Growth through capacity

A decade back idle capacity was abhorred. It was the duty of the plant manager to ensure that everyone was kept busy and the machines kept churning out material. High utilisation was a rule to balance the high costs of capacity. This also led to large batch sizes and long product runs. This was the time when demand was relatively stable, competition was manageable, retailers had low bargaining power and organisations were sure that sooner or later they would sell everything that they produce.

The ripples caused by the recession and the subsequent recovery have ensured a high variance in demand. There is a steady increase in the product variety being offered. Competing players are also coming out with new products and innovative promotions. Retailers are also more adamant on the exact type of products they need. Organised retailers can in fact bully manufacturers and brand owners in product assortment and dispatch frequency. Given this scenario, now the companies are laden with many products that they are not able to sell.

In the first scenario, the only cost of inventory was the cost of interest for the amount carried. This was a minor cost. If the cost of working capital was 12% (assumed for simplicity sake) and a product stayed in the factory warehouse for a month, the carrying cost would be only 1%. The product margin more than made up for this cost. Now, with the risk of the product not getting sold at all this inventory holding cost has shot up.

Directly reducing inventory would reduce customer service. Especially with a higher variety and fluctuating demand, low inventory would lead to low fill rates. This would lead to high costs of not lost customers. Factories operating at high utilisation would have inflexible and rigid production schedules. A change of customer requirement is usually met through inventory. With low inventories, a change would have to be met with a change of production schedules. Again, with low inventories, A change of production schedule will invariably cause a stock out of some other product B.

Demand variability is very difficult to control. So, it seems inevitable that companies learn to live with high inventories and high wastage. They can of course try to squeeze costs from vendors and other service providers. This is precisely what companies are indulging in now. What the companies need to do at this stage is to re look at the way they 'cost' capacity.

Look at this article here:
http://www.livemint.com/2010/07/12233422/HUL-aims-to-react-faster-to-ma.html
The largest consumer goods company in India, HUL is planning to combat the volatility with capacity expansion. They are planning an increase in the capacity levels and a few places like the Selvas plant has doubled their existing assembly lines.

Excess capacity is definitely cost. But here again, like the inventory of the earlier era, machines are sooner or later likely to be used. Having spare capacity means that the manufacturer is more flexible. They can be more responsive to the existing market demand and give the customers exactly what they want. Making consumer goods is not like making rockets. The lead time to make a product is a few hours provided the capacity exists. Thus firms can drastically cut inventories if they have spare capacity.

Yes, the machines would be idle and the operators would also not have anything to do once in a while. But, overall the total costs would reduce and the fill rates would go up. Cheers to HUL for this change. Now with the leader showing the way, may be the others will follow.

Profits from expansion

The hypermarket chain Hypercity has 7 stores in India currently - three in and around Mumbai and 4 in other cities. Shoppers Stop had a 19% equity in the store which they have increased to 51%. Now they want to open eight new stores by next year and expect to triple their revenues to 1000 crores (from current 330 crores) by FY2012. The statement from the group says that this will lead the groups to break even in the FY2012. The detailed article is here:
http://retail-guru.com/shoppers-stop-eyes-around-rs-1000-crore-revenues-from-hypercity/

Let me bet....I do not see Hypercity breaking even in FY2012. Hypercity will of course have new and creative reasons in 2012. Unless something radical happens, I am sure that I will win my bet. Let me explain.

Expansion helps improve the profits if it leads to better utilisation of existing resources. If a retailer has 5 stores in a city, starting say 3 more could help. The supply chain infrastructure would be more or less the same. The same overheads (city office infrastructure and professionals, buying team, etc) that earlier took care of 5 shops would now take care of 8 shops. The only new cost in opening the 3 stores would be the cost of employees in the store. So, there is a good chance of increasing the net profit for the retailer.

For Hypercity, each location is a large store and has a baggage of huge overhead attached to it. Every individual Hypercity store would have to replicate all these expenses. There would be very little central overhead that would be shared. As mentioned in the article, 60% of the store's sales are foods. Since the food preference is regional in nature the merchandising and the buying team would have to be different for every region, or for that matter every store. Since every store would be in a different city, new supply chain infrastructure would have to be set up.
So, assuming that they follow the same policy, it is difficult to imagine Hypercity making profits with expansion.

