CHAPTER 13 SUPPLY CHAIN PERFORMANCE MEASUREMENT AND FINANCIAL ANALYSIS LEARNING OBJECTIVES After reading this chapter, you should be able to do the following: • Understand the scope and importance of supply chain performance measurement. • Explain the characteristics of good performance measures. • Discuss the various methods used to measure supply chain costs, service, profit, and revenue. • Understand the basics of an income statement and a balance sheet. • Demonstrate the impacts of supply chain strategies on the income statement, balance sheet, profitability, and return on investment. • Understand the use of the strategic profit model. • Analyze the financial impacts of supply chain service failures. • Utilize spreadsheet computer software to analyze the financial implications of supply chain decisions. CHAPTER OVERVIEW Introduction Many organizations today have realized that performance metrics are critical to managing the business and achieving desired results. Many organizations want to do the “right things” (effectiveness) and do them “right” (efficiency). However, simply stating those two objectives is not adequate unless they have specific, measurable metrics that enable the organization to gauge whether or not these objectives are achieved. The purpose of this chapter is to (1) introduce the dimensions of supply chain performance metrics, (2) discuss how supply chain metrics are developed, (3) offer some methods for classifying supply chain metrics, and (4) use quantitative tools to show how these metrics can be linked to the financial performance of the organization. Dimensions of Supply Chain Performance Metrics What is the difference between a measure and a metric? Traditionally, the term measure was used to denote any quantitative output of an activity or process. Today, the term metric is being used more often in place of the term measure. Second, what are the characteristics of a good metric? The first question to be asked about a metric is, “Is it quantitative?” While not all metrics are quantitative, this is usually a requirement when measuring the outputs of processes or functions. The second question to be asked about a metric is, “Is it easy to understand?” This question is directly related to the fifth question, “Is it defined and mutually understood?” The third question to be asked about a metric is, “Does it encourage appropriate behavior?” A basic principle of management is that metrics will drive behavior. The fourth question to be asked is, “Is the metric visible?” Good metrics should be readily available to those who use them. The sixth question to be asked is, “Does the metric encompass both outputs and inputs?” Process metrics, such as on-time delivery, need to incorporate causes and effects into their calculation and evaluation. The seventh question to be asked is, “Does it measure only what is important?” The supply chain operation generates huge volumes of transactional data on a daily basis. The eighth question to be asked about a good metric is, “Is it multidimensional?” Although a single metric will not be multidimensional, a firm’s metric program will be. This is where the terms scorecard and key performance indicators (KPIs) will apply. The ninth question to be asked is, “Does the process use economies of effort?” Another way to ask this question is, “Do we get more benefits from the metric than we incur costs to generate it?” The last question to be asked about a good metric is probably the most important: “Does it facilitate trust?” If it does not, complying with the other nine characteristics makes little or no difference for the effectiveness of the metric. Evaluating current or potential supply chain metrics is critical to a sound metrics program. Also important to note is that metrics need to change over time; not only the performance standard but also the individual metric as well. “Internal” metrics focus on the performance of the shipping firm while “external” metrics measure the experience of the customer. Total cost is a measure of efficiency and was the rationale supporting physical distribution management. Least total cost was later used to support the logistics management approach. The focus upon a least total cost system required measuring the tradeoff costs when a suggested change was made in one of the components or elements of the system. Developing Supply Chain Performance Metrics The implementation of new technologies and the changing business environment have prompted many firms to reexamine their supply chain metrics programs. Another driving influence for this reexamination has been the desire of organizations to change their supply chain focus from a “cost” center to an “investment” center. First, the development of a metrics program should be the result of a team effort. Second, involve customers and suppliers, where appropriate, in the metrics development process. Third, develop a tiered structure for the metrics. Fourth, identify metric “owners” and tie metric goal achievement to an individual’s or division’s performance evaluation. Fifth, establish a procedure to mitigate conflicts arising from metric development and implementation. Sixth, the supply chain metrics must