Key drivers of profitability and competitiveness in supply chain

Since the recession began, supply chain management has been back on the agenda of companies’ boardroom. There is no doubt that it’s the perfect time for company leaders to exam their supply chain model, supply chain network and identify the hidden costs in the chain. By reshaping the supply chain strategy of companies, the supply chain can become the “cash” chain.
The below chart represents key drivers of profitability and competitiveness in the supply chain. There are three aspects that supply chain can do to drive “cash”: reduce expense, increase revenue, and improve assets liquidity. Companies should look into all aspects, encourage innovation and risk taking. Companies can not only streamline the processes to achieve a lean and efficient organization, but also make their supply chain organization into a revenue stream.

Profibility
Supply chain as cost drivers

This is the first thing that every company will jump into. “Cutting costs” becomes the slogan of the company. Many companies assign certain dollar amount to each individual as performance objectives. There is nothing wrong with that, except company leaders need to be aware of the existence of functional silos, and commit to transparency communication within the organization. As we all know, there are many tradeoff decisions to be made within supply chain, such as the traditional tradeoff between warehouse and transportation. Remember, pressure can increase the political level inside the organization and sometimes force people to make a decision based on making their numbers. High level leaders are responsible for the big picture of the whole supply chain and support the least total cost decisions for the organization. Unreasonable measurements or targets can discourage employee morale, damage organizational heath and sometimes lose supply chain talents for future growth.

Below is analysis for key drivers for supply chain as expenses and opportunities for cost reduction:
a. Transportation
There are many areas to be looked at in transportation to achieve cost savings. It has been discussed in detail in my article “Five Ways to Achieve Cost Savings in Transportation”.

b. Inventory carrying costs
It’s an area that many companies overlook and don’t even calculate and understand their inventory carrying costs. As standard rule of thumb, inventory carrying cost is 25% of inventory value on hand. When high inventory level is unavoidable during a recession, it’s a great opportunity for the company to look into their inventory carrying costs to identify opportunities. Below charts present all components for inventory carrying costs. I will discuss more into details in a separate article.

Inventory carrying cost

c. Variable production and warehousing cost
Variable costs are cost of labor, material or overhead that changes according to the change in the volume of production units. I believe many companies conduct ABC (Activity Based Costing) analysis to find out standard variable cost. Variable cost reduction can be done through process improvements to reduce wastes in production and warehouses, such as waiting time, movements, etc.

d. Raw materials
Raw material is considered as part of inventory. It includes direct and indirect raw materials. Collaboration and partnering with suppliers can lead to total inventory reduction in the chain to achieve a win-win situation, such as VMI or ERP. Scrutinizing suppliers in a difficult time will jeopardize companies in the long term.

Supply chain as revenue driver

Many companies recognize their supply chain as cost driver, but fail to see the prospect of supply chain as a critical role to drive revenue.
a. Supply chain service
Supply chain service level directly impacts customer satisfaction. Order fulfillment and on-time delivery are two major service metrics to measure company supply chain efficiency and effectiveness. Higher service levels bring higher customer satisfaction which prevents loss of revenue and leads to future sales. It’s worth noting that there is an exponential relationship between service level and cost. However, there is normally a predefined service level agreement between companies and their customers or trade partners.

b. Supply chain solutions
When business development is trying to break into a new sales channel, supply chain supporting capacity can often be brought up as a question. Example: A company wants to enter into a new market which can only order small LTL orders, but at much higher frequency. If the company has become accustomed to TL orders all the time, those LTL orders will become a market entry barrier due to increased logistics cost. Under this kind of circumstance, supply chain, as its supporting role to revenue increase, needs to be flexible and innovative to provide a solution as an enabler for market expansion without hurting the company’s bottom line. In this case, working with 3PL for LTL consolidation can often be the solution for the challenge.

c. Recycling or reverse logistics.
It’s one area that is easily neglected by many companies. Recycling, picking up disposed goods from the customers and reselling, can not only improve customer satisfaction and lead to new purchase, but also bring the company a new channel of revenue by reselling disposable goods to a safe recycling channel. It also helps companies to fulfill their social commitment for environment sustainability.

Supply chain as assets management

Asset management can be the most challenging task for supply chain because it would take a much longer time to make changes in company assets, such as leasing contracts for warehouses. Better asset management in supply chain will require will require organization transparency and a communication from upstream to downstream to minimize functional silo.

a. Fixed cost of DCs and docks
For a company with excess inventory, it’s costly to acquire more space for storage. For companies with extra space due to less demand, it won’t be easy to close DC in the short term and there is also a risk for a higher acquiring cost when the market is back. So companies can seek partner opportunities with each other to overcome the difficult time together. A project I worked on in the past is to provide a customer storage solution. With certain incentives, the customers purchase several months of inventory shipped directly from the manufacturer. They utilize their empty spaces to make storage revenue and the products are used for their future demand. While the company with excess can avoid the cost of new warehouse space and one leg of transportation from storage to the customers. Certainly this kind of process needs to be carefully managed to avoid skewing demand and other possible negative impact.

b. Fixed cost of plant
This is the most difficult part of all costs reduction opportunities because it may lead to the close of a factory or downsizing the workforce. It’s the last thing I like to see and propose because I’m also one of the millions who lost their job during the recession. The company should try their best to use other methods such as work sharing or payroll reduction to work with employees to overcome the difficult time together. However, as a business person, I can also understand “competitive advantage”. If closing a plant is the best thing for long term growth and efficiency, we just need to face the reality and move on.

