For some months now, I have been discussing how best to measure the value-add of the supply chain with Lora Cecere and Abby Mayer at Supply Chain Insights. Abby has started the Supply Chain Index blog and Lora’s latest blog is titled “What I have learned about supply chain excellence”. In other words they are on a mission, one in which I believe. I encourage you to read up on what they are doing.
For this discussion I will borrow the following diagram and some text from Lora’s blog. Lora calls the yellow half-moon at the top of the diagram the “effective frontier” and states that:
… the best companies propel themselves forward with a clear understanding of supply chain strategy, a well-defined multi-year roadmap, and an unobstructed view of how to make trade-offs on the supply chain effective frontier shown in Figure [above]. … they understand that the most effective supply chain balances the trade-offs of growth, revenue and costs while managing working capital, corporate social responsibility and asset strategies. These trade-offs are made based on the corporate strategy. Companies that shine and are good at delivering value through their supply chains focus on the trade-offs at the top of Figure [above].
This is in contrast with companies that are laggards and only look at the waste, or the symptoms of poor performance at the bottom of this figure.
I agree with Lora and see this as a matter of maturity. The issue is the disconnect between Operations and Finance, but principally it is an issue of a silo mentality. The more mature companies understand the interplay, or trade-offs as Lora calls them, between financial performance and operational performance, whereas the less mature Supply Chain functions focus on operational performance only. The very least mature companies don’t even have a supply chain focus and instead each function – Sales, Distribution, Manufacturing, Procurement, … – focus only on metrics specific to that function. This isn’t and ‘either/or’ discussion, it is an ‘and’ discussion. The most mature companies focus on all levels:
- the higher level metrics that combine financial and operational performance
- the cross-functional supply chain metrics
- the functional metrics
Before everyone thinks I am beating up the Operations people for always being in the weeds, let me be clear that it is equally bad if the Finance people only have their heads in the clouds. There is just as much of an issue of Finance people not understanding how Operations affects the financial metrics as there is of Operations people not understanding how Finance affects the operational metrics. To be truly effective we need both groups to develop an understanding of the other and to work together. Senior executives control the business and set strategy in Financial terms. It is very important for Operations people to understand these terms so that they can translate the corporate strategy in an operations business strategy.
As an example of the importance of alignment of terms and therefore understanding, about a month back I had a discussion with a prospect about how best to measure supply chain effectiveness. I did not have a diagram such as Lora’s and I started by discussing some of the lower level metrics, specifically Gross Margin, which was a mistake. This prospect was sophisticated enough to focus on Working Capital. Before I go on to being critical of Working Capital as a metric, let me be clear that I applaud this company for its level of maturity in measuring supply chain effectiveness. Far too few companies are at this level. I was winding up to a description of more sophisticated measurements, but I should have started from aspirations rather than reality, in other words from the top of the diagram and worked my way down. My issue with Working Capital is that it is more about efficiency than it is about effectiveness. It is too inside-out and too little outside-in. All too often when we hear Working Capital in reference to the supply chain we hear it in conjunction with ‘reducing’. In other words, with Working Capital there is too much emphasis on operating the supply chain leanly rather than understanding the trade-offs between capital requirements and sustainable profitability. Lora has it correct that sustainable profitability must be the ultimate goal of a company and therefore of Supply Chain specifically, and Operations more generally. (I’ll come back to this distinction between Supply Chain and Operations in a minute.) My take is that there are a lot of Treasury aspects of running a company – borrowing, financial investment, etc. – over which Supply Chain and Operations truly do not have any control, and therefore should not be considered when evaluating supply chain effectiveness. Where this matters is in our definition of profitability. I’m in favor of using Operating Income rather than EBIT or Net Income. First of all, this allows for better comparison of metrics across tax regions as well as eliminates the financing aspects. (But even as I write this I know that many decision are made in Pharmaceutical supply chains, for example, that are based upon favorable tax considerations.)
A quibble I have with Lora’s diagram above in this regard is that there is no mention of Cash Flow, which I think is the best metric to measure medium term supply chain effectiveness, rather than Working Capital. A more detailed representation of Cash Flow is the Cash-to-Cash Cycle, which I love as a metric for Supply Chain. In a recent comment in Supply Chain Digest, David Schneider, sitting in for a vacationing Dan Gilmore, makes some interesting points about Operating Cash Flow (OCF). Dave states that
I find that after that, many supply chain tacticians just don’t get it. They are basic operators, running floor operations or transportation operations. Their focus is on local optics and optima – how to improve productivity in the four walls of their warehouse, or how to get that extra dime a mile out of the trucker. These people trip over strategy like a root growing in the middle of the path as they look for the next measure of execution effectiveness.
