Good Supply Chain Measures: Balance and Causality

Good supply chain measures need to be balanced and must be relevant to your bottom line.

Brian Springman, Springman Consulting LLC

There appears to be a trend where the Finance department is becoming more interested in the relationships between operational performance and coporate profitability.  The interest may have already been present, but it appears now that more CFOs are taking direct responsibility for supply chain performance.  As a result, corporations are attempting to develop causal relationships between supply chain management and financial performance.  As in any good measurement system two things are needed: balance and causality.  In the case of balance, a corporation doesn't want to emphasize one measure to the detriment of other measures or the overall business.  In the case of causality, a corporation wants to focus on the key levers that have direct impact on bottom line results.

Balance

Supply Chain measures fall nicely into three categories which form the basis of a balanced supply chain measurement system.  These categories are: Operating Costs, Customer Service, and Working Capital.  It is necessary to balance across these categories because an improvement in any one of these areas will lead to poor performance in the other two areas.  Let's take three examples:

Working Capital Improvement

   Let's take a common scenario: upper management has released an edict for Operations to reduce working capital.  As a result, Operations makes cuts in finished goods inventories without addressing operating costs or customer service issues.  To maintain small finished goods inventories means that the product must be made in smaller lot sizes.  Smaller lot sizes results in higher per unit production costs.  Holding less finished goods inventory means that stock outs are more likely and customer service levels will deteoriate.

Customer Service Improvement

  In scenario two, let's assume that several customers have been complaining that they've had to back order recently because your company has been out of stock.  The easiest way to eliminate stock outs is to increase finished goods inventory.  However, that will now have a negative impact on working capital.  Telling Operations that customer service is paramount will often result in higher operating costs for overtime and expedited shipment costs for 'rush' orders.

Operating Cost Improvement

  In scenario three, let's assume that accounting is chiding Operations because per unit production costs are too high.  Operations will then tend to run larger lot sizes of the most efficient product.  This will result in an overall increase in inventories, and thus increase working capital.  While in most cases increasing inventories will increase customer service, it doesn't in this case because Operations will tend to over produce their most efficient product and under produce less efficient products.  As a result, the customer service levels for the less efficient products will plummet.

The key is to always measure all three of these variables and to address their improvement simultaneously.  Or at the very least, ensure that while improving one variable the performance of the other two variables does not deteoriate.  How does a company improve all three variable simultaneously?  That is a subject for another article but the answer comes from the Japanese who re-wrote the rules in several areas:

1. Higher quality (product and service) results in lower total operating costs.
2. Smaller lot sizes and inventories drive higher quality.
3. Smaller lots sizes and inventories can be achieved with a minimal increase in production costs. (Lean Manufacturing, Single Minute Exchange of Dies)
   

Causality

Causality comes into play as a company attempts to define the measures and goals under each one of the three areas: Operating Costs, Working Capital and Customer Service.  The causality test is simply: Does this measure have a direct and significant impact on the company's bottom line?  The answer to this question is going to be unique to each company based on their particular business strategy and markets.  I recommed a good article on causality 'Coming Up Short on Nonfinancial Performance Measurement' by Christopher Ittner and David Larcker, Harvard Business Review, November 2003.

The basic principle can be illustrated with a few scenarios:

Customer Service

  A client had a good strong customer service reputation with a major customer and on-time delivery of over 97%.  My client provided over 30% of this customer's total purchases of this particular product.  Would focusing energy on improving on-time delivery from 97% to 99.9% be a good use of resources for this client?  Probably not.  The customer was already purchasing the maximum volume they wanted to purchase from any single supplier.  Therefore, any significant increase in service levels wasn't going to result in a significant increase in sales.

Operating Costs

  Per unit production cost was used by a manufacturer to measure profit of individual products.  This cost was calculated on a fully allocated basis which included replacement cost of the production machinery.  Would focusing on reducing unit production costs increase corporate profitability?  Maybe not.  In the case of this company, Operations reduced the per unit production costs by outsourcing to a contract manufacturer.  The contract manufacturer had a lower total unit cost but a higher total variable cost than manufacturing internally.  As a result, the company lost cash profit on each unit outsourced.

In summary, when defining your supply chain measures be sure to incorporate the principles of balance and causality.  The variables of operating costs, customer service and working capital are the starting point for balancing your measures.  However, as you select the detailed measures under each of those categories apply the rule of causality to your particular strategy and markets.