Carlos Ramos, head of supply chain at KAR Foods, wondered why his inventories had not declined despite the significant improvement his team had made in its ability to handle mixed-load and small lot orders from customers. He felt that the problem was the discounting scheme offered by the sales team that encouraged customers to place large orders. Carlos arranged for a meeting with Vanessa Rebelo, head of sales and marketing, to discuss future plans.
Historical Pricing and Costs at KAR
KAR was a large Brazilian food processing company, headquartered in São Paulo, that produced fresh and processed meats. Starting as a slaughterhouse, the company had become a major global player after several acquisitions across the world. The company sold its products to several supermarket chains within Brazil. A typical supermarket chain purchased 10,000 kg of meat each month at a price of 4 real/kg from KAR. KAR incurred a cost of 2.50 real/kg to produce the meat. KAR operations were set up to produce at a steady rate that matched demand. Historically, KAR had encouraged its customers to order in large lots by offering quantity discounts of 2 percent (a price of 3.92 real/kg instead of 4 real/kg) if customers ordered lots of 27,500 kg or more. The quantity discounts were justified by the high fixed cost of 4,000 real that was incurred by KAR to process, load and deliver each order.
Supply Chain Improvements at KAR
As the company grew, it became clear that supply chain operations required significant improvement to compete with other multinationals that were entering the Brazilian market. Carlos Ramos was hired to lead this effort, given his extensive experience in the consumer packaged goods industry. A quick review of the status quo by Carlos identified several opportunities for improvement. He decided to focus on the large amount of inventory that was built up to fill customer orders. A reduction in inventory would free up capital and expensive cold storage space, and would also streamline operations. At the current holding cost of 20 percent, reduction in inventories could save a significant amount in overall holding costs. He quickly realized that the inflexibility of the current distribution system resulted in the high cost of 4,000 real to process, load, and deliver each order. Carlos changed processes and invested in technology to increase flexibility and make it cheaper to handle mixed loads. He also brought in routing software that made it easier to plan deliveries to multiple customers on a single truck. This helped reduce the fixed cost per customer order down to 400 real. Carlos hoped that these improvements would significantly reduce lot sizes and thus inventory.
Costs Faced by Customers
Given that there was very little decrease in lot sizes and inventories, Carlos wanted to understand why things had not changed. Before his meeting with Vanessa, he sought to learn about the costs faced by supermarket chains ordering from KAR Foods. He learned that each supermarket chain itself incurred a fixed cost of 100 real associated with each order. This fixed cost was incurred for order placement and receiving. He also learned that each supermarket chain incurred a holding cost of 20 percent.
Questions
Utilize the Economic Order Quantity for analysis of the optimal order size across supply chain partners. What do you think of the discounting scheme that KAR had used historically? Do you think it was justified given the circumstances?
Once KAR has reduced its fixed cost per order to 400 real, what are the downsides to leaving the discounting scheme unchanged?