The value of supply chain management

A well run supply chain brings many positive benefits and is a strategically important goal. Enrico Camerinelli, Chief Analyst and European Director of the Supply-Chain Council, explains how to get the measurement of your supply chain value right.

When discussing how best to measure the value of supply chain management, it is important to agree on a definition of supply chain management itself. One of the most respected sources of standard definitions, the Council of Supply Chain Management Professionals (CSCMP), says that it “encompasses the planning and management of all activities involved in sourcing and procurement, conversion, and all logistics management activities. Importantly, it also includes coordination and collaboration with channel partners, which can be suppliers, intermediaries, third-party service providers, and customers”. An alternative definition is given on Wikipedia as “the process of planning, implementing, and controlling [the operations] with the purpose to satisfy customer requirements as efficiently as possible. Supply chain management spans all movement and storage of raw materials, work-in-process inventory, and finished goods from point-of-origin to point-of-consumption.”

What these thorough descriptions do not cover, however, is the unchanged sheer nature of organisations. That is, their still functional and silo-based structure.As a consequence, an organisation observes supply chain management from three distinct perspectives: the operational, the technical, and the business perspective.

At the operational level the focus is on how to manage the flow of goods and how to balance the network of warehouses, distribution centers and transportation services. Attention is given to the activity of keeping raw materials and finished goods in stock and is paralleled by the challenge of managing the best the flow of components across suppliers and production centers. The common terms used under this perspective are economic order quantity, production throughput, WIP, order fulfillment, lean production and kanban.

The technical perspective portrays the supply chain as a network of hardware, middleware, and software components. They all serve the purpose of supporting the execution of supply chain operations through the collection of data, automation, and sharing of information. ERP, MRP, business analytics, database, CRM, EDI is the jargon terms used in this domain. This is the perspective of IT people in the company, where the flows of information replace the flows of goods.

At the business level, company executives monitor performance indicators that measure the value generated by supply chain execution. Flows of money are under scrutiny.

Clear communication

Because decisions that impact the supply chain can be made at different levels, different measurements must be employed throughout the company. At a minimum, there must be a decision view (boardroom), a management view and an operational view. The linkage between these views must be clearly defined. Tightly focused supply chain value management, enhanced by performance metrics, has been reinforced by board-level interest at many companies whose operational departments regularly provide the information and data needed.

ROI, risk vs. opportunity and price vs. performance are the indicators measured at the decision level. Middle management captures indicators related to resource availability, schedule vs. effort, costs vs. budget. At the lower – and more operational – level, typical measured KPIs are related to processes, activities, products, specifications, procedures and efficiency.

The real issue is not the lack of performance indicators, but the loose correlation between indicators used at different layers of the command chain. A recent study by IBM, The Agile CFO, shows that “the cascading of metrics down to functions and business units appears to lag executive level scorecards”.

Such a lack of correlation impedes the two-way communication of performance targets between the decision-making and operational levels of the organisation. The lack of effective communication of linked and aligned scorecard metrics to each business unit is becoming a major day-to-day issue for corporate executives. There is a growing recognition of the strategic importance of supply chain management, as well as the positive benefits that a well run supply chain can bring. The problem lies in utilising the correct metrics to evaluate (and, therefore, manage) such activities. The adage that what cannot be measured cannot be managed always holds true.

Business is the perspective of the CFO

The number one challenge for corporations is to improve the integration and sharing of critical business information between decision makers, operations, and technical divisions.

Corporations break down the barriers to sharing key data across and between major departments by empowering the financial director (CFO), who is now becoming the trustee of information and assets of the company. The IBM 2005 Global CFO Study describes this process: “Finance organisations plan to redouble efforts involving process ownership and mapping of processes. This emphasis on process ownership reflects a shift from viewing virtually all data and information as the property and responsibility of individual business units to viewing them as corporate assets that can be leveraged throughout the enterprise. While responsibility for accuracy of the data remains at the source, accountability for overall integrated data integrity shifts to finance.” It goes on that: “Today’s highly effective CFOs are focused on building insight capabilities across their organisations to give their enterprises the flexibility necessary to rapidly respond to changing business conditions.”

To support the CFO’s new role and objectives, many organisations are investing in cross-educational programs between financial and operations people. Operations are introduced to finance via job rotation, internal mobility programs as well as basic education on how to read an income statement, a balance sheet and the meaning of indicators such as IRR, NPV, cost of capital, and weighted average cost of capital.

