How should Nestle increase profit?
By taking advantage of
scale economies in purchasing.
BOSTON—When Paul Grimwood took over Nestlé SA NESN.VX +0.29% 's struggling U.S. operations a year and a half ago, he faced an unlikely problem: Hair nets.
Nestlé's seven independent businesses in the U.S., which run a total of 87 factories, were buying hair nets and safety shoes from more than 100 suppliers. Because the units weren't talking with each other, Nestlé, the world's biggest food company, couldn't get the best bulk discounts in its biggest national market. Now Nestlé says it uses just "a handful" of suppliers.
The same thing happened with flavorings. By combining purchasing departments across businesses, he chopped the number of flavor suppliers in the U.S. to four from 48.
"If you keep rolling that out across the scale and size of the whole U.S. market, it makes a phenomenal difference to the profitability," Mr. Grimwood said in a recent interview.
It is a smart move for Nestle to narrow down its orders to only a few suppliers. This strategy, generally, allows companies to capitalize on bulk buying which is a good leverage from which to negotiate discount prices on specific products. IKEA realizing the economic benefits from employing economies of scale (EOS), lowered their average long run costs over the years by exploiting technical EOS. The profit in this case, was generated through increased specialization.
ReplyDeleteThere are various marketing EOS that IKEA has benefited from over years, nonetheless, ‘bulk buying’ seems to be the most primary method used (Dugher). Companies producing on a larger scale should take advantage of bulk buying raw materials or product for resale in larger quantities. Consequently, they are able to cut out wholesalers by buying direct from producers, and transport costs per unit may also be reduced. Essentially, company can buy in large enough quantities to make very specific demands about product quality, specifications, service and so on, so that supplies exactly match their needs. One of the reasons big giant retail stores such as, Home Depot and Staples are successful is because they sell so many units that allow their suppliers to also enjoy scale economies (Freob).
Leo Palmer ESC Econ.
Reference:
Dugher Jack. How does IKEA benefit from Economies of Scale? Retrieved 2/6/15 from
https://jackdugher.wordpress.com/2012/09/11/how-does-ikea-benefit-from-economies-of-scale/
Froeb, MCcann, Ward, Shor. (2014) Managerial Economics. A problem Solving Approach. Ohio:South-Western Cengage Learning.
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ReplyDeleteBy coordinating the opportunity for the individual businesses to purchase in bulk, Nestle effectively created economies of scope for their various product lines.
ReplyDeleteThere are several factors that contribute to a company experiencing Economies of Scope by combining products and facilities. The ability to combine distribution processes, administrative processes, and efficient use of materials are three of them.
The ability to purchase supplies in bulk is one way to efficiently use materials in order to lower the cost of production for the combined products. By narrowing down the list of suppliers, Nestle was able to facilitate the more efficient purchasing of supplies, so the overall production cost for the various products was decreased. When the businesses were operating separately and independently, the raw materials cost more, so the production cost of the individual products was higher than the cost of producing them together.
The bulk purchasing of supplies created, or enhanced, the economies of scope between the multiple product lines, even if the facilities and administration were not combined. This was a good decision for Nestle and benefited the company as well as the individual businesses.
References:
Froeb, L. M., McCann, B. T., Shor, M., & Ward, M. R. (2014). Managerial Economics; A problem solving approach (3rd edition). Mason, OH: South-Western Cengage Learning .
ESC, Managerial Economics. Fall 2015
ReplyDeleteNestle would definitely benefit from simplifying and reducing to only a few suppliers. Being able to benefit from bulk discounts, and perhaps better pricing and financing options, they can decrease their overall cost, and because Profit = (price – average cost) x Quantity, if marginal cost goes down, there will be a boost in profits (Froeb, 2016).
Too often organizations try to increase profit by increasing the price of their product and reducing labor costs. While labor is a huge contributor to overhead, by simply reducing suppliers, and buying in bulk, the organization can reduce cost, thereby increasing profit.
In addition, the companies that Nestle will buy its supplies from will also stand to gain. Because the Marginal Cost stands to decrease per item with the additional quantity produced, the supplier will stand to “reduce marginal cost to below average cost and therefore achieve economies of scale” (Froeb, 2016). Cost per unit decreases as the volume of production increases.
Froeb. (2016). Managerial Economics. A Problem Solving Approach. Cengage Learning.
ESC, Managerial Economics, Fall 2015
ReplyDeleteKethem, your analysis of Nestle is well written and accurate. After reading this case, I thought about another large company, Wal-Mart. Wal-Mart for the past 6 decades has continued to dominant the marketplace with a strategy of economics of scale amongst other methodologies. Wal-Mart’s extraordinary buying power allows it to increase marginal revenue by manipulating marginal cost from its suppliers. By doing so, Wal-Mart continues to have extremely low buying costs due to its large orders while also having lower margins to keep its prices lower for consumers.
