CSCMP's Supply Chain Quarterly
October 22, 2018

Join the finance revolution

Major changes underway in supply chain thinking can improve company profitability. To participate in this financial revolution, supply chain managers need to take three important actions.

Supply chain management is a relatively young discipline, yet it is already undergoing significant changes. These changes stem from two important developments that are connected with the shift from logistics to the more comprehensive discipline of supply chain management:

(1) the broadening of focus from optimizing internal company processes to optimizing intercompany processes involving links with customers and suppliers; and

Article Figures
[Figure 1] The supply chain finance star of value
[Figure 1] The supply chain finance star of value Enlarge this image
[Figure 2] Service differentiation matrix
[Figure 2] Service differentiation matrix Enlarge this image

(2) the broadening of focus from simple cost control to maximizing supply chain productivity. The first is operational and has been acknowledged and discussed for several years. The second is very strategic and only recently is beginning to gain wider recognition.

Supply chain productivity—the focus of this article—falls under the domain of supply chain finance because it involves maximizing the earning power of a company's supply chain assets. That is one reason why supply chain management is becoming a premier area of strategic importance and, potentially, of huge financial gain in virtually every company. I call this The Coming Revolution in Supply Chain Finance.

To join the supply chain finance revolution and improve their companies' strategic positioning, market development, and financial performance, supply chain managers must take three essential steps. These include: (1) creating a systematic analysis of the current profitability of their products and accounts, (2) managing the deployment of a specific set of sharply focused "profit levers" to increase profitability, and (3) developing new ways to partner with counterparts in sales, marketing, and finance in order to ensure coordination and maximum financial results. This article will offer examples, explain these steps, and outline their benefits.

Baxter's big discovery
To get an idea of the different mindset I am suggesting, think about the following scenario. A supply chain manager works hard to reduce the inventory of a set of stock-keeping units (SKUs) by 25 percent, but these products end up being sold at a loss. Should the manager be satisfied with this outcome?

In times past, logistics-oriented managers would have focused on the inventory level and been satisfied. But today's supply chain managers should not accept such results. Instead, they need to focus on the broader consideration of supply chain productivity, maximizing the earning power of their assets in order to have a much greater impact on their companies' financial performance.

Baxter's development in the mid-1980s of one of the first vendor-managed inventory systems (which is now offered by Cardinal Health and called ValueLink) exemplifies how managers' focus on supply chain productivity can have exactly that effect.

Prior to that time, Baxter delivered its hospital supplies to its customers' loading docks. The products were chiefly intravenous (IV) solutions and related items; they were sold to relatively low-level procurement managers and were treated almost as commodities. At the same time, Baxter's logistics managers were careful about controlling costs within their own facilities and transportation network.

A very innovative general manager decided to review the distribution process and asked a two-person team to take a comprehensive look. The team members found that Baxter's internal operations were very efficient, but they became curious about what happened after the products were received at a hospital's docks.

When the team members followed the products through the hospital and did a rough cost estimation, they were astonished by the results. If the price of a liter of IV solution was about US $1 at the dock, the "landed cost" at the patient's bedside was about US $7. About half of that cost could have been avoided, mostly through taking simple measures that the hospital could not do on its own.

It turned out that Baxter had won or lost contracts based on whether its "dockside" price was US $0.98 or $1.02 per liter, yet $2 or $3 were wasted in getting the product to the patient's bedside. Suddenly it became clear: there was a huge supply chain-based opportunity to increase sales while simultaneously reducing costs, and for years no one had seen it.

Following that discovery, Baxter developed a process that bypassed stock rooms, extended its supply chain to the patient-care areas, and shared the savings with the hospital. This radical change produced three huge benefits, only one of which had been foreseen:

  • First, the Baxter team predicted that the hospital's costs would go down dramatically, which did occur.
  • Second, Baxter's own costs declined equally dramatically. As the company reduced the variance in the hospital's order pattern, it reduced its operating costs and safety stocks. No one saw this coming.
  • Third, when the model was extended to other Baxter customers, sales rose in hospital after hospital by over 35 percent, even in highly penetrated accounts. No one foresaw this, either. The new system produced big savings for the hospitals and solidified customer relationships. Importantly, the new relationships that drove sales were between Baxter's operations personnel and the hospital's nurses. These operations-to-operations relationships created enormous strategic advantage and barriers to competitive entry. The new system allowed Baxter's top management to build new ties to top hospital managers and spelled the end of commoditization.

