[From iSource Business, December 2002/January 2003] In the late 1990s, the value of many types of technology seemed to be intuitively accepted. When asked how the investment in the technology was justified, IT and supply managers frequently said it was necessary to use the latest technology in order to remain competitive. Managers implied that it was mandatory to use the latest technology in order for a company to be considered progressive, and thorough cost justification was frequently overlooked. But this mindset has since changed because of general economic retrenchment and the serious questions that have been posed about technology.
A challenge is now inherent with any technology acquisition: How are cost savings to be measured? Cost savings with some technologies, such as reverse auctions, may be relatively easy to measure by analyzing price changes. But cost savings with process technologies are often much more difficult, with costs being assigned to the various components of the process only to determine how they have changed after the new technology has been implemented.
Because analyzing process costs is such a challenge, managers are frequently tempted to assume that costs are reduced, without having measured them. Of course, costs may have been reduced at face value, but top management generally wants hard numbers that relate to the bottom line to prove the implementation was a success. How is it possible to develop hard numbers on process cost reduction?
In the April/May 2002 issue of iSource, guest columnist Tony Kotler suggests that four criteria should be met when developing a ROI model:
3. Relevant Comparisons
Based on Kotler's theory that these four points should be met when developing a ROI model, I've compiled descriptions of companies demonstrating how they used different types of cost reduction measures to meet the criteria of an objective, replicable, relevant and data-based ROI model. The important point is that each of the companies used the same third-party provider, in this case SPS Commerce, to provide process technology using almost the same model. However, for each company, the measures they chose to use were quite different, highlighting the fact that flexibility is key when reaching to meet the criteria.
In each of the three cases the buying organization mandated that its suppliers use either traditional or Web-based electronic data interchange (EDI) to transmit the standard business rules between the different parties. The suppliers were encouraged to use a third-party technology provider, and the technology provider offered the service to the supplier at an economical monthly charge, plus a per-use fee.
The third-party technology company communicated the requirements to the suppliers and fully supported the technology. In addition, supplier training was provided and customer inquiries were managed. In short, services were provided at a very low cost to the both the supplier and buyer organization.
In addition to having an economical monthly fee, little or no technology investment was required on the part of the supplier or buyer organization. This is an important point in these cases because it means no capital budgeting was required. This makes the initial justification and the subsequent cost analysis much easier, and it is a major reason why more companies are using a third-party technology provider.
Cost Reduction Measures
In the case of the first company, management saw two primary areas that could be attacked with improved technology. The first was labor costs. Prior to the new technology, 4.5 full-time equivalent positions were dedicated to business transactions. Although several suppliers used electronic data interchange (EDI), the bulk of the transactions were conducted via fax, e-mail and telephone follow-up. These processes were time consuming and errors occasionally resulted due to the volume of transactions employees were responsible for handling. This amounted to direct labor costs of over $130,000 that were reduced by 75 percent within one year when the new technology system was implemented. Most importantly, these lines of cost were not transferred or re-assigned they were totally eliminated. The savings went directly to the operating expense bottom line. Labor savings may be the easiest way to evaluate savings because it is clearly objective, replicable, relevant and data-based. However, companies must strive to not reassign the labor that is saved to related tasks, which lessens the impact on the bottom line.
The second area in which the company in this first case saw it could use improved technology to make reductions is order entry. Human engineering research has concluded that humans commit errors one out of every 100 times they execute a process, and this is true whether a person is a surgeon, an airline pilot or a data-entry technician. The error rate factor is also the logic behind eliminating human processes in critical operations whenever possible. The company in Case 1 had objectively monitored and analyzed the time that was required to correct an error made when entering an order. The observations were conducted objectively, they were replicated, they used employees' time as the relevant measure and they made the entire process data-based. The conclusion was that, on average, it took 30 minutes to correct any entry errors.
