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How to Define Total Cost of Ownership in a Reverse Supply Chain

How to Define Total Cost of Ownership in a Reverse Supply Chain

by Matt Zimmer, Chief Operating Officer, Flash Global

Reverse Logistics Magazine, Edition 94

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Article Abstract
Total cost of ownership (TCO) requires collecting all the data and information required to make informed decisions about the supply chain. Solid, accurate data and planning makes it possible to manage risk and reduce TCO by addressing the hidden costs and uncertainties unique to the reverse supply chain. When properly executed, the strategy can often create positive ROI from returned units.

This article addresses the following topics as they relate to TCO, as well as includes real world examples when appropriate:

• Freight costs
• Inventory levels
• Duties, taxes and paperwork
• Time to customer
• Cost of repair centers
• Opportunity costs
• Hidden costs
• Moving parts of TCO

New product launches, ad campaigns, and publicity tours excite and energize employees and company officers. Creating procedures to handle returns and repairs for these same products? Not so much. After all, few people really want to be the person who is already planning for failures, repairs, and returned products. Yet someone has to be. Without those plans, it’s impossible to accurately calculate the total cost of ownership (TCO).

In essence, TCO requires collecting all the data and information required to make informed decisions about the supply chain. Solid, accurate data and planning makes it possible to manage risk and reduce TCO by addressing the hidden costs and uncertainties unique to the reverse supply chain. When properly executed, the strategy can often create positive ROI from returned units.

Plan Ahead for Reverse Logistics
“End-to-end supply chain management” is a bit of a misnomer because it suggests that supply chains function as straight lines with rigidly defined beginnings and ends. Most believe it looks something like this: build the product, sell the product, ship the product, and you’re done. If only. In reality, supply chains closely resemble circles more than vectors. Many products that go out the door circle back at some point as returns, repairs, or items that need to be recycled.

True TCO must include costs from both directions: to the customer and back to the manufacturer/retailer. The return trip is far more complex and chaotic, so calculations are more complex. Unlike neatly packaged factory shipments on shrink-wrapped pallets stocked in warehouses and distribution centers, repairs/returns are haphazard:

• Shipped individually
• Often multiple labels exist from multiple touch points
• Packaging may be damaged or non-existent
• Overt or hidden damage to the product
• Requires more time to inspect and repair than bulk products.

Maximizing value at the end of product life requires careful planning and investment in reverse logistics on the front end of the supply chain. The following items are often-overlooked pieces of the TCO equation.

Freight Costs
Transportation is the last step in the forward supply chain, and the first challenge in the reverse. In repair centers, shipping methods are determined by lead time (the period between the initiation and completion of a repair process) and the amount of inventory carried in stock at one time.

Here’s the quandary. Do you maintain a robust inventory to minimize repair time and transportation costs, or wait for a certain number of defective parts before shipping repair components (or before returning repaired items) for restocking?

Fortunately, in most cases, this isn’t an either/or situation. The cheapest repairs (and shipments) are the ones you don’t have to make.

Consider this real-world situation. A manufacturer waits to collect 4-6 pallets worth of units before shipping the lot via boat from the U.S. to Asia for repair (a 4-6 week trip), repairs them, and ships them back to the U.S. A lot of expensive equipment is not usable for 3-4 months. That’s lost time for “repairs” that may not have been needed.

For example, in the technology space, typically 40% of parts returned as defective are in fact no trouble found (NTF) or no fault found (NFF). Usually there’s a user problem or software bug, but no hardware issue that requires repair. Imagine the reduction in TCO if 40% of “bad” units could be back in service in less than a week — no ocean voyage or air shipment required. In some cases, a routine screen on parts before they’re shipped can dramatically impact TCO.

Inventory Levels
Inventory is one of the biggest cost drivers in service supply chain and TCO. Accurate calculations depend on reliable answers to specific questions:
• How much inventory is on hand?
• How much inventory do you need to handle an influx of defective components?
• What is the best way to reduce downtime during the repair cycle?
• How much does a new product cost? A new unit may need to be put into inventory in case repairs dry up.

Global logistical challenges directly affect inventory levels. You can’t keep a service center within driving distance of every end user. Nor can you maintain one central stocking location that routinely overnights critical repair parts across the globe.

Here’s a real-world example of this challenge:
A point-of-sale equipment manufacturer has a $200 product for supermarket checkouts that costs $40-$50 to repair. It’s a relatively old product, so there’s limited inventory in the marketplace. Each time a product is serviced, it must be returned within 3-4 business days or there will be no defective inventory to repair. The low product price and constraint on defective inventory “cores” precludes shipping the components overseas for repair, so stocking locations must be maintained in-country. On paper, overseas repair rates are lower, but the cost of transportation and customer service expectations makes local inventory stocking the best option.

Cost can’t be the single driver for inventory considerations. Ultimately, larger supply chain issues determine your choice.

Duties, Taxes, and Paperwork
Details matter in every link of the supply chain, but none more so than import/export compliance. Even minor paperwork errors cause delays or major fines. Errors related to importer of record (IOR) and exporter of record (EOR) are serious. Valuable inventory can be held indefinitely if the compliance department isn’t on top of things.

Regulations vary between countries, and those details challenge in-house compliance departments. India, for example, maintains its own product coding system that takes the internationally recognized Harmonized Commodity Description and Coding (HS) system a step further. In that country, some items receive preferences depending on end use, so coding errors can raise costs by 10% or more.

Currently, manufacturers are watching with concern as worldwide trade tensions escalate. Companies who developed import/export plans based on established, stable trade agreements should probably reevaluate them in light of current events. As risk and uncertainty increases, cost often does as well.

