If a business wants to make more profit, it needs to maximize revenue and minimize costs. Net Profit is Revenue minus Costs. Even the value that a non-profit organization creates is limited by its budget. 

In this article we’ll discuss the definition of “costs”, and the difference between “costs” and “waste”. We’ll look at some direct and indirect cost examples, and examine some supply chain cost reduction strategies.

What are “costs” in a supply chain?

“Costs” in a supply chain can come at any stage: procurement, transportation, manufacturing, warehousing and distribution. They can fall into a number of different categories: quality, scrap, taxes, tariffs, compliance, returns, labor, risk, insurance, theft, damage, energy and more.

Indirect and direct costs

Direct costs are associated with a particular item, product, or service in a business. On the other hand, indirect costs are not associated with a particular item, product, or service.

Direct and indirect cost examples

Direct costs:

• Material costs
• Direct labor
• Manufacturing supplies and machinery
• Shipping costs

Indirect costs:

• Energy for heating and lighting buildings
• Insurance costs
• Warehousing
• IT department

What is “waste” in a supply chain?

Waste refers to “unnecessary costs”. These are costs that, in an ideal world, can be removed without reducing the performance of the system. We could consider investing the effort into understanding and reducing these costs in order to improve supply chain performance.

The foundation of any action on costs, including waste costs, is measuring them. It’s easy to measure some different costs here and there, but getting an overall appreciation of total costs allows us to put other identified costs into context, and this is essential.

What is the difference between waste and costs?

“Costs” and “waste” are similar but with a key difference. “Waste” is a subset of “costs”; costs can be either necessary or unnecessary.

Supply chain cost reduction strategies

Effective action on costs comes from perspective and prioritization. Collecting data on the total cost incurred (in your area of responsibility) gives you the opportunity for perspective when considering any particular idea.

Then we need to break down the total cost into categories, perhaps with Pareto Analysis. Identify the largest cost that is the easiest to have an impact upon, and give those your attention.

Without this, the danger is that we give all our attention and effort to reducing a certain high-profile cost that is only a tiny percentage of the total costs, whilst remaining ignorant of much bigger opportunities for reducing costs.

“Reducing costs” has always been a popular catchphrase, and so it should be. However, most costs serve a purpose, and are necessary to buy the materials and tools and run the processes to create and deliver value. We’d still prefer not to need to pay them, but in many cases we need to.

How to reduce costs in supply chain:

1. Collect data on the total cost incurred.
2. Break down the total cost into categories, perhaps with Pareto Analysis.
3. Identify the largest cost that is the easiest to have an impact upon, and focus effort on reducing this cost first.
4. Repeat the process.

Cost reduction in supply chain management

Managing costs is not all about reduction. The ultimate aim is profit, revenue “relative” to costs. Often, actively choosing to “increase” costs can be a good operations and supply chain decision. For example:

• An organization could use more expensive premium delivery services for faster, more reliable transportation that customers will pay more for. Although this increases costs, it also increases revenue. This would also perhaps give them the confidence to hold less inventory, which would reduce other types of costs.
• An organization could choose to increase costs by hiring quality inspectors or increasing training. This would reduce the costs and reputation damage of returns.

So, what are the total and largest costs in your supply chain operations? Which ones can you have the biggest impact on reducing (or increasing) whilst maintaining (or increasing) output and revenue?

Find more information about costs in a supply chain in our online training course Supply Chain Management A-Z.