Creating the Optimal Supply Chain - Review (You Can’t Manage What You Can’t Measure’: Maximizing Supply Chain Value)
16 October 2006Earlier last week, I linked to a special report published by experts from BCG and Wharton regarding the topic - Creating the Optimal Supply Chain. I want to get this week off to an early start because I know that this week is crunch time at work.
The report is structured under four main topics namely,
‘You Can’t Manage What You Can’t Measure’: Maximizing Supply Chain Value
Avoiding the Cost of Inefficiency: Coordination and Collaboration in
Supply Chain Management
Flexibility in the Face of Disaster: Managing the Risk of Supply Chain Disruption
Supply Chain Enterprise Systems: The Silver Bullet?
So I dug into the report accordingly. Let’s take it a section at a time.
‘You Can’t Manage What You Can’t Measure’: Maximizing Supply Chain Value
So who hasn’t heard of Dell? Or Walmart?
In the face of increasing complexity in global supply chains, more companies are realizing that supply chain management (SCM) is a mission-critical element, and no longer simply the domain of the warehouse manager or logistics director.
Alright, that’s a little unfair because everybody needs a lead in into a piece and its no good to spring on that salient fact. But the fact of the matter is that the lead-in is a poor one at that. The critical nature of the supply chain in the business model that Dell uses or even that of Walmart is the stuff of legend now - we’ve come a long way from the notion that Supply Chain Management is the purview of a warehouse manager or logistics director alone even if some firms insist on operating that way today.
However, in the light of current business trends, the report states
“The major trends in business right now - low-cost country sourcing, outsourcing, customization, globalization and more - all create tremendous complexities in a supply chain,” says Steve Matthesen, vice president and global leader for supply chain at BCG. “In most cases, however, companies have not changed how they manage this critical part of the business.”
But for a moment consider where we came from. The above business trend is a business created trend or what I mean is that outsourcing and offshoring as methods of procurement or manufacturing were created by the business world for the business world. In all truth, the increase in supply chain complexity was a trade-off, whether recognized or not, for the lower costs of production or procurement. Offshoring and outsourcing will generally tend to increase lead times and inventory levels across the supply chain and this is precisely what companies that chose to outsource or offshore need to be aware off.
Matthesen further notes that there are three major factors that have dramatically increased the stress on supply chains. My comments follow each specific stress area:
• Fragmenting customer needs, resulting in a broader selection of SKUs (stock keeping units) aimed at specific consumer segments, different price points, shorter product life-cycles, and less predictable demand patterns
Its quite obvious that if a firm’s customers demand very specific types of products and services and, if the response of the firm is to segment the customer into specific target areas with its attendant price points, product life-cycles and demand patterns, then the resultant is not one supply chain per product or product family but multiple supply chains with attendant characteristics. There is no real way around this except perhaps late stage design differentiation of products meaning that for a significant portion of the supply chain, the products or services have a common base platform which can be rapidly customized as one gets closer to the customer.
• Increased cost pressures based on global competition and shareholder demands to reduce working capital
This is the pushback from the investors who suddenly notice a lot more inventory on the balance sheet and that’s a direct result of offshoring and outsourcing. So if you have a lot more inventory sitting on your balance sheet, albeit acquired at a much lower cost of production, it still ties up working capital as a large volume of raw materials/partially finished goods/finished goods travel through the end to end supply chain.
• A new level of complexity brought on by more complicated distribution models, increased outsourcing, and “new technologies that promise efficiency but can increase complexity.
This is harder to parse because distribution models are rationalised with a focus on improving customer service and the more complicated a distribution model, the larger the company has gotten that demands it. However, when you take the example of Walmart, you have a firm that drive stupendous volume through a complex distribution model but nevertheless does so successfully. So has Walmart been able to manage complexity?
According to Gerald Cachon,
While supply chains are getting more difficult to manage, the competitive environment means that most companies need to further reduce costs. In such an environment, successful SCM “means getting better results with the same, or fewer, resources,” according to Gerald P. Cachon, Wharton associate professor of operations and information management. “It’s like squeezing more juice from a lemon, or maybe blood from a stone.”
I wonder if this is the right approach to take. If on the one hand one argues that today’s supply chains have become complex it makes little sense to squeeze more out of an admittedly complex supply chain without first de-complexing (don’t you just love such hyphenated words when using the word - simplifying would just have easily done the job) the supply chain.
Or in other words, how can you squeeze more juice from a lemon when it is difficult to get a grip on the lemon in the first place?