be consistent with corporate strategy. Finally, establish top management support for the development of a supply chain metrics program. Performance Categories The text identifies four major categories with examples that provide a useful way for examining logistics and supply chain performance: time, quality, cost, and supporting metrics. A number of approaches can be used to classify supply chain performance metrics. Time has traditionally been given attention as an important indicator of logistics performance, especially with regard to measuring effectiveness. There are five widely used metrics for time: On-time delivery/receipt, order cycle time Order cycle time variability, response time, and forecasting/Planning cycle time. The metrics capture two elements of time: the elapsed time for the activity and the reliability (variability) for the activity. The second category indicated in Figure 5.4 is cost, which is the measurement for efficiency. Most organizations focus on cost since it is critical to their ability to compete in the market and make adequate profit and returns on assets and/or investments. A number of cost metrics related to logistics and supply chain management are important to organizations. Quality is the third category of metrics and several dimensions in the Quality category are important to logistics and supply chain management. Another metric classification scheme that has been receiving increased attention is that developed by the Supply Chain Council and contained in the Supply Chain Operations and Reference (SCOR) model. The five major categories of metrics that need to be used to measure the performance of Process D1: reliability, responsiveness, flexibility, cost, and assets. Finally, another perspective suggests that performance metrics for logistics and supply chain management should include logistics operations costs, logistics service metrics, transaction cost and revenue quantification, and channel satisfaction metrics. Order cycle time (OCT) is another very important logistics service metric. OCT influences product availability, customer inventories, and seller’s cash flow and profit. Transaction cost and revenue relates to the value added by logistics. In other words, what is the service and price relationship, and what specifically is the customer’s perception of service quality? To add logistics value from the seller’s perspective, there are three basic alternatives as follows: • Increased service with a constant price to the customer • Constant service with a reduced price • Increased service with a reduced price Another perspective on transaction cost and revenue focuses on how a seller’s cost influences a customer’s profit and on how a seller’s service impacts a customer’s revenue. If the cost of a seller’s logistics service allows a customer to make more profit from the seller’s product, the customer should be willing to buy more products from the seller. The final category is channel satisfaction. This essentially looks at how logistics cost and service are perceived by channel members. Most of the focus on measurement has been on the perceptions of supply chain members of how well suppliers are performing on logistics cost and service. Leading-edge organizations are beginning to identify the impact of customer satisfaction on revenues and market share. The Supply Chain–Finance Connection The supply chain process influences the flow of products from the supplier to the final point of consumption. The resources utilized to accomplish this flow process determine, in part, the cost of making the product available to the consumer at the consumer’s location. This landed cost, then, impacts the buyer’s decision to purchase a seller’s product. The decision to alter the supply chain process is essentially an optimization issue. Management must view the supply chain alternatives as to their ability to optimize the corporate goal of profit maximization. Some alternatives might minimize costs but reduce revenue, and possibly, profits. By implementing supply chain alternatives that optimize profits, the decision maker is taking the systems approach and trading off revenue and costs for optimum profit. Supply chain management involves the control of raw material, in-process, and finished goods inventories. The financing implication of inventory management is the amount of capital required to fund the inventory. In many organizations, capital is in short supply but is required to fund critical projects, such as new plants or new warehouses. The higher the inventory level, the more capital is constrained and the less capital is available for other investments. Efficiency of the supply chain impacts the time required to process a customer’s order. Order processing time has a direct bearing on an organization’s order-to-cash cycle. Typically, the invoice is sent to the customer after the order is shipped. The longer the order-to-cash cycle, the longer it takes for the seller to get its payment. The longer the order-to-cash cycle, the higher the accounts receivable and the higher the investment in “sold” finished goods. So the length of the order-to-cash cycle directly relates to the amount of capital tied up and