Finance & The Supply Chain: Show Me the Money
Innovative supply chain management delivers financial benefits to your bottom line.
During the recent economic downturn, many companies stripped layers of cost from their supply chain operations. These cuts may not have been obvious to target or easy to accomplish. But moving forward, improving your supply chain’s financial performance will mean focusing on risk and relationships. And this focus could transform your supply chain and your organization.
In the old days, businesses focused on logistics internally. “Companies assumed they had to absorb and optimize every challenge thrown at them,” says Jonathan Byrnes, senior lecturer at the MIT Center for Transportation and Logistics and author of Islands of Profit in a Sea of Red Ink.
Today, however, companies are looking at logistics processes externally through integrating suppliers and customers. That change positions supply chain professionals as the driving force behind opportunities that can result in better financial performance for their companies.
Between 30 and 40 percent of every company is unprofitable by any measure—accounts, products, lines, transactions, orders. And 20 to 30 percent of every company provides all the reported profit and subsidizes the losses.
While a common reaction is to eliminate the unprofitable elements, “You don’t want to fire customers; you want to turn around the unprofitable accounts,” cautions Byrnes. “At the same time, you want to identify and lock in the 20 to 30 percent of elements you can’t live without.”
The traditional view of logistics focused on carefully managing and optimizing functional areas such as warehousing, inventory, order fulfillment, and transportation using mathematical optimization tools. But this new world of externally focused supply chain management presents significant financial opportunities.
Companies are realizing the financial benefits of integrating more with customers and suppliers. “The few who do it well are making a fortune, even in this tough economy,” Byrnes notes.
What fewer companies understand or do well is recognizing the impact a supply chain can have on the customer value proposition. “Supply chain management can have a massive impact on cost, profitability, cash flow, and risk,” Byrnes says. “For many companies, it’s the leading untapped factor in not only tightening costs, but in increasing financial performance.”
One example of this impact is vendor-managed inventory (VMI), a business process where suppliers manage and own selected on-site inventory. Done right, VMI can increase revenues by as much as 30 to 40 percent in the highest penetrated accounts. Companies operating a VMI program design systems and procedures that increase the customer’s profitability, resulting in increased sales and profits. In sales terms, that translates to increased share of wallet and, ultimately, increased market share.
“If you select the right customers, figure out how to make them more profitable, and invest in systems, relationships, and resources, they make much more money selling your products,” Byrnes says. “That results in huge sales increases. At the same time, you gain control over your own order pattern variances and substitutions, and get more visibility and better forecasting, which drives down your own costs.
“VMI offers the best of both worlds: your revenues radically increase and your costs go down,” he adds.
This is one area where a supply chain professional can deliver more revenue than a salesperson ever could, Byrnes points out. VMI also delivers more cost savings than you can achieve by simply managing the orders coming at you. “VMI is a flow-through system that can be highly forecasted, which helps reduce inventory and improve cash flow,” he adds.
The old approach of looking inward didn’t provide logistics and supply chain managers visibility to where sales were coming from. All they could do was look at the order pattern and guess—then carry enough safety stock.
Byrnes recommends supply chain and sales and marketing departments establish a strong partnership “by defining customer relationships, from arm’s length to highly integrated, with some notches in between,” he says.
He cites one company operating a warehouse where 40 percent of costs are wrapped up in one-off requests from minor customers. “It’s important to standardize customer relationships so you can run an efficient supply chain into each one,” Byrnes explains. “I call this multiple parallel supply chains.”
This requires close cooperation between supply chain management and sales and marketing in a process Byrnes labels “market mapping,” which matches customers to the level of relationship that is appropriate—not necessarily what they asked for. Highly integrated, close relationships are reserved for the best customers—not just the largest. And those customers with growth potential could garner a closer relationship than their business volume might suggest.
Traditionally, sales sets a goal for moving customers from where they started to where they should be. If you are a low-volume supplier to a customer who has high potential, what does it take to get more of that customer’s business?
Sales and marketing can identify customers with potential, but supply chain management can determine which customers have the willingness and ability to manage change and become true partners.
For high-potential customers, get acquainted with their operations team early on. Only then should you start investing the resources that will build a closer relationship. It’s important to know whether the customer is open to the transformation before dedicating resources that could be invested in other customers.
Among the qualifying factors, Byrnes cites the operating fit. Some questions to ask are: What can be accomplished if the partnership does everything right? And, are the customer’s operations personnel the type to partner or not?
This is the opposite of the traditional way sales would handle the operations connection—bringing in their own operations team at the end of the sales process for an introduction and a handshake. Using the new approach, operations personnel almost precede sales in building relationships and identifying strong candidates for the closest partnerships.
The benefits of this closer supply chain relationship include smoothing the order cycle, improving forecasting, and increasing profitability for both customer and supplier. The nitty-gritty operations details get ironed out in the process, but resources stay focused on the most productive and highest-potential partnerships.
“The market mapping approach provides tremendous value and strategic differentiation, and offers competitive advantage,” says Byrnes. “All the goals companies want to achieve today result from optimizing supply chain management.”
A Global Perspective
These concepts cross from the customer relationship to managing your supplier relationships. When customers are open to forming a closer relationship with key suppliers, they can work together to improve cost, service, and profitability. In a global supply chain, that can lead to lower risk, as well.
