Nov 2, 2006
Supply Chain Management Review has an article titled – Managing the Financial Supply Chain by Roland Hartley-Urquhart in a recent edition of their online magazine.
Understanding and managing all aspects of the financial supply chain is an essential ingredient for business success. While that statement has always been true, it takes on a new level of importance in today’s world of global sourcing and production outsourcing. The recommendations offered in this article can help supply chain professionals more effectively integrate the physical flow of goods with the financial flow.
As the previous series on Creating the Optimal Supply Chain amply demonstrated, there are three essential flows in a supply chain – Material, Information and Financial flow. While the first two are often frequently dissected and analyzed, the third is comparitively less so and thus I thought that I would do a piece on that.
Never have truer words been spoken:
Global sourcing and outsourcing have the added benefit of generating cash for many companies, as investments in plants, equipment, and working capital shift from the brand owners and original equipment manufacturers (OEMs) to their trading partners, who in many cases are overseas. While these benefits can’t be denied, business leaders need to assess the unintended consequences of their global sourcing and outsourcing strategies beyond direct cost and capital savings. In particular, they need to recognize that the labor cost advantage of moving these activities offshore masks hidden costs and risks within the financial supply chain.
And furthermore the implications for the supply chain are clearly:
While global sourcing and outsourcing may reduce the cost of the actual product—the “first cost”—they often decrease the capital efficiency of the value chain. Specifically, plants and equipment are often far more expensive to finance in emerging market countries. In addition, inventory tends to get pushed downstream to suppliers, which often have a higher cost of capital. Furthermore, global operations can add weeks to the value chain, tying up as much as 30 percent of product price in working capital.
There is no denying savings in direct costs and capital savings when it comes to decision making around offshoring or outsourcing – its simply ludicrous to do that. However, that is only one portion, the very visible portion, of the Total cost picture and that is what is frequently forgotten.
So what are some of the hidden costs that are implicitly present in offshoring or outsourcing?
Global sourcing and outsourcing also weaken control over the financial supply chain. This reduction in control can affect shareholder value, erode competitiveness, and introduce new business risks. Common challenges include the complexities around Sarbanes-Oxley compliance, complex chargeback management processes, and implicit foreign exchange risks.
Roland’s aim with this article is to enable supply chain practitioners to work together with the CFO and his team in order to advance better decision making around supply chain issues. His focus is on the following:
- Improve the financial performance of the extended value chain.
- Identify and manage hidden financial and operational risks associated with global outsourcing.
- Leverage existing supply chain visibility and sourcing systems to regain control over the financial supply chain.
- Reduce potential supply chain disruptions resulting from capital constraints within the business ecosystem.
Roland begins by outlining a long noted trend about the concept of ownership. In my opinion, ownership is intrinsically tied to the notion of Property rights but in the business world of today, the notion of ownership has undergone a shift. Historically, the following notion of ownership has more or less been the case epitomized by Henry Ford’s attempt to control critical elements of Ford’s supply chain right from key raw materials. (Development of JIT techniques starting with Henry Ford)
Ownership, in fact, was the only way to achieve the seamless flow of information that would allow them to truly optimize operations. Ownership also allowed organizations to take complete control of their businesses – a very appealing prospect to large enterprises in particular.
However, the following implications arise:
Although this approach may have been more successful in the past, it has always had several drawbacks. First, ownership is extremely capital-intensive. Organizations had to invest significantly in purchasing, building, and operating various pieces of the supply chain. Second, and perhaps more importantly, this model forced organizations to focus on business functions that were not their core competencies.
Also, ownership implies a significant lever of control over owned operations, critical or otherwise. However, the change from the traditional notions of ownership has been led by the realization that while it is still critical to own own’s core competencies and derive competitive advantage therein, a firm could exercise sufficient control over operations that were no longer owned by the firm. This has led to a whole slew of services cropping up to take over non-core competencies of a certain set of firms and converting that into their own core competency.
And it is precisely that which Roland has in mind:
The global access provided by advances in information technology and the resulting transparency into a business’s extended operations have facilitated a changing view of ownership. The Internet provides a seamless information flow at a relatively low cost. Companies no longer need to own their entire supply chain. Instead they can leverage the core competencies of their partners to create value. The traditional linear value chain exemplified by the vertically organized enterprise is being replaced by hubs of value whose arrangement is more accurately described as a “business ecosystem.”
But I would urge anyone to harken back to Porter’s 5 Forces Model because the above relinquishing of ownership is by no means to be considered a permanent state of affairs. As the Bargaining power of suppliers increases, it might exceed a point at which outsourcing one’s activity/process is no longer cost effective especially in the light of better technology. And that should be noted about the following:
In parallel, information technology and supply chain management practices have allowed organizations to refine the notion of what constitutes core competency. While outsourcing was once limited to such functions as public relations, human resources, and data entry, it now has been extended to a wide range of supply chain activities as well as to direct-material production.