Equally people working in finance departments are expected to understand how operations are run and managed. Internal mobility is the major practice adopted, which enables finance to take on the role of ‘coach’ and support operations to measure the corporate value created.

A good example of this process in practice is at Deutsche Post, the global mail, express delivery, logistics services and wide-ranging financial services group. It has invested a significant amount of its budget in the ‘House of Finance’ program. Finance managers learn about operations, while at the same time operations managers learn about finance basics.

Another sign of this trend is that formal reporting lines between finance and business unit functions are strengthening. Compensation of operations activities is tied to financial performance. At FedEx, controllers of operational units (e.g., mail, logistics, express packages) report to the CFO and the unit director through a solid reporting line. Fifty percent of the variable salary is set by the central financial function, while the remaining half is set directly by the unit director.

Current metrics for supply chain management

On-time delivery; production throughput; forecast accuracy; fill rate; overtime labour; supplier performance; freight and delivery costs; lead time performance; stock-outs and backorders; inventory turns; and obsolescence are all among the typical indicators of supply chain performance. The nature of these metrics, which are very much embedded into functional domains causes a significant problem to the supply chain manager.

In a company ecosystem the supply chain manager is seen as an operational expert. He is tasked with duties and objectives primarily aimed at controlling and reducing costs, while optimizing the material flows. In his duties, the supply chain manager usually has opposing targets and objectives to sales and marketing managers, which can cause tensions.

While sales and marketing tend to privilege customer satisfaction by offering new solutions to be delivered in quick turnarounds at almost no cost, the supply chain manager has to make ends meet between time-to-delivery and cost-to-serve. In his continuous effort to keep inventory levels low to contain costs, the supply chain manager becomes ‘the problem’ to the eyes of sales and marketing executives.

Moreover, it is an uncomfortable role to say no to the Board ‘stars’. That is, those who are the usual candidates for future Board-level positions. Cost-saving efficiencies are not the major process benefits that stimulate the interest of C-level executives either, especially CEOs and CFOs. It is, rather, the prospect of gaining a complete and unified perspective of all the financial and business activities, even those that take place outside the borders of the company.

In such a context, the supply chain manager has one way to elevate his position in the organisational hierarchy. He must communicate the results of his work and the impact of his decisions in the language of business. The language aligned with the one spoken by company decision makers. That is, the language of finance.

Linking financial decisions to supply chain performance

Since CEOs and CFOs will increasingly want to evaluate supply chain initiatives against financial performance indicators, supply chain managers must identify the key measures that will track progress against the strategic company objectives. This will enable a business case to be made for new projects and allow the performance of these projects to be quantified after implementation. Intangible benefits and those that are hard to measure (such as increased customer satisfaction and stronger relationships with suppliers) must be properly categorized as supporting justification to the tangible benefits.

There are two key metrics that business leaders focus on when measuring financial performance: profit and return on invested capital (i.e., asset turnover). These metrics form the basis for a concept known as economic value added or EVA (which is a registered trademark of Stern Stewart & Co.).

Although EVA can be used to formally measure financial performance in various operating units of a corporation, the calculations are complex and they are not widely used outside of large organisations. Nevertheless, the principles behind EVA are actually quite simple, and it is useful to apply these principles in evaluating the impact of a proposed investment.

Simply put, EVA is calculated by taking net operating income and subtracting a charge for the capital used to produce that income. Therefore, EVA can be improved by generating more income with the same capital (e.g. inventory, accounts receivable, cash, plants, equipment), or by producing the same level of income using fewer capital resources – or both.

Most often organisations use a graphical representation of the ‘EVA Tree’ (see graph on pg xx). The ‘leaves’ of the tree at the far right are the principal financial elements that contribute to the overall calculated value of the EVA figure (far left in the chart).

The importance of this framework is that while the breakdown of decision-level performance indicators into lower levels (that is, moving on the chart from left to right) is somehow accomplishable, the opposite bottom-up (i.e., from right to left) is not.

As an example, a typical performance target from the decision-level is to reduce the cost of capital by a certain amount. With some effort this high-level objective can be broken down into more managerial and operational performance targets (i.e. inventory, accounts receivable (A/R) or accounts payable (A/P)). But to measure how much value a single operational task contributes to the higher level performance indicator is not trivial. What would be, for instance, the impact on cost of capital (lower branch of the EVA tree) of an improvement in sales forecast accuracy? This figure certainly has a positive effect on accounts payable –as a matter of fact, an improved forecast in sales helps build and send a more reliable forecast to suppliers. Hence, suppliers’ relationships are improved and better negotiation terms can be agreed, which positively affect A/P. However, how much benefit this brings to the higher-level cost of capital parent figure is still undetermined.

