What’s Ailing Supply Chains?

The supply chain and logistics discipline started during World War II when armies needed to be supplied across multiple global theaters starting from Northern Africa to Europe to small Pacific islands.  A complex planning and coordination effort at a time when there were no computers and the internet. The ability of military planners to achieve this feat caught the eye of the commercial industry.  At the end of the war, they hired the experienced veterans to run their supply chains that had begun to span the globe.  Now, let’s move forward to the present times when we have computers, the internet, and real time information systems.  One would expect to see further great strides in supply chain management.  Unfortunately, United States Government Accountability Office (GAO) has been highlighting for the last several years that “Department of Defense supply chain management as a high-risk area due in part to ineffective and inefficient inventory-management practices”.  We are talking about hundreds of billions of dollars in excess inventory with huge back orders.  Plainly stated, the Government has too much inventory that it doesn’t need and too little the things it requires to fight war resulting in several billion dollars of losses to taxpayers every year.  More significantly, it compromises military readiness.

Is this problem unique to the Government?  No. Any big corporation, whether retail, automobile, oil & gas, consumer goods, health care and any other manufacturing industry will tell you that they experience precisely the same trouble.  They have a huge inventory of things their customers are not buying and back order of things that are selling.  The problem is very acute.  It’s estimated to take Gap, Inc. 9 to 12 months for their new designs to reach the market.  Imagine trying to predict fashion trends in advance, and then start the process of procuring fabric and making clothes globally to supply markets. On the other hand, Zara claims it takes them 10 to 15 days to get product from the design stage to stores.  They have designed a highly responsive and demand driven supply chain that they credit for their success.

Before we discuss the root causes behind supply chain problems, let’s understand what drives supply chain performance.

 What drives supply chain performance?

Simply put a supply chain the process of taking material from suppliers through manufacturing or conversion process and distributing to end users or customers.  Below is a simple pictorial that explains the process.  It would, of course, vary from industry to industry and depending on the scale of operations can get very complex.

Supply Chain

There is one simple metric to understand supply chain performance  – Total System Cost (the impact of customer service is built in as out of stock or missed opportunity cost).  The objective of the supply chain is to minimize the Total System Cost or maximize profit.  The costs are lower at the supplier end and builds up quickly as you get closer to end users or customers.  Depending on the industry, sales cost can range from 20% to 50% of the total system cost.  For some industry, the total system cost may go beyond their four walls and may include inventory being held by dealers or wholesalers (depending on how much liability and influence a company has in the inventory) to provide an overall perspective of the supply chain.

Supply Chain Cost Drivers ver2.jpg

What are the key challenges with supply chain?

  1. Hidden cost: Due to General Ledger structure in many companies, costs gets allocated to different functions that fail to provide an overall picture to management for decision making.  Some of the costs such as missing sales never show up in GL.  In our experience, among all the cost buckets sales cost is typically computed erroneously as the opportunity cost of missed sales and inventory costs are not well understood.  Inventory cost includes the cost of carrying the inventory, warehousing, obsolescence, pilferage and other costs.  Similarly, missed sales cost should include both the lost margin and the impact of lost advertising, after sales revenue and potential long term impact of losing customers to the competition.  Without proper computation of cost, management may make decisions that are not financially sound.  Sometimes decisions are made to hold more inventories or run longer batch sizes without really understanding its impact on the total system cost.
  2. Silo decision making: The supply chain gets broken into different organizations within any company.  The sourcing organization manages material cost whereas manufacturing organization is responsible for the conversion.  Most managers tend to make a decision that optimizes metrics they are accountable for, without understanding interdependencies and impact on other parts of the company.  For example, manufacturing organizations may like to increase the batch size to improve throughput without fully taking into account inventory and obsolescence costs upstream.
  3. Archaic planning and business processes: Most companies and governmental agencies have implemented ERP systems.  Financial transparency and control are the primary focus.  The business processes for most other functions have been ported from pre-ERP days to ERP without fully utilizing the capabilities of the new system.  So, the new system instead of being helpful works as a roadblock to achieving business results.  To our surprise, we have found many supply chain planners use Excel and other point solutions to plan their dispatch instead of utilizing the capabilities of the ERP system.
  4. Increasing complexity: Supply chains are becoming more complex.  The trend of globalization has extended supply chain to its limits.  It’s common now for products to be manufactured in China, assembled in another country and sold in a third country.  The lead times have become longer which directly impacts system inventory.  Also, products have proliferated due to the desire of companies to mass customize.  One has just to step into a grocery store to see how many different varieties are available for simple things such as salt or yogurt.  Product proliferation significantly increases cost all through the system – more products have to be manufactured, they have to be held in inventory and higher potential for going out of stock.
  5. The cost impact of service levels not well understood: Sales organizations may not be fully aware of the financial impact of service levels and in their desire to do better than competition makes service level commitments that could break the bank and the supply chain.  At a large telecom company, the sales team was making promises of delivery of equipment to large corporations with unrealistic lead time resulting in significant penalties.  This practice is quite common across industries.
  6. Data analysis not leveraged: ERP system provides real time point of sale and supply chain performance data.  Most companies don’t have the capability to analyze this information on a monthly or quarterly basis let alone in real time.  There is a trove of valuable information available that can be used for better decision making.