c. Cost of private fleet
It’s very similar to the fixed cost of DCs and docks. When it’s not possible to reduce the size of the private fleet in the short term, partner with suppliers or customers to share the capacity to reduce costs.

d. Inventory management
Inventory is the biggest issue to any company during a recession when consumption drops dramatically. It’s a big topic and there are many things that can be done in inventory management. It not only requires day-to-day tactical inventory management to minimize inventory DOS and maintain a targeted customer service level, but also requires some strategic decisions from higher levels to achieve inventory goals.
I. Use demand driven forecast, instead of sales & marketing driven. Many companies include their marketing goal in their demand forecast which produces an inflated the demand forecast. Inventory overflow is unavoidable when the market is down. Face the reality, and forecast based on customer demand.
II. Centralize inventory management, instead of decentralize. A decentralized ordering or inventory management can normally cause higher inventory in the entire supply chain. Centralized inventory management will lead to better forecasting at an aggregate level and hence result in a lower inventory.
III. Inventory optimization and classification. ABC classification can improve inventory turn while maintaining fulfillment service levels. Optimization will lead to SKU reduction so companies can focus on their critical products for better service and lower cost.

Established metrics leads to total supply chain excellence

Besides all of these actions and factors to enable supply chain to become the “cash” chain, leaders should not forget to establish well-designed metrics for the entire organization to achieve total supply chain profitability and competiveness. Company leaders need to be aware that high costs in some areas are normally the symptoms of root causes, and many times, those problems are caused by the wrong metrics in the organization. Requesting cost savings without removing the root causes and establishing accurate performance metrics, the cost savings initiatives can be a failure. For example, production cost per unit is a great measurement of manufacturing efficiency, but it can result in high inventory when manufacturing ignores other cost components in supply chain and over produces in order to reduce cost per unit to meet their metric. This kind of story actually happens every day, and it’s a daily battle for many supply chain professionals. The right metrics convey the right positive incentives and drive the right decisions. When overhauls in supply chain need to be done at a strategic level to achieve day-to-day tactical operational efficiency, company leaders have the obligation and responsibility to face reality and to make the right strategic decisions for the organization.

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Will Home Depot Achieve Its inventory Goal Through Supply Chain Transformation?

I just read two articles regarding Home Depot supply chain transformation. Home Depot’s supply chain overhaul to free up cash, improve inventory by Rachel Ramos at Atlanta Journal-Constitution dated Sep, 2008. Another article Aggressive Supply Chain Transformation at Home Depot by Dan Gilmore, editor of SupplyChainDigest, dated Jun 2009.

Both articles discussed that high inventory at Home Depot stores forced the company to transform its supply chain network from the previous direct-to-store model to a traditional RDC model. The direct-to-store model made sense to Home Depot in the past because of its high sales in each store. With network expansion and competition, per store sales dropped and a decentralized ordering model caused high inventory problems for Home Depot. The aggressive supply chain transformation started in early 2007 and should be able to help Home Depot improve their current inventory turn from 4 to a higher number.

Out of curiosity, I looked up the financial reports of both Home Depot and Lowes to get their inventory turns data. I used the standard formula of inventory turn of COGS/average inventory. The below table shows the result:

HDInvTurn

What can those numbers tell me?

First of all, there was not much improvement in last two years compared to 2006. In the first two quarters of 2009, Home Depot had inventory turn lower than 1 in both quarters, which can translate to an annually turn lower than 4. It can be explained due to current economy downturn. The RDC model didn’t seem to fix the inventory problem. So, if inventory is not in stores, they might be accumulated in RDCs.

Second, we see a declined number from Lowes. Same story for first two quarter of 2009, Lowes even had a lower inventory turn number than Home Depot did. Lowes has had the traditional RDC model since the beginning. So, I can conclude that the RDC model will not be the only fix to improve its inventory turn.

Supply chain network remodeling to RDC model can definitely help Home Depot to improve the right level of inventory at stores and offer consumers a cleaner shopping environment. It will also help to improve forecast accuracy at an aggregate level. However, Home Depot seems to have more to do in order to increase their inventory turn from 4 to 5. From my point of view, there are at least two more things that Home Depot should do beside supply chain network redesign:

1. Inventory optimization through SKU ABC classification.

70% of 35,000 SKUs having a lower than one sales one store per week represents an opportunity. Even though Home Depot doesn’t plan to cut any SKU to meet customer satisfaction, it can use traditional ABC classification and establish different inventory turn targets for different types of SKUs. Those 70% of SKUs normally will represent about 20% of sales for Home Depot. They should be classified as B or C SKU, which can be allowed a lower inventory turn to reduce ordering administration. However, for A SKU, which normally account for 20% of SKU but about 80% of revenue, should be closely monitored to meet a much higher inventory turn target. From SKU ABC classification, Home Depot can focus on their key SKUs to improve overall inventory turn and at the same time to satisfy customers’ needs.

2. Supply chain technology enhancement.

I agree with what Mark Holifield, SVP of SC, said that the biggest challenge is culture change. However it might be a good time for Home Depot to invest on a robust supply chain system to accurately reflect customer demand at each store in a timely manner and hence result in a better demand driven forecast. Wal-Mart had a surprising inventory turn of 8.8 in 2008 and looks like to be able to achieve the same level based on the number of tuns in the first two quarters of 2009. As we all know, Wal-Mart is a huge pusher for supply chain technology and RFID. I’m a believer that utilizing technology will drive workflow automation and thus drive process and culture changes. An advanced supply chain information system will give Home Depot the competitive edge in the competition.

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