it would be unfair to say that companies did not manage their risks before this crisis. For example, many have long sought to cover the risks associated with fluctuations in demand and deviations in delivery times. For this, insurance reserves were created, which Kseniia calls an excessive structure, designed to become something like an airbag. In addition, the companies directly affected the sources of such risks as spoilage and loss of cargo during transportation, and tried to eliminate them by resorting to the services of insurance companies. This rank includes the insurance of goods in the warehouse.
However, in the current environment, such point measures have become insufficient, and logisticians need to master such a broader and more complex category as SUSTAINABILITY of the supply chain. The concept of sustainability considers both the risks themselves and the mechanisms of their compensation, as well as the methods of reducing them already at the stage of planning the chain, as well as working with these risks at the time of their occurrence, i.e. detection and elimination of violations in the process of Supply Chain implementation.
Three points of support
If you analyze and group all the factors that affect the sustainability of the supply chain, you can identify 3 main vectors of influence on the chain that ensure its sustainability.
First, it is a counteraction to the targeted influence of activating factors. These include point measures, for example, the removal of goods from warehouses in Simferopol and Luhansk, as well as the temporary suspension of supplies to problem regions of the country, which reduces the risk of spoilage, loss and the occurrence of insurance cases in the territory of these regions.
The second strategically important vector is inventory management. In this case, it is understood more broadly — not only as the creation of insurance reserves, but also the management of the process in general.
And the third pillar of a sustainable supply chain is a balanced level of controlling and activating influences. It is necessary to clearly understand the extent to which the measures taken are justified in terms of the strength of the negative impact and its possible consequences, as well as the extent to which the preventive measures laid down in chain planning are adequate to the potential risk. After all, the company cannot create redundant structures, invest a lot in insurance reserves and additional security measures.
Financial health
One of the consequences of the Pareto principle states that reliable control established over 20% of the components of the system allows controlling 80% of it. This golden rule clearly works in the context of the problem of risk management — it is enough to properly allocate resources and shift the focus of attention to inventory management to solve the main problem of managing the risks of the entire supply chain. This will not only ensure 80% controllability of risks, but will also allow optimizing the energy and resources of the managers themselves.
The main purpose of the inventory management process includes 2 key aspects. On the one hand, it is the maximization of the company’s profit by the maximum satisfaction of demand at all levels of the system and at all points where possible, i.e. creation of such stocks that will allow to satisfy the purchase demand as much as possible. On the other hand, this is the same profit maximization, but at the expense of increasing inventory turnover.
| Note
Working capital is the difference between the company’s current assets and current liabilities. With its help, the company calculates current liabilities, purchases raw materials and supplies, and performs operational activities. Working capital = Funds + Accounts receivable + Inventories – Accounts payable – Short-term loans |
This indicator reflects how effectively the company works and settles with its suppliers, and also provides buyers with the necessary resources to purchase goods, raw materials, materials and settle with service providers.
If we consider the structure of assets (Fig. 1), we can see that most often the lion’s share is made up of inventories. From the point of view of financial accounting, such a picture can look quite prosperous, because the larger the assets, the greater the difference between them and liabilities. But this is only from the accounting point of view.
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Fig. 1. Asset structure
But if most of the assets are inventory with low turnover, it means that the funds are frozen. And then the company is faced with the fact that it is necessary to purchase new goods, and there is not enough money for this. In the current difficult realities, the success or failure of the company as a whole depends to a large extent on how much the stock is negotiable, whether the company has time to return every hryvnia invested in the stock before the time comes to pay the loan.
— And since inventory management is part of the Supply Chain’s area of responsibility, the financial health of the company largely depends on it, K. Valieva emphasizes. — And this is one of the main challenges for logistics today
As an example, we can cite a fairly common situation when buyers receive a “beneficial” offer to buy an additional batch of goods and receive a certain discount, say 5-10%. The question arises: how to act? You can buy this product, make money, reduce the cost price, fulfill or even exceed your KPIs, get bonuses — but freeze funds in inventory. Is it worth doing? What will be the results? Of course, it is easiest for a logistician to answer this question in the language of numbers.
If you simplify the situation somewhat and omit the details, the calculations will look like this.
- Suppose there was a need to order a batch of 1,000 units of the product. At a unit cost of €10, this batch will cost €10,000 (1000 units × €10 = €10,000).
- The supplier offers a 10% discount on the condition that 2,000 units are purchased and paid for in full upon shipment. In this case, the customer’s additional profit will amount to 2 thousand euros (2,000 units × 10 euros = 20,000 euros; 10% = 2,000 euros).
- Let’s assume that the logistics arm (the time from placing the order with the supplier to the posting of the goods in the warehouse) is 4 weeks. Funds are frozen for this period. To understand how much it will cost the company, the possible benefit from alternative investments of these funds is usually calculated. For example, you can calculate what the result will be if you put this money on a deposit. With a conditional deposit rate of 24% per annum, the cost of freezing funds for 4 weeks will be 160 euros (18,000 – 10,000 = 8,000 x 2% = 160 euros).
- In addition, VAT and import duty must be paid on the additional lot, which will amount to another 3 thousand euros or 60 euros of frozen funds.
- Cost of storage for 4 weeks = 100 euros.
- Due to the war, the total cost of purchasing an additional batch of goods will be 160+60+100 = 320 euros. The additional profit will be equal to 2 thousand euros — 320 euros, i.e. 1680 euros.
