Warehousing: Maximizing Distributor Profitability Part 2

The warehouse is where most distributors make it or lose it. Sales is responsible for the top line, but if the warehouse (including inventory management) does not meet the six critical measures of success, all of the sales in the world will not help because you will lose customers quickly. Last month, part 1 covered Metrics and Management, and can be read on our blog.  This month we’ll cover the cost of mistakes.

Cost of Mistakes
Given all of this information, it is also important to be able to determine the cost of a mistake. As indicated, the cost is variable depending on when it is caught. For example, a shipping error caught before the packing box is sealed is significantly less costly than one found at the customer’s location when a package is opened to get an individual part for immediate use. Plus, this type of discovery incurs additional soft costs for lost customer satisfaction on top of all expenses related to the return and replacement of the incorrect part.

Some of the costs associated with warehouse errors (even the ones caused by incorrect sales documents or influenced by others) include:

  1. Extra processing to eliminate errors (this occurs when there are a large number of errors and extra steps are implemented to check and even recheck picks to make sure the right number of the right product are pulled for packing and shipping).
  2. The cost of shipping both ways if incorrectly sent mate­rial has to be returned. Where replacement parts have to be shipped overnight or even same day, the extra cost is rarely recoverable.
  3. The lost margin if a significantly more expensive item is shipped and billed at the price of the expected item (the other scenario rarely happens where a customer is charged for a more expansive item, but a cheaper one was sent—customers find and complain about those quickly).
  4. There is the cost of extra handling of material, paper, invoicing, credit memos, and customer service time to correct the error and placate the customer.
  5. The soft cost of damage to the firm’s reputation is much more difficult to determine, but it can be a relatively large number.
  6. There is potential damage to parts or equipment that makes it impossible to return the wrong items to the shelf for a future sale.
  7. There is the potential cost of having to purchase the correct product on an emergency basis at a much higher cost than was used to calculate the selling price.
  8. There are long term costs associated with reduced customer retention due to ongoing problems with erroneous shipments.
  9. There are long term costs associated with reduced cus­tomer retention due to late shipments, wrong quantities, and lack of quality.

The cost of lost loyalty is one of the most difficult to quantify. It is proven that a disgruntled customer will tell many more prospects than a satisfied customer. Measuring lost opportuni­ties due to bad reputation is almost impossible to do accurately. Distributors who hire outside firms to measure such data are often surprised to learn what the marketplace thinks of them.  Surveys and the metrics they can create are often valuable management tools, but outside the scope of this paper. Surveys require specialists who know how to word questions, select par­ticipants, and report data to be useful. They need to be done on a regular basis and the results must be compared and reported to be of the greatest benefit to the organization.

Adding up all of the potential charges will put the cost of errors into perspective. Industry experts have published numer­ous papers showing individual costs (such as $45 to $70 for an invoice and $10 to $25 for a credit memo), but there is no accepted total for a warehouse error. For the purposes of this article, it would be easy to defend a conservative estimate of $200 per error.

Assume one only does 100 ship­ments per day and achieves 99% accuracy (one error per day). In a year of 220 working days, that generates 220 errors. At $200 per error there is an annual cost of $44,000. This could require $2.2 million of additional sales to cover the cost of those errors. These are significant numbers.

In addition to the cost of any specific error is the cumulative effect of poor customer service. Over time, it may force some customers to stop dealing with their current supplier and buy from another source. What is the charge or value associated with the loss of a customer?  There are two types of costs that should be considered. The first is the value of the lost customer. What profitability would they have added to the bottom line over the next period?

Research by Paul Wang at Northwestern University uses the concept of Customer Lifetime Value (CLV) to quantify the cost of losing customers. CLV uses revenue, margin, and customer retention rates to compute the current value of a customer during a projected lifecycle. In simple terms, this means we can estimate the total value that a customer (usually by some combination of demographic data like size, type, age, etc,) will provide in any give year.

If we assume warehouse errors can be directly blamed for the loss of some number of customers and multiply that times the projected net revenue that would be generated from that cat­egory of customer, we can estimate an impact number. Keeping the numbers simple, we might guess that our average customer purchases $10,000 annually at a 25% gross margin. That means that each lost customer reduces the annual gross margin by $2500. If only 10 customers are lost in a year, the reduction in gross margin is $25,000. Lose eight customers per month and almost a quarter of a million dollars is lost every year. That is a major impact for most distributors.

Understanding these costs helps us realize the significant impact that warehouse errors can have on the profitability of the business.

The second type of cost to consider is the cost of acquisition of a new customer to take the place of the lost customer. This has to include sales time, administration to set up the customer in the system and perform a credit check (assuming you actually do a credit check and establish a credit limit). It also should consider any extra effort that is required learning the new customer’s requirements during the first few sales.

An easy way to look at the cost of acquisition is to take the total budget spent on marketing and sales and divide by the number of new customers added in a given period. Of course, much of the expenditure is necessary to encourage current customers to keep buying or to encourage purchases of specific items. Estimates of anywhere from $500 to $2500 per new customer can be reasonable.

Then there is the absolute cost of a lost sale (even if it does not lead to the loss of a customer) when a product cannot be found for immediate delivery (whether or not it was put away wrong, accidentally shipped due to a picking error, or on the receiving dock, but no one knew it was there). On top of the lost gross margin, there may be higher levels of customer dissatisfac­tion and a negative impact on internal personnel when manage­ment attempts to assess blame for the mistakes.

© Brown Smith Wallace Consulting Group 2010

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