The way you build your supply chain is a strategic decision that should support your business model. And the ultimate goal of your supply chain should be to maximize gross margin.

I have witnessed many smart people look at a company’s supply chain believing that the ultimate goal is to minimize costs. If you are one of the those people, I hope I can change your mind with this post.

First some background….

The low-cost supply chain: If you look across product categories today, most industries and most companies that mass produce physical goods have moved their manufacturing overseas to low cost countries (LCCs) such as China, Taiwan, etc.

• Advantages: lower cost of raw material inputs/labor; investments in advanced technology (some industries have completely moved overseas); greater scale, which can mean higher capacity, speed, and quality
• Disadvantages: longer lead times largely due to international transit (least expensive method is container shipment by boat which takes ~40 days China –> NYC); communication challenges; added cost of international trade due to duties, quotas, etc.

Companies that choose to manufacture in LCCs make the trade-off of time vs. money. This works for businesses with one or more of the following criteria:

• Predictable demand – easy to forecast consumer demand and get it “right”, limited inventory risk
• Long product lifecycles – product doesn’t become obsolete so excess supply is a balance sheet problem but not an income statement problem, limited inventory risk
• Very high volume – scale, capacity may be a concern locally
• “Localized” technology – impossible to find affordable/quality manufacturing locally, e.g. knitwear in NYC just doesn’t exist.

A LOT of companies/products do not fall into those 3 categories. So an alternative approach is better.

The local supply chain: Responsive and flexible. Ideal for companies/products that meet the following criteria:

• Unpredictable demand – particulary true for startups, new product launches, or trend-driven products like fashion apparel, requires highly flexible supply chain that can ramp up/down as needed
• SKU complexity – this ties closely with demand uncertainty – the greater the SKU complexity, the greater the sales volume required to have adequate availability across all SKUs
• Frequent product refreshes – characterized by short product development cycles, which can be industry-driven (i.e. fashion) or “growth stage”-driven (i.e. in early stages iterative, quick product development is best. fail early, fail often.)

The financial “kicker”

AKA how SC impacts revenue & cost

• The #1 goal of  any supply chain should be to get the right products to the right place at the right time. For many businesses, this means the ability to adjust production to meet unexpected changes in demand. If you have an inflexible supply chain you may be stuck with too much product (markdowns!) or not enough (lost sales!).

Numerical example – a dress

Let’s assume we’re selling a dress.

The retail price is $158 regardless of the supply chain decision, but the realized price differs based on the supply chain:

• LCC – Based on well-known industry targets, we can hope to sell-through 65% of our inventory at full price and the remaining 35% at a 70% discount at the end of the season. This gives us an average realized price of $119 per dress.
• Local SC – Because we are forecasting inventory on a shorter time horizon and able to replenish inventory as needed, we can expect to sell a greater percentage of the inventory at full price. In the model below, I have assumed that 80% of the inventory is sold at full price and the remaining 20% is sold at a 70% discount at the end of the season. This gives us a realized price of $136 per dress.

From a cost standpoint, our locally produced dress costs 2x as much as the dress produced overseas. Yet, we’re able to earn those GM dollars back due to a higher realized sale price.

For companies that have mastered the art of JIT (just in time) manufacturing, like Zara, these numbers can be even more attractive.

In conclusion

Of course, local supply chains do not make sense for every business, but far too many companies have jumped on the low-cost bandwagon. If more companies were managing their supply chains strategically to maximize profit rather than cost, we would not only have more manufacturing jobs in the U.S. but a number of companies would benefit from more efficient, profitable operations.

So next time you find yourself considering how to value a supply chain or operational decision, I urge you to consider both the revenue AND the cost-side of the equation. I promise you’ll get a better (more profitable!) answer this way.