A Non-traditional View of Operational Costs

Going beyond traditional financial metrics to measure supply chains

Traditional financial metrics contained in the profit-and-loss (P&L) statement of any company are key indicators of that company's health, but they do little to identify specific performance gaps relative to competitors, especially from a supply chain standpoint.

Management is missing out on the complete picture by looking only at measurements such as cost of goods sold (COGS) or selling, general and administrative (SG&A) expenses and not taking a supply chain view of performance.

Example

Consider a global pharmaceutical company that closely monitored traditional financial metrics such as COGS and SG&A in comparison to competition. These numbers indicated that all was well and the company was competitive even though a serious inventory problem was developing. In their struggle to improve delivery performance and control inventories, their existing metrics were insufficient.

The answer is that it can be helpful to go outside traditional costs to understand the root cause of operational problems or develop a competitive edge. To gain a deeper perspective on the P&L and how it compared to competitors, the pharmaceutical company decided to examine the cost of managing its supply chain based on a metric defined by the Supply-Chain Council, called Total Supply Chain Management Cost.

The Supply-Chain Council is a non-profit, cross-industry organization that endorses and maintains the Supply Chain Operations Reference (SCOR) model. This particular metric measures the cost of managing source, deliver, return and plan, and typically includes the following: cost of the procurement organization, the cost of all levels of planning, the supply chain portion of IT, inventory carrying costs, freight and distribution costs, and order management costs. These are the costs associated with managing a supply chain.

The methodology is straightforward: (1) collect and itemize each cost within the organization; (2) gather competitive benchmark data for comparison; and, (3) calculate and analyze the performance gap to determine opportunities for improvement.

Collecting Costs

The Supply-Chain Council's definition of each cost has just been updated on version 7.0 of the model (see Figure 1: Definitions for Total Supply Chain Management Cost). There are a number of considerations when determining which costs come into play within each component.

Figure 1: Definitions for Total Supply Chain Management Cost

Procurement
This is usually a straightforward expense because it is often captured within a single cost center. It's important to remember that there may be both local or factory organizations as well as strategic sourcing function at the company level. The key question to ask: If I did not have any procurement activities, what costs could I eliminate?

Planning
There are a variety of planning roles to consider, such as annual supply chain planning, plus lower-level planning like distribution, manufacturing, sales and operations, and materials. This lower-level planning makes collecting costs tricky, since those who occupy full-time planning positions are usually scattered throughout the organization.

It's easier to start with a list of planning activities by considering the meetings, report and ongoing activities associated with planning on a daily basis in order to account for all the labor costs. The idea is to determine full-time equivalent employees and apply a standard burden rate to that headcount. The organization's finance or human resource director can estimate an average cost for salary and benefits to apply to the estimated headcount.

Supply Chain IT
It's best to start with the IT professionals in the organization to determine what portion of the total IT budget supports supply chain costs. Usually, any systems activity related to procurement, planning, inventory management and control, distribution, and order management is appropriate. A breakdown of IT costs should include both hardware and software and related maintenance costs.

Supply chain costs will, most likely, be everything but engineering, quality and human resources systems. If a reasonable estimate cannot be made, another approach is to estimate a ratio of supply chain related IT costs based on headcount of supply chain personnel relative to total headcount. Counting supply chain PCs versus total PCs is another potential ratio to consider.

Inventory Carrying Costs
These cover five broad areas:
1. Insurance and taxes on inventory. These costs can usually be provided by the finance of legal department.
2. Storage costs. This includes the full cost of warehouse buildings, off-site rented space and any other storage space (including portions of the factory floor); a portion of the maintenance cost per square foot of storage space; and all employees who handle, move and count the stored goods. By reducing factory floor or warehouse storage space, costs can be realized by eliminating rented properties or avoiding new construction.
3. Obsolescence and deterioration costs. This happens when materials are scrapped or written off due to shelf-life issues.
4. Shrinkage. This can be caused by pilfering, incorrect inventory counts and unreported use of materials. It can usually be determined by taking net inventory adjustments from annual physical inventory counts or ongoing cycle counts.
5. Cost of money based on the investment value of the money tied up in inventory. This is a fairly straightforward calculation for the finance department.