The number of errors, however, was more subjective. Even though the number of errors was not precisely monitored, it was determined that 1 percent was a reasonable figure to assume, because people were involved in paper tasks and it was logical to assume a standard error rate. The company figured that the number of annual invoices divided by 100 provides the number of errors. Then, the number of errors multiplied by 30 minutes provides the amount of time allocated to error correction. At this point it is possible to combine another subjective measure with a quantitative measure it may be assumed that the number of errors was reduced by 90 percent. This is a subjective measure, but it is verified by the objective measure that the labor was reduced by 75 percent, indicating that time was not required to correct errors. By using these figures, it was possible to develop an objective measure to evaluate the cost reduction of the new technology. In addition, the number could be replicated and relevant comparisons could be made to the figures both before and after the new technology was implemented.
The company in this case took an entirely different approach to the way it viewed its inventory and inventory turns, specifically, which are the number of times inventory is turned over during a calendar year. For a company, the more times its inventory turns over the less investment that is required for materials in the warehouse or merchandise on the shelf, and also the lower the total cost that is reflected on its books.
The best way to assure that materials don't go out of stock is to order extra materials, but this action, unfortunately, raises inventory costs. Several reasons exist for ordering safety stock: uncertain forecasts, protection against a supplier's stock-out and protection from receiving incorrect orders. When buyer-supplier communication can be completed quickly and correctly, each of these concerns can be better managed. Unexpected demands can be more quickly met, buyers will be aware of a potential supplier stock-out, and alternative suppliers can be found and incorrect shipments reduced.
When inventory is the focus, the effect of buyer-supplier communication technology can be easily determined. All that is necessary is to determine what is the reduction in inventory turns, the average cost of inventory and then calculate the cost of capital for having that extra inventory. Again, this is an objective, replicable and data-driven method for determining cost reduction, and the reduction in inventory costs can be directly related to the bottom line. The chief financial office will always be pleased to report a reduced inventory level.
The company in this case is in a situation that is quite different from the previous two companies because of its growth. Out of approximately 1,200 unique, small suppliers, around 700 have received orders for under $25,000 per year. On top of this, the company was expanding and expected to continue its rapid growth rate. The manual process of handling all of these orders had become overwhelming. To quote a top manager: "The paperwork was becoming overpowering, but we didn't know where to go with it."
In this case, the return on investment (ROI) could be calculated by a combination of the methods used in the first two cases: labor savings, error reduction and reduced inventory levels. In addition, it was possible to look at the reduced technology expenses recall that new technology costs are minimal because no new software or hardware is required, and, as strange as it may seem, implementing new technology actually reduced technology expenses. In addition, the suppliers are responsible for much of the expenses prorated according to the amount of business they conduct with the buyer. Therefore, it is little expense for the buyer and a rather attractive variable expense for the supplier, because it is directly related to increased revenue.
Traditionally, considering the growth rate of this company, it would have also been necessary to add the cost of fax machines, as well as increased telephone costs and increased costs for any new traditional EDI for large suppliers. But in this case, each cost was avoided. Cost avoidance may often lack objectivity, relevance, and it may not be based on facts. In this case, however, it was possible to directly relate the growth rate to increased buyer-supplier expenses. As a result, the company could be more factual and objective. In addition, the cost reduction is relevant because it directly relates to the company's expenses. Even though it is a matter of cost avoidance, the cost savings met the criteria for good measures.
Flexible Bottom Line
When looking for hard numbers, labor costs are often the most obvious and easy to measure. But when these are not easily obtained, it may be possible to measure the reduction in errors or decreased inventory levels. Or, as in the third case, cost avoidance may be a good choice, especially if it is objective, relevant and data-based. The bottom line is that hard measures can be found in different places for different companies, and it is necessary that companies adapt the measures to individual situations. The key is to be flexible when reaching for objectivity, replicability, relevant comparisons and data-based criteria when developing a ROI model.
Larry Smeltzer is a professor of supply chain management at Arizona State University.