What can companies do?

  1. Get total system cost: Finance organizations can put together a by and a large picture of system cost that could significantly help in making informed supply chain decisions. The trickiest part is to estimate the sales cost as there are no agreed norms for estimating inventory and missed opportunity cost.  With some basic principles agreed (such as inventory cost as 15% to 20% of inventory value), these could be estimated consistently across product lines or geography.
  2. Ensure business goals drive organization metrics: It’s important to rethink functional metrics tied to overall organization goals to avoid silo decision making.  For example, for high margin companies, manufacturing throughput is not as important as responsiveness to back orders.  If plants are not able to meet their orders in a timely fashion, then sales cost will increase significantly.  Similarly, if suppliers are unable to provide quality products, it would result in rejection during manufacturing or recall at a later date.  In that case, it doesn’t make sense for the sourcing organization to save money by focusing on these suppliers.  There is a need to understand interdependencies better to reduce total system cost.
  3. Move to demand based planning where feasible: Due to ERP and point of sale technologies, demand data are now readily available and can be used to plan for shipment.  But many companies and government agencies spend enormous time and money trying to forecast customer demand and use it in shipment planning.  Which one you think is more accurate, actual demand data or forecast based on historical data?  Demand based planning has shown to reduce inventory, complexity, and cost while increasing quality.  Procter & Gamble in India implemented demand based planning which reduced total delivered cost from 75% of sales to 55% of sales, reduced system inventory from 115 days to 60 days, perfect order (right quantity, right time, right billing) from 40% to 90% and improved quality (PPM) from 30,000 to 5,000. Then, why demand based planning is not popular?  Well, it requires significant change management.  For example, you need the discipline of not shipping or producing more than what is being demanded by end users.  This is tricky when you are dealing with organizational silos and old ways of cost accounting.
  4. Manage complexity: We can’t change the trend towards increasing complexity – globalization and product proliferation are likely to continue.  Apple launched iPhone with one model; now it comes in so many different sizes and colors.  A better way is to think about how best to manage complexity with supply chain design.  Most companies have one size fits all supply chain for all types of products, whether the demand patterns are regular or random.  A product that has regular demand, it would be logical to have a streamlined manufacturing and supply chain.  Think of it as an assembly line production.  However, a product that has unpredictable demand (for example, cosmetics) an assembly line production will not be appropriate and would require much more flexible manufacturing and supply chain.  These turns of the supply chain by demand pattern have shown to reduce sales cost by reducing out of stock and inventory.
  5. Ensure sales team understands the cost implication of service levels: Most companies don’t have a good way of evaluating the financial impact of different service levels.  A modeling exercise could provide insights into the cost involved.  Agreeing with the principle of rationalizing service level based on some customer profitability metric is helpful and provides guidance on the sales team on what they can promise to customers.
  6. Use data to identify improvement areas: Data analytics can not only provide timely reporting but also help in modeling and simulation exercises.  For example,  many companies assume their network design is fixed.  However, data analytics can provide insights into how best to optimize and tweak the network as market demand changes due to seasonality or changes in consumer preference.

Supply chains can provide significant competitive advantage to companies.  However, increasing complexity (globalization, product proliferation, etc.) is overwhelming it.  Getting total system cost to drive design and improving business processes can fix the underlying ailments.  Processes such as demand based planning, tiering of supply chain based on demand pattern, and rationalizing service levels based on customer profitability have shown to improve supply chain performance.

About Author: Suman is a Partner with Three S Consulting. The firm drives value for clients through Strategy, Supply Chain, and Sourcing.

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