Obviously Dave is expressing many of the same points I made earlier about measurement maturity and the difference between efficiency and effectiveness. He goes on to state that
Supply chain management affects both the income statement and the balance sheet. The combination shows up on the Cash Flow Statement. The resulting costs of the operations and the working capital invested in inventory are hard to see on the income statement or the balance sheet. The operations costs appear on the income statement while the inventory asset appears on the balance sheet. … OCF [Operating Cash Flow] … forces a supply chain, within the constraints of company strategies, to manage tradeoffs and focus its efforts in a way that generates the maximum amount of cash for the company.
Why I like Cash-To-Cash Cycle (C2C) as metric is that it adds ‘velocity’ to the concept of OCF, while also combining aspects of Working Capital. C2C measures how quickly cash invested in supply is converted into cash from sales and how much working capital is invested in inventory. C2C is calculated as Days of Sales Outstanding (DSO) + Days of Inventory (DOI) – Days of Purchasing Outstanding (DPO). When I talk to many supply chain practitioners they balk at using C2C as a metric because the only element of C2C over which they have direct control is Days of Inventory. Well, yes, but shouldn’t they be running the supply chain in a manner consistent with the corporate objectives for DSO and DPO? Besides which, DSO and DPO can be manipulated, legitimately I must add, to reduce DOI. For example, many agricultural equipment manufactures stuff their sales channels with inventory during the winter anticipating strong sales in spring. But many companies reflect the finished goods inventory sitting in the dealerships in DSO, not in DOI. They have transferred the ownership of the inventory to the dealers on delivery and extend long payment terms. This practice is based upon the fact that the sale of agricultural equipment is very seasonal and the investment required to build factories that could meet peak seasonal demand is untenable. The point is that if Supply Chain only takes DOI into consideration it may appear that they are doing really well, when in fact the company has an enormous liability in finished goods inventory sitting at the dealers. Similarly, DPO can be used to obscure the fact that a company has a lot of raw material inventory. Only by combining the three elements of DSO, DOI, and DPO can we get a clear picture of how quickly a company is converting cash invested in purchases into cash received from sales.
Coming back to the distinction between Supply Chain and Operations, I want to bring in Gartner’s Top 25 list which they have published for past 10+ years. While there is much that we can criticize in Gartner’s methodology, a fundamental point is that Gartner tries to balance sustainable profitability with supply chain effectiveness. Moving the mouse over the figure below on the Gartner web site brings up call-outs that relate the different operations aspects of Supply, Product, Demand, and Information to the Gartner maturity model levels of React, Anticipate, Coordinate, Orchestrate. It is the balance across several aspects of Operations that I find to be compelling in Gartner’s approach.
While I do not quite agree with Gartner that revenue growth is a perfect measure of sustainable profit, the key point is that Gartner is bringing in more functions than purely Supply Chain, particularly Product, to capture innovation, as well as information to capture process innovation. Lora uses Profitable Growth instead of Revenue Growth. In other words, if all you focus on is efficiency by reducing Working Capital requirements you may be starving innovation and therefore future revenue. It is the trade-offs – there’s that word again – between investing in the company through effective Operations, not just Supply Chain, that drives sustainable profitability. As a quick side note, investing in product innovation is not a guarantee of sustainable profitability, but not investing in product innovation is a sure way to go out of business. It is for this reason that I prefer to look at Free Cash Flow (FCF) because it includes how much a company is investing in capital equipment, which is an indirect measure of how much they are investing in process innovation, which itself is a driver of productivity gains, another important metric for measuring supply chain effectiveness. Nearly anyone can make a company profitable in the short term by reducing investment in innovation, which is why I prefer FCF over OCF as the metric to use for measuring sustainable supply chain effectiveness. It is truly a measure of how much cash is generated by a company.
If a company does not invest in product and process innovation it won’t show sustained profitability over the medium and long term. It is aligning all aspects of Operations that truly drives growth in Operating Income. But in today’s outsourced environments so much of Operations is outside the four walls of a company, which is why an outside-in approach is so important. Alignment of all of the Operations functions to satisfying the financial objectives set by senior executives is crucial to sustained profitability. Orchestrating the achievement of the company’s financial objectives through an operating strategy and managing the visibility, agility, and alignment across functional and organizational boundaries is where Operations Control Towers come into play. I’ll be writing more about Operations Control Towers over the next few weeks.
In closing, as I have commented previously in a blog titled “Real Option Analysis is relevant to Supply Chains too”, I am really encouraged by the increasingly sophisticated manner in which we are measuring our supply chain effectiveness, exemplified by the prospect who challenged me on Gross Margin. So let me know about your journey in financial understanding, perhaps even your company’s journey, and what the next steps will be. If you think I am blowing smoke, tell me why.
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Posted in Control tower, Control Tower Concepts, Sales and operations planning (S&OP), Supply chain management
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