In this case, ordering an additional batch of the product really makes sense.
— But it was like that before the crisis, — emphasizes the expert. — Then we could calculate, make such a decision and be happy that we reduced the cost price, got a more interesting financial result, and the money earned can be spent on the development of the company, training of employees, and strategic measures.
Companies now have to live and work in the conditions of permanent overdue receivables, when both retail chains and distributors pay for supplies on time. Therefore, supplier companies periodically run out of funds and are forced to negotiate with their service providers, partially transferring these risks to them, since in such a situation everyone is closely interconnected. At the same time, they cannot avoid paying VAT and duty to the state, which is a lot of money. And with the correction for today’s reality, the calculations will look different.
In order to pay the supplier 18,000 euros, the company today needs to attract a financial resource, i.e. borrow money at 24% per annum. It can be returned only after its client has settled, i.e. no earlier than 90 days after delivery (deferral of payment according to the contract). Based on practice, it is possible to confidently predict that the client will not pay within 90 days.
— We have to wait 90 days only according to the contract, — K. Valieva shares her sad experience. — And then another month we write claims, receive part of the payment, another month — another part. That is, ideally, we will receive payment no earlier than in 120 days.
Thus, only the interest on the loan that the company will pay for these 4 months will be 1,440 euros (18,000×4×2% = 1,440 euros).
As experience shows, at least one month should be set aside for the risk of late repayment of receivables with corresponding additional costs, which in this example will amount to 360 euros (18,000 × 1 month × 2% = 360 euros).
Taking into account the previously calculated storage costs, alternative investment of funds for customs payments, etc., the total costs for the purchase of an additional volume of goods will amount to 2120 euros (1440+320+360).
With a potential profit from the deal of 2,000 euros, such an amount of expenses does not require comment.
Of course, such a straight-line calculation scheme does not work in every company and not for every situation — depending on the specifics of the business, it needs to be adjusted each time. For example, in Ukraine there is a fairly large number of goods for which prices in the high and low season differ by 2-2.5 times (this is especially true for manufacturing enterprises that purchase raw materials). An example can be sugar — even with the correction for the need for a specialized warehouse and freezing of money, it is still more profitable to create a speculative stock.
The main essence of the issue is that logisticians should expand the scope of their vision of the inventory management process. Reorganize for the wave of financial indicators and consider the procurement strategy not only from the point of view of cost, but also turnover.
Adaptability as a trend
To achieve a balance of management influences, which is one of the necessary conditions for ensuring the sustainability of the supply chain, companies will be helped by the current and very popular strategy of efficient customer-oriented response (Efficient Consumer Response, ECR). It requires close cooperation of all chain participants and is based on the following basic principles:
- high-quality and operational information exchange;
- the possibility of prompt demand forecasting and supply planning.
Considering that in today’s markets competition is no longer so much about products as about supply chains, it is the ECR strategy aimed at maximizing the flexibility and adaptability of the chain that can ensure its viability and competitiveness.
What specific steps in this direction can Ukrainian companies take right now?
At a minimum, this is a transition to an electronic document management platform. Unfortunately, there are still many enterprises in Ukraine, including rather large retail chains, which still have not switched to electronic platforms. The suppliers connected with them in one chain are, of course, highly dependent on them, and all that remains for them is to persuade, to conduct explanatory work, to convince of the necessity and importance of this step, in particular, to reduce overall costs and losses in the chain.
Another opportunity to increase supply chain adaptability is inventory management at distributors. It is clear that retail networks play a key role, as they account for 60-80% of sales. However, there are still distributors and linear retailers who are also ready to implement EDI, as well as automated forecasting and planning systems.
Thus, the UPECO company is at the stage of implementation of the auto-ordering system project for distributors based on secondary sales. In Europe and the USA, similar systems have been operating for a long time, in particular, at such large and reputable market players as WallMart, L’Oreal Paris, Maybelline N.Y. etc . Ukrainian national networks still do not allow their suppliers to do this, but it turned out to be quite possible to implement such a project with distributors.
Another important area of supply chain optimization is the fight against excessive inventory. This includes measures such as analysis of stock in the regions, removal of surpluses to the central warehouse, distribution of goods to the regions according to the ABC principle, etc. It should be noted that retail chains, distributors, and manufacturing companies are interested in reducing the level of inventory. After all, the suppliers are unable to endlessly cover all the unjustified requests of each chain, and then, at the end of the season, take 30% of the delivered products, which have not yet been unpacked, from the RC of retailers, because they did not even have time to reach the retail outlets. Therefore, everyone is interested in successful work in this direction.
The key to success
Even a year ago, discussing the one shown in Fig. 2 scheme of the evolution of production and logistics concepts, it could be argued that today is the information economy, and that information production is in the lead. But this year, the focus must be shifted to competencies and interactions.
— Last year, I did not think that TOMORROW would come so soon, and we would have to work in other realities, — K. Valieva admits. — Currently, it is not enough for us to simply be specialists — we need to learn how to interact effectively within the team.
Fig. 2. Evolution of production and logistics concepts
A separate role in this difficult time should be assigned to cooperation and effective interaction within the team. The time has come for competence and cooperation. And how quickly logistics will be able to get out of the “shell of purely logistical issues”, will destroy the stereotypes that logistics is only purchases or transport or warehouse… It will come to the realization that nowadays it is not goods that compete, but supply chains. This is how quickly the company will be able to withstand this difficult time and develop at a new qualitative level.