not available for other investments. The Revenue–Cost Savings Connection While process efficiency and cost savings are worthy goals, top management generally refers to corporate improvements in terms of increases in revenue and profit. The apparent conflict between the goals of top management and supply chain management can be readily resolved by converting cost savings into equivalent revenue increases. To accomplish this, the following equations can be used: Profit = Revenue − Costs where Cost = (X%)(Revenue) then Profit = Revenue − (X%)(Sales) = Revenue(1 − X%) where (1 − X%) = Profit Margin Sales = Profit/Profit Margin The Supply Chain Financial Impact A major financial objective for any organization is to produce a satisfactory return for stockholders. This requires the generation of sufficient profit in relation to the size of the stockholders’ investment to assure that inventors will maintain confidence in the organization’s ability to manage its investments. The absolute size of the profit must be considered in relation to the stockholders’ net investment, or net worth. An organization’s financial performance is also judged by the profit it generates in relationship to the assets utilized, or return on assets (ROA). The supply chain plays a critical role in determining the level of profitability in an organization. The level of inventory owned by an organization in its supply chain determines the assets, or capital, devoted to inventory. The order-to-cash cycle affects the time required to receive payment from a sale, thereby impacting the accounts receivable and cash assets. Channel structure management includes decisions regarding the use of outsourcing, channel inventories, information systems, and channel structure. By outsourcing supply chain activities, the organization might realize lower supply chain costs (outsourcing firms possess greater functional expertise and efficiencies), a reduction in assets (use of an outsourcing firm’s facilities), and increased revenue (from improved supply chain service). Decisions that lower supply chain assets and/or improve revenue through supply chain service improvements result in a higher ROA. Inventory management decisions that reduce inventory (safety stock, obsolete and/or excess stock) and optimize inventory location (in relation to sales or use patterns) reduce the investment in inventory. Effective order management not only reduces supply chain costs but also supports increased revenue, the combined effect resulting in a higher ROA. Finally, reducing transportation transit time and the variability of transit time will have a positive impact on revenues as well as on inventory levels. Financial Statements Attention must now be given to two very important financial statements: the income statement and the balance sheet. The data contained in the Supply Chain Profile for CLGN Book Distributors.com will be used in this section. Figure 13.12 presents the CLGN income statement, and Figure 13.13 shows the balance sheet for CLGN. Both financial statements have been prepared using a spreadsheet software program, and the symbol column indicates the symbol and/or equation used for each of the entries. Financial Impact of Supply Chain Decisions Another methodology available to perform the same financial analysis is the strategic profit model (SPM). The SPM makes the same calculations that were made in the spreadsheet analysis. Asset turnover is the ratio of sales to total assets and indicates how the organization is utilizing its assets in relation to sales. Return on equity indicates the return the stockholders are realizing on their equity in the organization. Supply Chain Service Financial Implications The results of supply chain service failures are added to the cost to correct the problem and lost sales. Figure 13-19 shows the methodology for determining the cost of service failures. When supply chain service failures occur, a portion of the customers experiencing the service failure will request that the orders be corrected and the others will refuse the orders. The refused orders represent lost sales revenue (refused orders times revenue per order) that must be deducted from total sales. For the rectified orders, the customers might request an invoice deduction to compensate them for any inconvenience or added costs. SUMMARY • Performance measurement for logistics systems and, especially, for supply chains is necessary but challenging because of their complexity and scope. • Certain objectives should be incorporated into good metrics—be quantitative, be easy to understand, involve employee input, and have economies of effort. • Important guidelines for metric development for logistics and supply chains include consistency with corporate strategy, focus on customer needs, careful selection and prioritization of metrics, focus on processes, use of a balanced approach, and use of technology to improve measurement effectiveness. • There are four principal categories for performance metrics: time, quality, cost, and miscellaneous or support. Another classification for logistics and supply chains suggests the following categories for metrics: operations cost, service, revenue or value, and