Thursday, January 22, 2009

A Framework for Measuring Supply Chain Costs

In defining the long term trends in the environment that will impact supply chain strategies, I talked about two main changes happening in the environment. One was the costs and redistribution of costs/incomes; and second was environmental consciousness.

Let us explore what constitutes the supply chain costs and the specific processes that impact these costs. Some of the supply chain costs are crisply defined, readily available, and widely used in the industry. Others are less well known, and tend to get lost in the heaps of corporate data. However evaluating supply chain costs requires that we understand them, invest in defining them as clearly as possible, have processes to capture, report, and analyze them. Only such a complete picture of supply chain costs can truly drive new initiatives, find gaps in existing processes, and help in continually improving the cost and efficiency of the supply chain operations.

To clearly understand the impact of supply chain costs, corporations need to develop a "cost framework" to define, develop, and measure these costs. The discussions below helps in understanding what such a framework should look like, the scope of such costs, and how they affect the total supply chain costs for an enterprise.

To understand the scope of these costs, we will organize them into three categories as in the picture below. Grouping these costs into these categories will not only help us understand the source of these costs, but also provide an understanding of how to measure them and how to optimize them to make the supply chain more efficient and cost effective. In doing so, though one must use caution, as a single minded focus on cost alone may not be the most optimal supply chain strategy. Since supply chains must address the twin objectives of cost and flexibility (or responsiveness), supply chain performance must be measured using metrics that allow capturing both of these aspects. However, in the current discussion, we will focus on the cost aspects alone, and leave the flexibility for another day.

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Direct Costs

These are the direct costs of merchandise, and services. These are easy to capture, understand, and report. Examples of these costs are the cost of merchandise (purchase orders), cost of freight (load tenders), cost of warehousing services (3PL warehousing costs), and so on. As most of these costs are captured through standard enterprise transactions like purchase orders, or load tenders, they are easy to capture and measure at the corporate level. The complexity arises when there is a requirement to allocate these costs across organizational entities such as product groups, or regions, etc. Such cost allocation is not unusual, and helps in establishing profitability of separate business groups, merchandise portfolios and so on. Though a well thought out accounting structure should be able to support such allocations objectively.

Spend Analysis directly focuses on this aspect of the supply chain costs. Consolidating all direct spend costs across the enterprise, helps in understanding the total spend layout with the vendors and service providers, and allow the enterprises to negotiate better deals and volume discounts.

  • Consolidate all spend by merchandise category, vendor, and service providers. Look for volume discounts, and negotiate on other costs such as credit terms, returns, quality, etc.
  • Analyze the merchandise demand, establish long term contracts for merchandise with stable and predictable demand. Implement software systems for bid evaluation and purchase planning when multiple suppliers are viable.
  • Evaluate possibility of using traditional and reverse auctions for one time and/or seasonal purchases where product attributes allow for such purchasing strategies.
  • Implement transportation optimization systems to directly impact the freight costs from the cost equation.
  • Evaluate all service provider contracts with transaction based fee and analyze historical usage for possible reductions by converting these transaction-fee contracts to fixed-fee contracts.

Process Costs

Process costs relate to the organizational teams that directly support supply chain processes. These processes may provide critical supply chain decisions to support operations, and support compliance requirements for regulatory purposes. Examples of such processes are demand management (forecasting, inventory planning, and replenishment teams), supply management (purchasing, expediting teams), logistics (shipment planners, load & route planners, and dispatchers), and global trade teams supporting imports and exports. These are direct personnel costs and can be impacted positively by improving process efficiency that leads to smaller teams handling the same volume of transactions. Such efficiency improvements can be a result of process automation, processes simplification, or process elimination.

  • Evaluate if the process can be automated through a system, completely or partly. Most IT applications provide automation for the transaction processing, some do so for the planning processes as well. Supply chain planning solutions routinely provide optimization based algorithms that can provide decision support for complex situations, such as determining optimal inventory levels at various locations. Such systems make processes efficient, as well as more effective by handling large amounts of data and computations that are otherwise impossible to be processed manually. They also allow more frequent reviews of supply chain policy parameters (such as inventory levels, flow-paths, seasonal inventory management, forecasting parameters, etc.) to keep them aligned with the changing demand and supply scenarios.
  • Evaluate if the process steps can be simplified, or eliminated. For example, consider whether all purchase orders need managerial approvals, or is there is a possibility that purchases within defined constraints (purchase value, vendor status, resulting inventory level etc.) can be made without such approval. Evaluate processes where all transactions are currently reviewed manually, and consider defining transaction profiles so that the system can identify exceptions for manual review while automatically processing the rest. Replenishment planning, purchasing, load tenders are all examples of processes where exception based management can be effectively implemented and manual effort can be reduced.

Technology Costs

The last category of supply chain costs are technology costs. Some examples of these costs include the software & hardware costs of deploying supply chain systems at the corporate office, dimensioning system & RF handheld units at the warehouse, and the geo-location tracking units on the trucks. The technology enables faster processing time for planning, near real-time execution, continuous visibility of inventory and operations from end-to-end, and enables decision support systems that leverage complex mathematical models to provide optimal results. But all the technology adds its own cost to the supply chain. As technology continues to play ever bigger part in supply chains, managing technology costs becomes more important. This is a difficult area as it straddles the business and IT groups, and requires that both collaborate closely to measure, contain, and evolve a technology strategy that allows for a cost-aware technology evolution with flexible supply chain solutions. This is easier said than done, however, these costs must be measured before they can be contained.

  • Establish an existing and to-be technology roadmap for supply chain. Create a checklist of business best practices and establish the gaps in current technology, prioritize new technology, and plan a purposeful adoption rather than an ad-hoc reactive evolution.
  • Establish costs of all technical resources, software, hardware and people. Establish maintenance and projected upgrade expenses. Clearly identify what the technology costs, and what it provides in return.
  • Evaluate technology diversity -- while diversity in general is good, it may not be so in technology. Too many technologies quickly become expensive to maintain due to specialized skill requirements, hardware requirements, and annual maintenance fees. Consolidate common standards for technology stacks across applications, adopt SOA architecture for custom developed applications, evaluate annual license renewals for continued need, consolidate hardware vendors, virtualize, have consistent application & technology architecture, have business readiness plans in place through backups & disaster recovery. Empower enterprise architecture.
  • Measure, question, evaluate, evolve!

Most corporations do not have a consolidated view of costs of their supply chains. This constraints their ability to accurately identify opportunities and problem areas, prioritize supply chain investments, and constrains their ability to execute simple profitability analysis accurately. Creating a broad cost view of the supply chain requires careful analysis, planning, and processes to gather data, however, it allows for quickly analyzing the impact of changes, even predict such changes, and manage an ever-evolving supply chain for the optimal corporate efficiency.

© 2009, Vivek Sehgal, All Rights Reserved

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