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The Supply Chain Index: A new way to measure value

Comment
Supply chain executives need a more relevant set of metrics in order to better measure performance improvement. That's why the Supply Chain Index was created.

Supply chain management is a balancing act. Progress is made slowly through alignment and continuous improvement. The supply chain leader is charged with improving the potential of an organization at the intersection of operating margins, inventory turns, and case-fill rate. Sometimes the choices are made consciously, but others are unconscious and seem to just happen. Conscious choice in alignment with a business strategy is a strong factor in determining supply chain excellence.

While supply chain excellence is not the sole factor in a company's success, it is hard for a company to succeed without it. Ensuring success requires a nuanced approach that uses a portfolio of carefully selected metrics. In the journey toward excellence, we find that discrete industries are more focused on cycles, and process industries are more focused on the optimization of flows. However, all companies want a measuring stick of supply chain improvement.

Article Figures
[Figure 1] The supply chain effective frontier
[Figure 1] The supply chain effective frontier Enlarge this image
[Figure 2] Aggregate performance of companies within an industry on the effective frontier
[Figure 2] Aggregate performance of companies within an industry on the effective frontier Enlarge this image
[Figure 3] Grid for Supply Chain Index calculation
[Figure 3] Grid for Supply Chain Index calculation Enlarge this image
[Figure 4] Orbit chart: Inventory turns vs. operating margin for selected food and beverage companies (2009-2012)
[Figure 4] Orbit chart: Inventory turns vs. operating margin for selected food and beverage companies (2009-2012) Enlarge this image
[Figure 5] Orbit chart: Inventory turns vs. operating margin for selected food and beverage companies (2009-2012)
[Figure 5] Orbit chart: Inventory turns vs. operating margin for selected food and beverage companies (2009-2012) Enlarge this image
[Figure 6] Supply Chain Index for food and beverage for 2006-2013
[Figure 6] Supply Chain Index for food and beverage for 2006-2013 Enlarge this image
[Figure 7] Comparison of performance and improvement for food manufacturers
[Figure 7] Comparison of performance and improvement for food manufacturers Enlarge this image

It is difficult to determine whether a company is making progress. It is for this reason that we built the Supply Chain Index.

Definition of the Supply Chain Index
The Supply Chain Index of performance improvement is built on the framework of the Effective Frontier (shown in Figure 1). In this model, growth and profitability must be maximized, cycle time should be reduced, and complexity needs to be managed. It is a complex system. An overweighed focus on any one of the four categories can wreak havoc on a supply chain's operations; similarly, a focus on a single metric can throw the supply chain out of balance.

Using this model, the Supply Chain Index is designed to measure supply chain progress on a portfolio of metrics. To build the index, we chose the metrics of year-over-year growth, return on invested capital (ROIC), operating margin, and inventory turns.

The index assumes that its three components—balance, strength, and resiliency—should be valued equally. Balance tracks the rate of improvement in growth and in return on invested capital, while strength and resiliency factors are based upon progress in profitability and inventory turns. We believe that together these three factors provide an effective tool for measuring supply chain performance and improvement over a set time period.

Each industry has different potential, or ability to reach metrics targets. It is a mistake to include information from different companies in a single spreadsheet and evaluate them as a group without understanding their industry potential and market drivers. The maturity and potential of each industry within a value network is very different.

The Supply Chain Index is a measurement of supply chain improvement. In this analysis, the starting year and the duration of the analysis matter. Some industries, like chemical, that struggled significantly during the Great Recession have rebounded with greater gains in recent years. Similarly, the overall results for apparel and food and beverage companies improved in this period, while results for retail and consumer packaged goods stalled. (See Figure 2).

Index methodology
There are three components of a Supply Chain Index score: Objective performance on balance, strength, and resiliency. Each contributes 30 percent of the final score. Maintaining balance in the supply chain is a constant struggle. Reduced inventory availability wreaks havoc on customer-service levels. Excess inventory leads to high carrying costs and obsolescence of product. Excessively long days of payables leads to weakened supplier health. The examples are endless, but one thing is clear: balance is critical.

The two metrics that determine the balance factor are revenue growth and return on invested capital. As a metric, return on invested capital is not as well known as return on assets (ROA). Return on assets has a narrower focus; our research indicates that, as the formula below suggests, ROIC has better correlation with stock market capitalization and provides a broad perspective on cash-flow generation and profitability, both of which drive shareholder equity.

ROIC, then, is a measurement of a company's use of capital. The goal is to drive higher returns than the market rate of the cost of capital.

The balance measure in the Supply Chain Index is a mathematical calculation of the vector trajectory of the pattern between growth and ROIC for the period of 2006 to 2013. The overall trajectory of this vector from Year 0 (2006) to Year 6 (2013) is simplified into a single value that represents the company's ability to balance growth and ROIC. Companies that were able to drive improvement in both metrics score the best, while companies that deteriorated in both metrics did the worst. A negative score on the balance score translates to a supply chain that lost ground on the metrics compared to the starting year. In this report, we consider two time periods. Our initial analysis considers performance based upon a time period of 2006-2012. Additional analysis focuses on the narrower time period of 2009-2012 in order to examine corporate performance as companies emerged from the Great Recession.