Freight and Distribution Costs
These include the cost of finished goods warehouses (don't double count this with inventory carrying cost). Freight falls into three categories:
1. Incoming materials freight if this cost is included in the cost of the materials, it should be estimated
2. Internal freight the cost to move materials within the company from building-to-building, plant-to-plant or site-to-site
3. Outgoing freight costs from the manufacturing location to distribution warehouses and/or the customer.

Order Management Costs
These encompass all the costs involved in taking orders from customers and usually include the customer service organization.

Analyzing Performance Gaps


After a few weeks of collecting and analyzing data, the following performance issues were revealed:

To compare the pharmaceutical company's Total Supply Chain Management Cost against its competition, benchmark data was found through publicly available data, including annual reports, benchmarking services and professional organizations in the pharmaceutical industry.

After six weeks of this global company collecting and analyzing both sets of data, the following performance issues were revealed:

  • Overall, supply chain management costs were significantly above industry averages. However, IT spending was less than industry average. This suggested that more costly manual processes were being used in place of IT functionality. This idea was reinforced by the high number of people involved in order management (a cost that also was well above average). With proper IT systems, fewer people would be needed to take and manage orders.

  • Another unexpected discovery was inventory carrying costs. A detailed determination of these costs indicated they were higher than the figures in use by the finance department. Using an understated carrying cost resulted in an incorrect assessment of the cost of carrying more inventory.

  • An examination of outgoing freight costs revealed very high spending on airfreight. The disconnect came in the fact that though investment was being made in quick delivery, the distribution system still carried high levels of inventory. The company was taking full advantage of the rapid delivery in which it was investing.

The Value of Metrics

Total supply chain management cost as a key metric can provide a non-traditional view of operational costs and reveal performance gaps and opportunities for improvement that may not otherwise be obvious. Structuring metrics from a supply chain viewpoint is the customer-focused way to examine operations since the customer is one end of a supply chain.

Before companies dig into the details of the performance gap, the first question to answer is, Is my overall supply chain management cost in line, high or low? If it's high then an opportunity to improve competitiveness has been identified and a performance gap has been quantified. If it's low then it may represent a previously unknown competitive advantage.

Even if the costs are in line with the industry, there's an opportunity to examine these individual costs to determine if they represent the best balance between manual and automated processes.

Another way to find opportunity is to look at each cost gap and ask, Why am I low in this cost? Is that necessarily a good thing? How is this potentially impacting my level of on-time delivery and customer satisfaction?

The pharmaceutical company's managers planning and other deficiencies led them to fix one metric at the expense of another. Once they recognized this, they took a more holistic approach and identified improvement opportunities that wouldn't penalize any one area it its business.

Improve the Supply Chain

Companies may want to consider initiating a full supply chain optimization project to determine why they are out of alignment in these costs and where best practices should be applied. This can be done in a single area, such as procurement, or a broader approach to span an entire supply chain.

The Total Supply Chain Management Cost metric results may provide the rationale to convince upper management that a full examination would identify gaps with the most revenue potential. The Supply-Chain Council's SCOR model allows companies to examine and measure their supply chain processes, determine where weak links exist and identify how to make improvements. This approach can provide a comprehensive view of supply chain operations and includes a way to examine material flow and work and information flow to determine performance gaps for improvement.

Traditional financial metrics are critical to understanding business performance, but they may not provide enough direction when it comes to identifying improvement opportunities and competitive performance gaps. A metric such as total supply chain management cost can help solve this problem.

About the Author: Dan Swartwood is a senior consultant with PRAGMATEK Consulting Group in Minnesota. He may be reached at dan.swartwood@pragmatek.com.

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