Or just as the process of outsourcing has taken place for certain non-core competencies, changed circumstances going forward or the discovery of non-core competencies of the past as current sources of competitive advantage will lead to insourcing as well. Improving technology will definitely play an important role in enabling this kind of insourcing as well.
However as Roland points out, traditional notions of ownership are capital-intensive because of the investments in equipment, technology and people that have to be made in order to effectively manage a firm’s processes.
Increasingly, companies are discovering that the benefits of global sourcing and outsourcing transcend cost and working-capital savings. Combined with lean manufacturing practices, these approaches can smooth out business cycles.
I have a little difficulty understanding this part of his article though because I would contend that its a mixed bag. If one took the Lean part of his assertion – it is extremely difficult to do Lean when you’ve gone and outsourced/offshored parts of your operation (regardless of whether it core or non-core competency) and simultaneously driven up inventory in all parts of your supply chain to cover the increased lead times in the supply chain. Such a thing for all philosophical purposes is anti-Lean. As for the former part, what exactly is working capital? Working capital is simply what companies use for everyday business operations. Or,
Working Capital = Cash on hand + Accounts Receivables (Money owed by customers) + Inventories – Payroll – Accounts Payables (Money owed to suppliers) – Short Term Debt Costs
So on the positive side of the Working Capital equation, more cash is being tied up in Inventories from which a smaller amount of Accounts Payables is being deducted because of the cheaper costs of production. So what is the big chunk of the expected savings – It has to be Payroll because there is a significant savings in labor costs to be had by outsourcing or offshoring (more so in the case of offshoring than outsourcing from what I hear). However, carrying all the inventory that one now needs to keep production going in the case of offshoring will not smooth out the business cycle – if anything, it will exacerbate the situation at inflection points.
However, there is a broader picture that Roland has in mind and that is about the economy:
At a broader level they can dampen inflationary pressures in the economy overall. Alan Greenspan was one of the first financial policy makers to acknowledge the dramatic financial impact of supply chain management and related technology. In testimony to Congress, the former Federal Reserve chairman justified a program of aggressive interest-rate cuts this way:
“Extraordinary improvements in business-to-business communication have held unit costs in check, in part by greatly speeding up the flow of information. New technologies for supply chain management and flexible manufacturing imply that businesses can perceive imbalances in inventories at a very early stage-virtually in real time-and can cut production promptly in response to the developing signs of unintended inventory building.”
One hopes that the above were indeed all true but I am not so sure of it. While new SCM technology and manufacturing paradigms can indeed help firms identify and then decrease inventories, the firms can only do so when they have an appreciation of the impact some strategic decisions such as offshore manufacturing etc have on their business operations. And in an outsourced manufacturing operation, a firm is contract bound to take in delivery of production at the offshore location or face some cost for not taking delivery of the goods. In theory, SCM technology and improved manufacturing practices may indeed deliver positive effects on the economy as a whole but I still think its an open question whether that is occurring in practice.
Global sourcing and outsourcing also have served to insulate participants in volatile industries such as high-tech manufacturing. For public companies, the ability to report predictable and consistent earnings despite dynamic market conditions is vital. An adaptive, demand-driven business model can insulate these companies to some extent from rapid market changes, as suppliers bear the burden of fixed overhead or inventory obsolescence during sudden market contractions.
Is there a free lunch anywhere? That alone should warn anybody of expecting the above simply because suppliers are not going to bear the risk of such changes in business conditions without driving up the costs of doing business in some other fashion.
Here is what Gene Tyndall, president of Supply Chain Executive Advisors, has to say about the financial supply chain in today’s business world:
Both sourcing and manufacturing have gone global, Tyndall notes, which adds to the importance of the financial supply chain. Adding to the complexity are longer lead times, the involvement of multiple parties, added duties, taxes, longer delays, disruptions, security regulations, and so forth—all of which complicate financial flows and cash management.
There can be no doubt that going global has indeed complicated certain parts of the supply chain and what’s more important to note – it is precisely non-core competencies such as import management, customs and duties, compliance etc that need increased attention.
But Gene notes the following as well:
Despite the growing importance of the financial supply chain, many companies still don’t give it the attention it deserves.
Steve Payne, president of Hackett-REL, a firm that helps companies generate cash improvement from working capital, agrees. “Collaborative working capital management between supply chain partners—based on shared goals and visibility—is the North Star of the supply chain management journey,” Payne says.
The answer that seems to present itself is that such a competency is sorely lacking withing companies to begin with which is why new players are beginning to address this issue:
Instead, financial institutions are filling this vacuum with financial supply chain products that improve the overall capital efficiency of the supply chain. This is hardly surprising given the opportunities to profit from the arbitrage of capital-cost imbalances inherent in many supply chains.
In the next article, I will review the rest of article on Managing the Financial Supply Chain, delving into the kind of competency that firms have to develop in order to manage their financial supply chain, new processes needed, the inherent complexity of it all and some proposed solutions. In the meantime, fasten your seat belts, its going to get worse before it gets better.