The second factor in the index is strength. A successful supply chain is a strong supply chain. Supply chain leaders deliver year-over-year improvements. Our research over the past two years has uncovered a rich relationship between operating margin and inventory turns. For most supply chain leaders, these are some of the most important measures of their performance. Not only are they important, they also are more directly influenced by supply chain decisions than other, broader corporate metrics. It is for this reason they are the two components of our strength metric.

Similar to the calculation of balance, the strength measure in the Supply Chain Index is a mathematical calculation of the vector trajectory of the pattern between inventory turns and operating margins for the period of 2006 to 2013. The overall trajectory of this vector from Year 0 (2006) to Year 6 (2013) is simplified into a single value that represents strength. Improvement on both metrics simultaneously is graphically shown as movement to the upper-right quadrant, with increasing values for both inventory turns and operating margin over the period.

The strength metric comprises 30 percent of the total Supply Chain Index calculation. Sustained improvement on both inventory turns and operating margin indicates a strong supply chain and is reflected in a high strength score.

The third factor is resiliency—a word often used to describe one of the key qualities of a successful supply chain in today's volatile world. However, the concept of resiliency is difficult to define, and there is rarely clarity among stakeholders as to what resiliency is or should be.

As we plotted orbit chart after orbit chart, we could see that some supply chains showed very tight patterns at the intersection of operating margin and inventory turns, and that other companies had wild swings in their patterns. (An orbit chart is a plot of the trajectory of two metrics. It is useful in pattern recognition.) We wanted to find a way to measure the tightness, or reliability, of results for these two important metrics. For help, we turned to the experts at Arizona State University (ASU). After evaluating several methods to determine the pattern in the orbit charts, we settled upon the Euclidean mean distance between the points (a measurement of the compactness of the chart).

The resiliency metric is similar to the cash-to-cash cycle in that companies should work to minimize the value. A lower number for resiliency is an indicator of a tighter pattern and greater reliability in results over the time period. The results for these companies are more predictable and stable for operating margin and inventory turns.

The balance, resiliency, and strength values are calculated and then stack-ranked. Figure 3 shows the framework we use for making this determination. In the analysis, each industry segment, as defined by the U.S. Census Bureau's North American Industry Classification System (NAICS) codes, will be considered on an individual basis. As a result, Colgate-Palmolive Company will not be directly compared against Ford Motor Company or Wal-Mart Stores Inc. The definition of a best-in-class supply chain varies depending on the complexities and realities of the operating environment and it is not a one-size-fits-all business measurement.

"Most improved" does not mean "the best"
It is important to clarify what the Supply Chain Index is and is not. It is a methodology for ranking supply chains by industry and NAICS code, and the measurement is one of relative improvement. Our goal is to combine data on companies that have performed well—in the top 20 percent of their peer group for both inventory turns and operating margin for the period—along with a measurement of improvement, as measured by the Supply Chain Index.

It is critical to note that "most improved" over a specific time period does not mean best over that same time period. Industries like apparel that have historically underperformed on supply chain processes have greater opportunities for improvement than do companies in industries like consumer electronics, which has been a leader in supply chain performance for many years.

Oftentimes the results can be surprising, and this distinction between performance and improvement is critical. Often, companies that have the largest gaps in performance will improve at the fastest rate. To understand the methodology, let's take a closer look at the food and beverage category.

Food and beverage manufacturers struggle with the unique challenges of volatility in commodity prices, a high degree of seasonal fluctuations from both the supply and demand sides, and perishability of products, as well as regional food profiles that make global management challenging. The orbit chart in Figure 4 illustrates the patterns for inventory turns and operating margin performance within the food and beverage industry for a group of industry leaders. As can be seen in Figure 5, which looks at four companies from within that group, General Mills operates at a higher level of performance than the other three competitors in both operating margin and inventory turns. (The asterisks indicate the starting year.) But as shown in Figure 6, Hershey is achieving the greatest improvement.

The better the supply chain, the tougher it is to drive improvement. So, while we could debate whether the top performer is General Mills (which operates in the top 20 percent on operating margin and inventory turns and shows slow improvement) or Hershey (which shows the greatest improvement), what is clear is that Conagra, Hillshire Brands, Kellogg, and Maple Leaf Foods are not among the top performers in terms of improvements.

Improvement needs to be looked at together with performance. When we do this, as shown in Figure 7, we find that General Mills achieves both above-average performance for the period in inventory turns, operating margin, and return on invested capital, and is making year-over-year improvement in supply chain performance ahead of its peer group.

A measure of excellence
Supply chain leaders want to excel. They need to measure performance improvement, but due to the complexities of the metrics, this is harder to do than many think. Averages only tell part of the story.

We find that the patterns representing year-over-year performance are a better indicator of supply chain excellence than single measurements presented in year-by-year snapshots. The Supply Chain Index is a measurement of supply chain improvement and is a useful methodology for comparing the progress of companies within a peer group. As such, it is a helpful tool for the supply chain team to use to gauge supply chain potential, or for defining reasonable targets based on a feasible rate of improvement.

Lora Cecere is founder and chief executive officer of the research firm Supply Chain Insights.

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