As firms deploy their inventories across multiple continents to serve growing markets, the costs of transportation itself, and just as importantly, the direct impact of transportation modal decisions on a firm’s inventory investment requirements and annual carrying costs requires careful planning and analysis. Firms must employ a rigorous transportation mode choice decision-making methodology that recognizes all the costs associated with their transportation decisions. In this article, we discuss the imperative that a firm employ a modal choice decision-making methodology which evaluates both annual costs and long run inventory investment requirements to identify the best transport mode choice for products shipped on its major transport lanes.
The importance of integrated (rather than siloed) decision-making on a firm’s manufacturing and distribution network has been recognized for many decades. The evolution of logistics from “physical distribution” in the 1960s, to “integrated logistics management” in the mid-1980s to the early 2000s, to the present practice of “supply chain management” reflects the relentless efforts over the years by supply chain professionals to manage networks based on an ever-increasing holistic, coordinated approach. Nevertheless, one can still observe today that some firms fail to evaluate thoroughly the true costs of alternative transport options on their logistics network. And even those firms that do take into account all annual costs sometimes fail to carefully evaluate the investment aspect of their transport mode decisions.
Case Scenario and Costs
To facilitate our discussion, consider a hypothetical scenario in which a firm must evaluate whether to ship product by air or by ocean between two of its facilities located on different continents (e.g., Asia and Europe). Assume that the firm manufactures finished goods inventory (FGI) in a plant in the Far East and distributes these products to customers in Europe from its distribution center located somewhere in Europe. Further assume that the firm supplies make-to-stock products on demand to its customers from this distribution center. Thus, it must maintain inventory at the distribution center to fill orders immediately as customers place them, and it must maintain a safety stock or buffer inventory to cover the variability in demand over inventory replenishment lead time, and the variability of replenishment lead time. The question the firm must now evaluate is whether to ship FGI from its plant to its distribution center by air or by ocean. In what follows, we provide a brief overview of a methodology that enables a firm to:
(1) integrate inventory costs into its transport decision-making strategy, and
(2) evaluate both annual costs and inventory investment costs to guide its transport mode selection strategy.
Key Costs to Evaluate
To evaluate whether to establish air or ocean inventory pipelines to transport the firm’s products between its plant and distribution center, we must consider five major cost factors which will differ depending upon which transportation mode the firm selects. These are:
1) the freight costs
2) the inventory carrying costs of inventory in the pipeline
3) the inventory carrying costs of cycle stock at the receiving distribution center
4) the inventory carrying costs of the required safety stock at the receiving distribution center
5) the investment cost required to produce the inventory to fill the pipeline (i.e., the average total inventory required in transit and at the distribution center).
The first four cost factors are annual recurring costs which will continue as long as the transportation inventory pipeline exists, while the fifth cost represents a one-time cost required to initiate the pipeline.
Integrating Inventory Investment Analysis and Annual Costing
The annual costs can be analyzed using traditional spreadsheet calculations once the proper supporting data have been developed. However, calculating the initial inventory investment and determining the return on investment associated with an inventory pipeline modal choice is not as straightforward. Investment decisions typically involve weighing an expected return against the investment necessary to generate that return. In other words, to evaluate the pipeline modal choice from a long-term investment perspective, a company must quantify both the investment and the expected return associated with each transport mode.
The best way to do this is to focus on incremental costs and investment, determining whether the annual savings in transport costs from an ocean pipeline justify the incremental investment in inventory needed to build it – i.e., the ocean pipeline inventory investment less the air pipeline inventory investment. This approach views the annual incremental savings or cost avoidance associated with ocean transport as the incremental stream of income resulting from the incremental investment in an ocean pipeline. An ocean pipeline will, of course, always require a larger initial inventory investment than an air pipeline because the transit time is longer – and hence the days of inventory is greater. With the incremental annual stream of income and the incremental pipeline investment defined, one can now calculate standard measures for evaluating the alternatives, such as return on investment and the investment payback period.
Final Comments
We have briefly summarized an approach to develop long-run transportation network re-supply strategies. I first developed and implemented this methodology while working for a Fortune 100 firm whose manufacturing and distribution organizations could not agree on whether to use ocean or air pipelines to ship several key products between their plants and distribution centers. The manufacturing group was responsible for inventory costs and wanted to use air transport, while the distribution group was responsible for freight costs and wanted to use ocean transport. The two groups agreed to use this integrated freight and inventory annual cost and investment cost methodology, and were then able to align on which products to ship via ocean and which to ship via air.
The reader interested in exploring this methodology further is referred to the references at the end of this article for detailed explanations and step-by-step analytic examples. The actual analytics of this method are very straightforward, and users can easily input the required formulas in a simple spreadsheet.
References:
“Integrating Inventory Analysis into a Firm’s Ocean, Air and Combined Ocean/Air International Transport Mode Strategies”, by Tan Miller, Supply Chain Management Review, September, 2024
Practical Supply Chain and Logistics Analytics, by Tan Miller, Routledge Publishers, United Kingdom and New York, 2026