A service supply chain partner who maintains a regional presence and an experienced compliance department skilled in leveraging compliance laws can help reduce TCO — especially in times of market and regulatory turmoil.

Time to Customer
How long does it take to get a repaired part or working unit to the end customer? This is a crucial factor in gaining customer trust and satisfaction. Falling short of customer expectations also hurts a company’s reputation in the market because one angry customer with a Twitter account can influence thousands of potential customers.

Consider the ire of Apple iPhone customers faced with 6-to 7-weekslong waits for replacement batteries. Volkswagen diesel auto owners weren’t any happier about long wait times for repair after the company admitted falsifying emissions data.

Obviously, quicker is better, but other issues and costs also factor into the decision. Increased repair part inventory affects TCO by increasing inventory carrying costs. Transportation costs rise when critical repair parts have to be shipped via airfreight. The minimum acceptable distance between repair centers and end users also is a factor.

Cost of Repair Centers
Repair centers are expensive. Construction costs for a thorough test and repair line for a single top-tier OEM costs $1-$2 million to fully stock with all test beds, fixtures, and servers that mirror the test environment, and environmental chamber, etc. It’s not usually feasible for a company to locate a fully functional repair center in every country or region where customers operate. This large initial investment is often why many companies have just one repair center — even though that option affects costs of inventory, transportation, and customer satisfaction.

Additional unexpected or hidden costs to consider include:
• Proper documentation flow and automated inventory tracking systems. These supply the traceability data that’s increasingly required by consumers and regulatory bodies.
• Import/export regulations. Customs officials often scrutinize repaired or remanufactured products more closely. They may be subject to additional regulations.
• Customer expectations. Foreign industrial buyers tend to place a premium on after-sales service. They need to feel confident that an international vendor can meet service requirements.

This is another area where many manufacturers can reduce TCO by partnering with a service supply chain company with a global footprint and expertise in repair operations.

Opportunity Costs
Calculating opportunity costs is more art than science. They are hidden costs because you’re basically valuing an action not taken or an opportunity refused. For instance, a company may decide to accept less money on a new project because of a need to take care of a current customer and keep them in the portfolio. It’s taking a risk that less money now will lead to more opportunity later. Ideally, the calculated risk pays off — but sometimes it doesn’t.

With international expansion, your opportunity cost is defined by time, money, and effort. What would the same amount of time and effort produce if expended in another area of the business? Many companies go overseas because they want a lower repair labor rate, but consider the time and effort involved in setting up a repair center or looking for a repair partner. Another issue is repair time and time to customer if the repair cycle lengthens to months instead of days.

Understanding where to put time and effort is the most important exercise of senior executive managers. They must understand the value of time and people, and balance them to maximize value. Employees can generate additional revenue or profits, or preferably both.

Hidden Costs
These are the hardest to define and quantify, but they’re critical parts of the TCO equation nevertheless.

International operations carry a host of hidden costs that often aren’t factored into TCO — at least in the beginning.

• Additional inventory costs for “safety stock.” Longer supply chains carry greater risk, so companies have to balance inventory costs against the danger of disruption from events like hurricanes, earthquakes, labor unrest, and poor transportation infrastructure.
• Travel and training costs. Company employees will need to travel to scout new sites, set them up, and meet and create relationships with suppliers and customers, among other things. There are many global communication tools, but nothing substitutes for personal contact and on-the-ground knowledge. Companies are often surprised by the high cost of travel and training (including language lessons) involved with international expansion.
• Internal administrative costs. Companies going global need a trade compliance department and export/import management compliance program teams.
• Currency volatility. Political instability affects currency values, and swings often can’t be anticipated. In 2016, the British pound fell to a 31-year low after the Brexit vote. It later recovered, but negotiations with the EU are still ongoing, and experts aren’t sure what to expect.
• Trademark and patent infringement risks. Every U.S. manufacturer is concerned about infringement of intellectual property here and overseas. China has been criticized for allegedly forcing foreign companies to turn over intellectual property to Chinese companies.
• Cultural differences. In some countries, bribery is an everyday cost of doing business. In the United States, companies that pay bribes or kickbacks in foreign countries often wind up paying fines to the U.S. government.

Just a few short years ago, the hidden costs associated with “political instability” were only a factor in emerging markets. 2016, though, was a sort of “black swan” year for international trade.

That year, Great Britain voters unexpectedly decided to leave the European Union and U.S. voters elected a president suspicious of free trade agreements. The current political uncertainty about established trade agreements, tariffs and trade wars is injecting an added element of risk into international trade. Commodity futures markets have experience a great deal of volatility, adding risk and uncertainty to cost projections, while increased tariffs affect the expected cost of components and selling prices of finished products.

The Moving Parts of TCO
As you can see, every supply chain decision is about far more than comparing one cost to another or always choosing the lowest price. TCO is a complex equation with a lot of variables. Maddeningly, the variables are dependent, so changing one alters the value of others. It’s almost impossible to calculate TCO with 100% certainty. Instead, you’re taking calculated risks and making the best guess possible based on solid, accurate information.

In operations, or in traditional cost management roles, always pay close attention to areas outside of cost. Those may be strategic revenue, value creation, or strategic creation — areas that could be better places to spend money. Although you can’t definitely calculate cost to the last decimal place, those areas may add more on the upside and increase growth and profitability in the future.
Matt Zimmer is Chief Operating Officer of Flash Global, which designs and implements service supply chain strategies for rapidly expanding companies. He loves building high-performing teams. Connect with him on LinkedIn.
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