Although Wal-Mart continues to do well in the marketplace, competitors like Amazon continue to aggressively market their products to compete. However, Amazon has lower overhead costs such as fixed costs like Wal-Mart (Laseter et. al, 2003). Wal-Mart has many locations throughout the United States and internationally while Amazon has distribution centers and primarily focuses their business via online buying. This allows Amazon to create even lower margins for consumers to enjoy slightly more affordable products to outcompete its competition.
References
Laseter, Tim, Martha Turner and Ron Wilcox. (2003). “The Big, the Bad, and the Beautiful.” Strategy and Business. http://www.strategy-business.com/article/03402?gko=cdf1a
Basker, Emek. (2007). “The Causes and Consequences of Wal-Mart’s Growth”. Journal of Economic Perspective. Volume 21, Number 3—Summer 2007. Pages 177–198. http://www3.nd.edu/~jwarlick/documents/Consequences_Walmart.pdf
Knowing whether your long run costs exhibit constant, decreasing or increasing returns to scale, help you make better long-run decisions (Froeb, 2014). Paul Grimwald, taking over for Nestles in the US, recognized the size and complexity of the organization and operation. With that knowledge, he looked at suppliers of the organization and recognized the pure number of those suppliers. Pursuing economies of scale, reducing the supply chain allowed Nestle’s to leverage their size to cut costs. Additionally, reducing suppliers also allowed the reduction or realization of the number of personnel required to manage purchasing and accounts payable. Economies of scale provided the opportunity to “right size” the organization and create wealth, saving money.
ReplyDeleteFroeb, M. S. (2014). Managerial Economics A Problem Solving Approach. Boston: Cengage.
With all due respect to Nestle….this seems like an obvious move and one that should not have needed to be found by their CEO. Economy of scale for simple production supplies is one that should have been noticed much earlier. Though there may be additional costs for distribution across all of the Nestle facilities, it’s not only likely but probable that Nestle can have a central warehouse to distribute these supplies. I work in manufacturing, and one of our tightest areas of scrutiny is production supplies and non-production supplies. Production supplies directly contribute to value, whereas non-production supplies are necessary but contribute little value. Hair nets and safety shoes most certainly fall into that category. Though it might have been the case that each facility had their own purchasing agent and it simply never occurred to them that greater savings might be had. I would be interested in the actual dollar amounts of those savings.
ReplyDeleteNestle has been around since the eighteen hundreds and having supplier issues is not something that should have happened. If they had decided to utilize different suppliers because of cost that would make sense but that was not the case here. When the CEO had come into the picture, he had to deal with the learning curve on how Nestle used suppliers. Most company use just a few suppliers depending on the need for them. Unfortunately, this supplier issued had resulted in Nestle offering fewer flavors of their chocolate then they had previously. Nestle should utilize one supplier for things because this will enable them to have a reduced cost on these items.
ReplyDeleteClearly,
ReplyDeleteThis is a case where Nestle can use economies of scale to negotiate better deals with suppliers thereby lowering costs and improving its bottom line. Ordering hairnets and safety shoes from just one or a few suppliers for all of the 87 plants that it operates in the US, should allow Nestle not only to negotiate better pricing, but to request a detailed quote from the perspective supplier, outlining the pricing structure. Nestle can achieve the same, and probably already has, by narrowing down its flavor suppliers to 4 from 48. Typically, a company that is seeking to place an enormous order will want to see the pricing structure of the manufacturer to ensure that any inefficiencies present in the manufacturing or sourcing process are not passed on to them in form of higher pricing.
In the chocolate industry for instance, ingredients can be just barely ok, average, premium, ultra-premium. The price difference between ingredients can constitute a range of several dollars per pound. When a giant retailer with pricing strategy as a competitive advantage is negotiating with a perspective supplier, they are going to want to know whether the chocolate being used is barely or premium. In the case reselling the $ 2 difference in price between the two chocolates to the manufacturer can turn into a price that is $ 5 or more higher per pound for the premium chocolate than it will be for the barely ok chocolate when the product t finally hits the shelf. With a lot of low cost chocolate substitutes on discount retailer shelves, someone like Walmart will be vary of the elasticity of demand and will request that a cheaper or cheapest chocolate be used by the perspective supplier.
It is the same with manufacturing efficiencies. If the perspective supplier does not have an up to date, high speed manufacturing line, then they will have trouble producing hairnets for Nestle at a competitive rate. Similarly, a company with an outdated and slow chocolate enrobing line may be able to cover a few hundred pounds of chocolate an hour. Even if they will be able to cover all the pretzels in chocolate that Walmart needs, they may have trouble fulfilling orders from other companies that are willing to pay more for higher quality ingredients. The opportunity costs of devoting an entire production line to Walmart’s chocolate pretzels may cause the perspective supplier to quote a price that is not as good as the price that they would be able to offer if they had a chocolate enrobing line could process several thousand pounds per hour instead of just a few hundred.