Place matters. Instability in the Middle East highlights just how quickly apparently stable governments can come under attack. With supply chains extending thousands of miles and sourcing that reaches into emerging economies, the stability of even long-term governments is coming under added scrutiny. Many risk managers are looking at low-cost sourcing countries and asking, “Can instability happen here?”
In Asia, for example, “Never underestimate the Chinese government,” says Chris Holt, CEO of Tiger Medical Group, which sells hospital and medical supplies to institutional healthcare buyers worldwide. Based in Shanghai, Tiger also maintains administrative offices in Hong Kong, where most trading takes place.
“The Chinese government is incredibly savvy and organized, and they think 20 years ahead,” Holt says.
As a result, China focused on developing infrastructure to reach inland regions while it concentrated on making its coastal cities prosperous. The obvious value of developing near major ocean ports first was easy access to global trade. But as the country’s growth has continued, it has pushed economic development out to the hinterlands.
China can accomplish this because it spent years developing highways, bridges, canals, and railways to reach inland regions. Now, fewer people need to migrate to the coastal regions for employment as this economic engine drives more domestic growth.
If the government wasn’t taking these steps to develop the economy, says Holt, “you’d have the potential for one billion hungry people rallying to a cause.”
Tiger Medical Group’s management team—comprised of about half Chinese and half Westerners—also mirrors its supply chain. This mix helps build supply chain relationships among the company’s largely U.S. and European customer base and mostly Asian suppliers.
Tiger’s market in healthcare products faces some challenges related to its significant growth potential and extended supply chain. As an industry, the medical surgical supply segment has increased the volume of product it sources from Asia to nearly 10 percent, says Holt. That’s a result of many U.S. and European networks that are Tiger’s customers shifting more of their U.S., Mexican, and European factories to facilities or sourcing in Asia.
The move allows suppliers to increase the margin on products that are now sourced in Asia and supplement lower-margin, domestically sourced products. The question then becomes, how do you manage an Asia-based supply chain?
The traditional supply chain had senior management, product design, engineering, manufacturing, sourcing, marketing, sales, and logistics all located in the domestic market (see chart, below). The evolving U.S. supply chain may have all manufacturing in Asia, some sourcing, and some logistics in both the United States and Asia. The Asia-based supply chain serving a U.S. market maintains most of its functions in Asia, but splits marketing between Asia and the United States, while keeping the sales function in the United States.
The conventional supply chain managed from the United States with heavy sourcing in Asia faces challenges from the number of intermediaries in that supply chain, a problem Holt says is common to the healthcare industry. In addition, culture, language, time zones, and distance add to lead time and risk.
An Asia-based supply chain has the advantage of putting the management function in a similar low-cost geography to the supply chain it manages.
But, Holt notes, much of the existing management team is not likely to jump at this type of opportunity. Most team members will have been born and raised in the same area where they have spent their entire career. Few will have even short-term experience in overseas positions and, with family and other ties, it won’t be easy to move them.
Political risk is certainly a factor in any sourcing/supply chain decision, but currency, taxes, duties, and other factors increasingly come into play. Some larger companies hedge currency in their finance department, but, suggests Holt, there’s probably little awareness or involvement at the supply chain management level.
Another type of “hedge” might hit closer to home: forward contracts for raw materials can help guarantee supply and price. This is one way to take some control over a risk and avoid a sudden increase in supplier costs if raw materials prices rise.
Another strategy is to take a portfolio approach. “Companies with a wide portfolio of products coming from numerous countries and going to a variety of markets will realize more profit on some products and less on others because of all that variability,” Holt says. The goal is to manage the overall performance of that portfolio of products.
The trap that many companies fall into is creating a supply chain heavily based on one or two currencies and one or two products. “They try to forecast out 14 months in one category, and if any of the variables rise or fall, the process becomes erratic,” says Holt. “They celebrate if the variables move in their favor or blame currencies if the variables go against them.
“Know the variables that are in play, which ones you can manage, and how to handle the rest,” he suggests.
That’s the point behind the currency hedge and forward contracts for raw materials. It also comes into play with capacity and the relationship you maintain with your suppliers. Locating in a tax-friendly geography helps, but you must monitor tax policy changes.
Going Into Labor
Labor is another significant variable. Holt offers an example of wage increases in China. For Honda, which was already paying a higher wage, the increase amounted to 24 percent. But for Chinese technology manufacturer Foxconn, wages rose 70 percent in the same period.
“If you neutralize the riskiest variables a bit, you can withstand more noise in the others,” says Holt. If you allow all the different elements to be risk factors and don’t do anything to control any of them, you face significant risk if they all go against you at the same time.
Holt cites one electronics company that experienced a 100-percent increase in labor costs to assemble its product in China. Its margin on the product was very high. “But where margins are low, you can’t withstand that financial shock,” he says. “You need to employ supply chain techniques to manage risk.”
While sourcing in Asia can be risky, it is still the trend. Managing that global supply chain well could have another payoff as India and China’s domestic markets continue to evolve a strong middle class. About 50 percent of the world’s population is located in the region, and it accounts for 75 percent of world economic growth.
Supply chain management today is about much more than finding a low-cost source. The financial contribution of a well-positioned and well-managed supply chain extends to all key players. While cost controls, optimization, efficiencies, and operational excellence are important to a successful supply chain, relationships and risk management will differentiate the big winners.