McDonald's in India had a model where they limited themselves to around 30 stores in a few pockets for 4 years. They made all the stores profitable, mapped the necessary processes, created the support infrastructure and then had a full blast expansion. McDonald's was a proven global brand. They had most of the processes available and could have implemented the same in India. Their India people were smart and they instead expanded slowly.

At Rs. 330 crores from 7 stores, the current revenue comes to an average of Rs. 45 crores per store. In 2012, when the news release expects Hypercity to break even, the 8 new stores would only be one year old. It would be reasonable (or optimistic) to assume that each of these 7 new stores would also have a revenue of around Rs. 45 crores in 2012. This totals up to Rs. 360 crores. The existing 7 stores would have to get Rs. 640 crores and this comes to more than Rs. 90 crores per store. What we are talking of here is a 100% jump in revenue in just two years. Surprisingly the news release mentions that the strategy would be the same. I am not sure if it is wise to expect the same strategy to yield such amazing hyper growth for Hypercity.

Expansions help improve profits if the basic model is correct. Else the expansion could merely be postponement of the inevitable failure. To use expansion as a way out of losses is a tried and tested methodology and it has almost always led to failure. Somehow business professionals have a scant respect for history and they forget that history repeats itself.

Vendor Capacity Planning

Boeing has decided to its capacity to produce the super successful Boeing 737 from the current 34 planes a month to 35 planes a month in early 2012. Read the article here:
http://www.dailymarkets.com/stocks/2010/06/16/boeing-boosts-737-production/

It may seem surprising that a 3% hike in capacity (from 34 to 35 planes per month) should take more and 18 months. Unfortunately this scenario exists in many industries. Even though significant opportunities exist, firms are unable to ramp up capacity fast enough to take advantage. In some cases, the demand piles on in the form of backlog. However, in many cases customers gravitate towards less deserving competitors and the demand is lost.

The issue in most cases is that firms ignore to plan the capacities of their vendors. Making a product will need all the items as per the Bill of Materials (BOM). A constraint in even one single BOM component will limit the expansions. The problem here could be as small as water availability at a key vendor or in some cases the disposition of the vendor to expand the business.

A key component in supply chain planning would be to monitor and keep track of the capacity on the supply side. It is necessary for firms to ensure that all the necessary vendors build enough capacity and are able to ensure the necessary supply. The OEM needs to take the lead time to build capacity at its vendors in consideration. Only then can the real increase in output happen.

Maintenance budgeting

I am a frequent traveler in the new AC buses started by BEST (Mumbai public transportation). They are very comfortable buses and they run more or less on time. Generally there is a place to sit and it goes significantly faster than the other buses. Lastly given the record breaking heat and the pollution around, the bus presents a great option.

Early last month I saw that the digital watch in one bus was not working. Next, in a few buses I saw the radio/ speaker system not functioning. Yesterday I saw a bus with the LED display that shows the destination in a faulty state. All this is really surprising since the buses are less than 6 months old.

Somewhere 'maintenance planning' is not a part of the budget and operations in many organisations. Assets wear out. In any business that is dominated by such assets, it is imperative that some resources are committed to ensure a certain minimum level of performance. Maintenance is a big expense these days and companies have to ensure that this is budgeted in the capital budgeting plans and the reasonable costs taken care of. Besides the cost, there has to be a seperate process to ensure that defective and worn out parts are replaced regularly.

Maintenance is not rocket science. Most equipment have a specific life cycle and need replacement in a specific time period. Organisations have to factor this and create individual or group replacement policies for components. The overall aim would be to ensure that the asset gives the desired performance for the longest possible time period.

Dell to ship by sea

This will be the fourth post of Dell on my blog. The first three are available at:
http://bit.ly/9S5nGz

Now, Dell is planning to actually use ships (water route) to move products. Read this article here:
http://bit.ly/bewrOV

Fundamentally using ships will increase the lead time. Direct affect of this is an increase of in transit inventory. With a higher lead time, the forecasts are also 'more' wrong. So to meet the same service levels, Dell would have to maintain a higher inventory of whatever they plan to send by sea. There would be an overall increase in inventory levels. On the other side, there would be a drastic reduction in the transportation costs. The catch is to compare the total cost and make the decision accordingly.