channel satisfaction. • The equivalent sales increase for supply chain cost saving is found by dividing the cost saving by the organization’s profit margin. • Supply chain management impacts ROA via decisions regarding channel structure management, inventory management, order management, and transportation management. • Alternative supply chain decisions should be made in light of the financial implications to net income, ROA, and ROE. • The SPM shows the relationship of sales, costs, assets, and equity; it can trace the financial impact of a change in any one of these financial elements. • Supply chain service failures result in lost sales and rehandling costs. The financial impact of modifications to supply chain service can be analyzed using the SPM. ANSWERS TO STUDY QUESTIONS 1. “Performance measurement for logistics managers is relatively recent. Their focus was previously directed toward other managerial activities.” Do you agree or disagree with these statements? Explain your position. A question might be raised as to whether or not the focus on performance measurement is a recent event in industry. The answer to that question is a definite “no.” Recall from Chapter 2 that the development of the physical distribution and logistics concepts was based upon systems theory with the specific application focused upon least total cost analysis. Total cost is a measure of efficiency and was the rationale supporting physical distribution management. Least total cost was later used to support the logistics management approach. The focus upon a least total cost system required measuring the tradeoff costs when a suggested change was made in one of the components or elements of the system. For example, this could include switching from rail to motor transportation or adding a distribution center to the distribution network. Cost has long been recognized as an important metric for determining efficiency. This is still true today. However, we have evolved from measuring functional cost to supply chain cost. This means the relevant point of measurement has changed from totally internal to a firm to the collective costs of many firms involved in the supply chain. The second part of the question is subjective and must be evaluated in that light 2. What role should employees, in general, play in the development of performance metrics? Why is this role important? First, the development of a metrics program should be the result of a team effort. Successful metrics implementations involve development teams comprised of individuals representing functional areas within the firm that will be impacted by the metrics. Because this phase of development requires metric identification and definition, it is critical that all impacted areas agree on the appropriate metrics and their definitions. This agreement will lead to a more successful implementation and use of the metrics to manage the business. Identify metric “owners” and tie metric goal achievement to an individual’s or division’s performance evaluation. This provides the motivation to achieve metric goals and use metrics to manage the business. 3. “Metrics must focus upon customer needs and expectations.” Explain the meaning of this statement. Why have customers become more important for performance measurement? What role, if any, should customers play in developing supply chain metrics? Involve customers and suppliers, where appropriate, in the metrics development process. Because customers feel the impact of metrics and suppliers are actively involved in the execution of the metrics, their involvement is also critical to successful implementation. Another perspective on transaction cost and revenue focuses on how a seller’s cost influences a customer’s profit and on how a seller’s service impacts a customer’s revenue. If the cost of a seller’s logistics service allows a customer to make more profit from the seller’s product, the customer should be willing to buy more products from the seller. As to the second and third part, the student should present their thoughts based on classroom discussion and the case studies in this chapter. 4. It is generally recognized that organizations go through several phases on the path to developing appropriate supply chain metrics. Discuss the stages of supply development for supply chain metrics. Choose which of the stages of evolution you think would be most challenging for an organization. Explain your choice. The implementation of new technologies and the changing business environment have prompted many firms to reexamine their supply chain metrics programs. Another driving influence for this reexamination has been the desire of organizations to change their supply chain focus from a “cost” center to an “investment” center. First, the development of a metrics program should be the result of a team effort. Second, involve customers and suppliers, where appropriate, in the metrics development process. Third, develop a tiered structure for the metrics. Fourth, identify metric “owners” and tie metric goal achievement to an individual’s or division’s performance evaluation. Fifth, establish a procedure to mitigate conflicts arising from metric development and