And this is what appears to be one of the major issues for the supply chain manager. He has very little room of manoeuvre to explain in ‘the language of finance’ the business benefits derived from having implemented with his team a project that improves the accuracy of sales forecast. Maintaining their traditional perspective of the supply chain manager as a ‘cost controller’, C-level executives will miss the big picture by just concentrating on whether costs have been reduced.

Although the EVA tree is a good start for the supply chain manager, in practice it isn’t helpful for operational staff. The manager needs to know what processes, and what tasks within each process, his team should better execute to accomplish the business result set by the decision level. As an example, should A/P be the business target set by corporate executives, are the activities currently performed the ones that, more than others, strongly impact this indicator? And, once the activities are defined, what are the metrics that will tell if the results are going in the right direction?

The supply chain manager needs a set of processes and tasks that can be measured with operational metrics and, at the same time, be mapped to financial indicators.

The SCOR model metrics

A solution comes from the SCOR model of the Supply Chain Council. The SCOR process reference model is a common framework and an operating communication standard for the sharing of best practices in supply chain management. The model sets an industry standard to model supply chain processes, apply the proper metrics, and identify best practices that resolve problems identified during the modeling and measurement phases.

The metrics of the SCOR model are structured in a hierarchy, going from high level down to more operational. The commonly used high-level (or level one) metrics are perfect order fulfillment; order fulfillment cycle time; supply chain management costs; cost of goods sold; cash-to-cash cycle time; return on supply chain fixed Assets.

Each of these level one metrics is broken down into level two and level three – the more operational – components. The relevant contribution of the SCOR metrics is that they have an impact on financial performance indicators in the income statement and balance sheet.

The graphical representation of this qualitative correlation is shown in the chart (see page xx), which is an excerpt from the SCOR metrics impact table. The ‘?’ and ‘?‘ values in the cells relate to the effect each metric has on the corresponding financial item, while an empty cell indicates that no correlation has been found. Currently this is simply a qualitative correlation showing a positive or negative impact; defining a numerical correlation factor is part of ongoing research.

This allows the supply chain manager to link these SCOR operational performance metrics to the ‘leaves’ of the EVA tree (which are, by all means, components of the balance sheet P&L statements) and build a solid correlation with financial performance indicators.

In addition to this, the SCOR model provides a predetermined association of the SCOR metrics with supply chain management process elements (i.e., tasks). This means that the supply chain manager can identify those operational metrics that impact financial results and recognise and select the areas of supply chain management operations (e.g., planning, sourcing and purchasing, manufacturing, delivering and distributing, returning) that must be addressed and improved in order to achieve the desired business results.

Conclusions

In the current complex and dynamic business environment it is paramount that each company department proves how well it is contributing to the overall corporate business value. Supply chain makes no difference, with the additional constraint that supply chain managers have been traditionally seen as focused only on the cost side of the profit-and-loss equation. To speak the corporate language, which is the financial language, supply chain managers must extend their knowledge in the areas of finance and accounting.

The role of corporate finance is to connect the investor mandate with operations. The supply chain manager will hence identify those operation processes that impact the results of the financial mandate.

We do not expect any ‘silver bullet’ or sophisticated mathematical algorithms to draw the correlation links between financial decisions and supply chain performance metrics. The Supply Chain Council community proves that common performance standards can be based on consensus and peer review.

Just like the correlation of the elements that compose a balance sheet or an income statement are not driven by scientific evidence and rigor but by ‘general accepted accounting principles’ (GAAP), we envision a similar GAAP-based chart of accounts for supply chain management.

Enrico Camerinelli is Chief Analyst and European Director of the Supply-Chain Council (SCC), a global, not-for-profit trade association open to all types of organisations interested in improving supply chain processes. It sponsors and supports education and training programs, including conferences, workshops, retreats, benchmarking studies and development of the Supply-Chain Operations Reference model (SCOR is a registered mark from the Supply Chain Council).

Chart 1. A graphical representation of the EVA tree.

Chart 2. An excerpt from the SCOR metrics impact table, showing the correlation between SCOR metrics and the balance sheet.