The solution proposed by the authors of this section of the report titled - You Can’t Manage What You Can’t Measure’: Maximizing Supply Chain Value is to first identify what is to be measured in a supply chain and then using the framework of an efficient frontier (see box for more information about efficient frontier, More information about efficient frontier here, here) determine a path/strategy for supply chain execution.
The term efficient frontier was first defined by Harry Markowitz in his seminal paper on Portfolio selection. The essence of the idea is to determine a portfolio that resides on the frontier that trades off expected rate of return and risk. The relation between the expected rate of return for a portfolio of securities and the risk associated with the chose portfolio of securities is a curved graph such as shown in this link here.
The secret behind the efficient frontier really is the covariance between the different securities within the portfolio which allows an investor to select a portfolio that maximizes expected returns for a given risk level. A key assumption here is the definition of risk which is the standard deviation from the mean for a particular security which means that it is based on past peformance of the concerned security.
So what do the authors of this piece mean by the efficient frontier in supply chain space?
If the essence of supply chain management is to provide the right products in the right amounts to the right place at the right time — all at the right cost — then a concept called the “efficient frontier” is a useful way to gage capability. For any business function, an efficient frontier can be found by plotting points along a trade-off curve between two or more performance metrics. Applied to supply chain performance, “the efficient frontier is a twodimensional space, with service level and costs along the two axes,” says Mark D. Lubkeman, a senior vice president in BCG’s Los Angeles office.
In addition to the frontier plotted in the report between service levels and cost of providing that service, the succint observation when it comes to service level and cost tradeoff is that there is diminishing returns of service level improvement for every additional dollar spent above a certain level. However, there is a critical assumption that is often forgotten when such trade-offs are presented and it is a key assumption. The frontier so plotted between service levels and cost is valid for a particular business model (and by extension business/operational strategy) i.e. there are diminishing returns in service level improvement for every additional dollar spent within a particular business model. Since service level is defined to be some sort of customer centered performance metric, a disrupting innovation in communications technology (such as the internet for example) or transportation method (such as the introduction of parcel service) radically changes the notion of service level and therefore the tradeoff curve. The tradeoff curve still exists but it has been moved laterally and in an ideal case diagonally higher.
Nevertheless as Cohen notes,
Getting to the efficient frontier is not a simple task, notes Cohen. “You may not be managing processes correctly, not using the right technology; there are a variety of reasons to explain why some companies are not on it and others are.”
And thus the need for consultants - would you believe it? But, I do think that consultants can really provide value here because they can truly provide a fresh pair of eyes to the situation at hand.
But here is something interesting - interesting because other than a simple tradeoff model like the one depicted above, is an efficient frontier on multiple performance metrics available to anyone?
“If you give me a set of parameters, a particular supply chain structure and an assumed forecast, we can find the efficient frontier,” says Cachon. “But no firm ever has all the information they need. What are all the costs? What are the demand distributions? What are the uncertainties in terms of weather, union strikes, and fires?”
He adds that as supply chains become more complex, they have more participants, more locations, and are geographically more dispersed. The amount of information needed to find the efficient frontier appears to grow exponentially.
And more observations to take note off:
“Making it to the efficient frontier involves the application of optimization techniques which require careful data collection and generally customization to the firm’s particular environment,” said Cachon, who studies how new technologies can improve supply chains and consults for companies that provide optimization solutions for retail customers.
“I have directly seen how the smart application of optimization technology can improve a retailer’s inventory performance, with higher service and higher turns.”
Lubkeman believes that incorporating new efficient frontier software programs can be a plus. “They basically help you optimize transactional decisions,”
he said. But he adds a warning: “Unless you’ve got the underlying understanding of the customers and articulated the strategies you need to serve those customers, you run the risk of having the technology drive the strategy instead of the other way around.”
However the major pay off in understanding, designing and executing one’s supply chain is sustainable competitive advantage. Here’s how Mattheson describes it:
The pay-off is substantial. “A fully aligned supply chain and strategy delivers a superior business model,” Matthesen adds. “Given the difficulties of achieving this, the benefits are often sustainable and create real advantage. Your competitors are likely to want to copy pieces of your strategy without realizing how the entire strategy and supply chain work together — and they will not be able to match your performance.”
So, I really don’t know whether Walmart has been able to manage supply chain complexity any more than its rivals but I do know that the path to creating the future lies in creating one or several sustainable competitive advantages in your supply chain - perhaps, fleshing out the notion of an efficient frontier along multiple performance measures and integrating that with supply chain design (the kind that MPMLT seeks to do when I am able to finish it) is the way of the future - the theoretical and practical future.
Tags: Optimal Supply Chain, BCG, Wharton, Supply Chain Strategy, Efficient Frontier, Sustainable Competitive Advantage, Supply Chain complexity
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