In the IT hardware industry, a major part of the cost of carrying inventory is the obsolete unsold stock. Thumb rule estimates say that a finished product is obsolete within a year. Dell could select some products - finished goods or components (raw material) that do not have such a high obsolescence rate and then ship them by sea. A DVD drive may not change in configuration as frequently as a microprocessor (an assumption, please correct if I am wrong). Thus they may have a good cost advantage.

Unfortunately, life is not as simple. Shipping by sea would mean that Dell would need an entire new set of people and processes to handle sea shipments. This would be a huge cost. When Dell had all the components coming by air, assembly planning would have been an easy operation. Everything for one order would have come individually. Now, there would be some components that would be ordered for every requirement and others (shipped by sea) that would have to be pulled from stock. This would surely contribute complexity and ensure faulty delivery.

There would be two drastically different supply chain processes. The packaging for air cargo and ships would be different. The documentation would be different. Ordering policies, reorder points, etc. will have to be different. Managing this difference in one company, and especially when the organisation does not have prior experience and expertise in managing this diversity would be very difficult. I have my own doubts of the success of this move.

Dell has had a drastic drop in their sales - to the tune of almost 20% in financial year 2009. The sales revenue has decreased from $ 61 billion in FY 2008 to $ 51 billion in FY 2009. Logistics is always and unfortunately the first target of companies facing such a downturn. The seek to maintain the bottom line (in spite of the reduction in top line) by reducing expenses. Again unfortunately for these companies, logistics cost has a direct bearing on service levels (and product availability). An 'unsmart' reduction in logistics cost would further decrease revenue and put more pressure on cost reduction. This would start a never ending cycle leading to destruction. Best of luck Dell.

takes a thief to nail another

Pharmaceutical companies, I feel, make too much money. Making money is not a problem, but to do it under the guise of a 'noble' profession or creating artificial non tariff barriers is definitely not right. Bayer has some cancer drug and Cipla has introduced a copy cat version at 10% of the price. Read the article in Economic times.

http://economictimes.indiatimes.com/news/news-by-industry/healthcare/biotech/pharmaceuticals/Cipla-makes-cancer-drug-cheaper/articleshow/5776074.cms

Point one - To invent a radically new drug there are high R&D costs. Every drug maker needs to have a business advantage for some period of time so that it can recover the cost of this R&D. This is what the patents do. In this period pharmaceutical companies price medicines more than 100 times the material (and variable) cost as they have to recover the sunk costs (R&D). The debate is on the length of this free run time. With pharmaceutical companies having profitability significantly higher than the average corporate rate, it is obvious that the free run period is a bit longer than what it should be.

Point two - Cipla says that they are introducing the new drug for Indian patients. I doubt this. They are doing it to make money. Like I said before, the material cost in such cases is less than 1% of the sale price. Since Cipla has not done the basic R&D for the product they would be making a huge profit on the drug. They do not have any other major fixed cost to recover. If they were really interested in 'serving' the Indian patients, they could have offered it at a 10% or 50% margin over the material cost. This they will surely not do.

'Profit' from a store?

There is news in today's Economic times that Aditya Birla Retail MORE have closed 39 of their stores in Gujarat. This is one third of their stores in Gujarat. The reason was that the stores were not making money. Have a look at the complete article:

http://economictimes.indiatimes.com/articleshow/5748697.cms

Calculating the 'profit' from an individual store is difficult. How do you attribute costs of a delivery vehicle serving five stores in one locality. Closing one store is not going to reduce the logistics costs by 20%. Similarly the costs of the central buying team, and the CEO is not proportional to the number of stores. Thus, if the decision has been taken using traditional costing, I think it would be a blunder. It is incremental cost that matters here.

While costs are not proportional to the number of stores, unfortunately sales is. When stores are shut, sales will definitely go down in direct proportion. It is only the lease and the local manpower costs that would come down. The costs of expensive expat CEOs and the central organisation overheads would stay. Sometimes the drop in sales could be higher than the drop in store level variable costs and put the company in deeper problems.

Stores have been opened without detailed analysis based on some global ballpark figure. This was the first wrong step. Every retailer opened multiple formats. The second wrong step. Now, with cash crunch they are closing the stores recklessly, the third wrong step. My take: If a retail group is sinking, shutting a few shops is not going to help, yes the inevitable could be delayed a little.