implementation. Sixth, the supply chain metrics must be consistent with corporate strategy. If the overall corporate strategy is based upon effectiveness in serving customers, a supply chain metrics program that emphasizes low cost or efficiency could be in conflict with expected corporate outcomes. Finally, establish top management support for the development of a supply chain metrics program. Successful metrics programs cost more than expected, take longer to implement than desirable, and impact many areas inside and outside the organization. Top management support is necessary to see the development and implementation of the metrics program to its successful conclusion. As to the second and third part, the student should present their thoughts based on classroom discussion and the case studies in this chapter. 5. Using a spreadsheet computer software program, construct a supply chain finance model and calculate the profit margin; ROA; inventory turns; and transportation, warehousing, and inventory costs as a percentage of revenue for the following: Sales = $200,000,000 Transportation cost = $12,000,000 Warehousing cost = $3,000,000 Inventory carrying cost = 30% Cost of goods sold = $90,000,000 Other operating costs = $50,000,000 Average inventory = $10,000,000 Accounts receivable = $30,000,000 Cash = $15,000,000 Net fixed assets = $90,000,000 Interest = $10,000,000 Taxes = 40% of (EBIT – Interest) Current liabilities = $65,000,000 Long-term liabilities = $35,000,000 Stockholder’s equity = $45,000,000 *Denotes change from base. 6. Using the supply chain finance model developed for Study Question 5, calculate the impact on profit margin; ROA; inventory turns; and transportation, warehousing, and inventory costs as a percentage of revenue for the following scenarios: Transportation costs increase = 20% Warehousing costs decrease = 5% Average inventory decrease = 10% Warehousing is outsourced with: Net fixed assets reduced = 20% Inventory reduced = 15% Warehousing costs = $0 Transportation costs reduced = 5% Outsourcing provider costs = $2,500,000 7. Develop a strategic model to depict the scenarios given in Study Questions 5 and 6. 8. Construct a financial model to determine the redelivery/rehandling cost, lost sales, invoice dedution cost, and net income for the following: a. On-time delivery increases from 90 percent to 95 percent with a 5 percent increase in transportation cost. b. Order fill rate decreases from 96 percent to 92 percent with inventory reduced by 5 percent. Selling price/order = $150/order Gross profit/order = $35/order Lost sales rate: On-time delivery failure = 15% Order fill failure = 20% Supply Chain Performance Measurement and Financial Analysis 181 Annual orders = 200,000 Rehandling cost = $125/order Invoice deduction/service failure = $150/order Transportation cost = $1,000,000 Average inventory = $1,000,000 Interest cost = $1,500,000 Inventory carrying cost rate = 25%/$/yr. Warehousing cost = $750,000 Other operating cost = $500,000 Cash = $3,000,000 Accounts receivable = $4,000,000 Fixed assets = $30,000,000 Tax rate = 40% *Change from base Case Studies CASE 5.1 Wash & Dry, Inc. Case Questions 1. If you were hired as a consultant to develop these KPIs for WD, how would you assess what KPIs they should be measuring? In general, what areas of service and cost would these KPIs address? Be sure to include both internal and customer KPIs. Students can use Figures 13.4, 13.5, and 13.6 to develop their answer. With these frameworks, students should include orders delivered on-time and in-full as customer KPIs and productivity KPIs for both the manufacturing and distribution center facilities. 2. What KPIs would you recommend for the manufacturing facility? Why? One KPI that should be included for the manufacturing facilities is compliance to schedule. This KPI measure the percent of time that a manufacturing facility makes what the production schedule recommends. Compliance to schedule impacts the firm’s ability to ship on-time and in-full. Another KPI that should be included is manufacturing cost per unit. Finally, waste as a percent of cost of goods should be another KPI. 3. What KPIs should be used at the distribution center? Why? KPIs such as inventory turns, order fill rate, and on-time shipment should be included for the distribution center. Inventory turns is a productivity KPI while order fill rate and on-time shipment are service KPIs. The latter two KPIs impact service levels to customers. 4. How would you measure the revenue and profit impacts of these new KPIs? Students can use Figures 13.12 through 13.18 to demonstrate the revenue and profit impacts of the new KPIs. CASE 5.2 Paper2Go.com CASE QUESTIONS 1. You are the logistics analyst at Paper2Go.com and have been asked to do the following: a. Calculate the financial impact of increasing order fill rates to 98 percent from 92 percent. b. Develop a strategic profit model of both the old system and the modified system that reflects the suggested adjustments. Solution Manual for Supply Chain Management: A Logistics Perspective John J. Coyle, John C. Langley, Robert A. Novack, Brian J. Gibson 9781305859975
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