Initially, Baxter's sales representatives worried that the new distribution method, dubbed the "stockless system," would interfere with their customer relationships. But when they saw the huge sales increases that resulted, they all wanted their customers to implement the new system. This was not feasible, however, either because some customers were not capable of managing coordinated supply chains, or they were located too far from the distribution hub. Moreover, because the supply chain team did not control the customer relationships, the salespeople often proposed relationships that would have caused the company's costs to explode.

What is the moral of this story? Supply chain management can have an enormous impact on a company's strategy, revenues, and competitive positioning, but to reap the full benefits, supply chain managers must be deeply involved in sales, marketing, and finance. Supply chain-based strategies have the potential for great gain, but if they are not managed well, they can end up causing big losses.

The "star of value"
The impact of Baxter's stockless system on the company's financial picture was profound. This impact occurred in six critical areas, which I call the Supply Chain Finance Star of Value (see Figure 1).

The star includes six important elements that determine a company's financial performance: revenues, costs, profitability, cash flow, asset productivity, and risk management. Each of these is strongly affected by supply chain finance. Consider Baxter's experience regarding each of these areas:

  1. 1. Revenues. Baxter's supply chain initiative dramatically increased the hospital's profitability, and this drove large revenue gains, even for customers where Baxter already had a high level of sales penetration. The operations-to-operations relationships cemented these sales increases. The new supply chain-based system created sustainable competitive advantage.
  2. 2. Costs. When Baxter's operations took control of a hospital's internal materials management process, the company's supply chain managers gained the ability to reduce the order variance. This gave them supply chain visibility and greatly improved forecasting, which in turn led to permanent cost improvements.
  3. 3. Profitability. Baxter was able to create enormous new value for the customer and share in this value through the assessment of new fees and stronger pricing. These more than offset the additional costs of providing the new service.
  4. 4. Cash flow. The company achieved large reductions in inventory thanks to the reduced order-pattern variance and other new operating efficiencies. This generated a large amount of cash from the start.
  5. 5. Asset productivity. The new system enabled Baxter to clearly identify the assets that were directly related to the new business. Baxter's managers could link the assets to their earnings, with clear measures and responsibilities. They could also tie asset productivity directly to the compensation of the account management team.
  6. 6. Risk management. In the new system, inventory levels were low, fixed costs were minimized, and barriers to competitive entry were very high. Both the customers and Baxter experienced large mutual gains. This radically reduced the business risk on several fronts.

    Why are terrific opportunities in supply chain finance like those Baxter discovered arising today? And why have traditional approaches to logistics and supply chain management not equipped supply chain managers to take full advantage of these emerging situations? The answer is rooted in recent business history.

    For most of the past century, businesses operated in the "Age of Mass Markets." In this era, companies sought economies of scale through mass production, and they distributed their products as widely as possible through arm's-length (independent or non-integrated) relationships. Most of our current management information and processes were developed during that period, which largely predated computers. Managers correctly focused on aggregate revenues and aggregate costs, and the role of a logistics manager was to move and store products at the lowest possible cost.

    Today, all that is changing. We are in a new era, which I call the "Age of Precision Markets." Now, companies form very different relationships with different groups of customers, and these relationships feature different degrees of supply chain integration and coordination. The Baxter example illustrates this new model. What is holding other companies back from similar achievements is that most supply chain managers are not systematically involved in creating and managing customer relationships. Instead, they are still primarily focused on internal cost control—like the logistics managers of old.

    The consequence of this deficiency is a pattern of profitability in which 30 to 40 percent of the company is unprofitable by any measure—accounts, products, orders, order lines—and 20 to 30 percent provides all of the reported profits and subsidizes the losses. This is the enormous supply chain finance opportunity that today's supply chain managers can and must address.

    Managing supply chain finance
    As noted earlier, to improve their companies' strategic positioning, market development, and financial performance, supply chain managers must take three essential steps: (1) creating a systematic analysis of the current profitability of their products and accounts, (2) managing the deployment of a specific set of sharply focused "profit levers" to increase profitability, and (3) developing new ways to partner with counterparts in sales, marketing, and finance in order to ensure coordination and maximum financial results. A brief discussion of each step will provide some guidelines for applying them.

    1. Analyze profitability of products and customers.
    The first step is to develop a baseline understanding of supply chain profitability. I call this process profit mapping. If 30 to 40 percent of a company is unprofitable, and 20 to 30 percent provides all of the reported earnings, the obvious question is, which part of the company is which?

    Today's accounting systems, with their aggregate measures of revenues and costs, do not give the granularity managers need to understand the profit landscape and to change things using sharply targeted initiatives. Instead, they need to build a new picture from a transaction-by-transaction (i.e. order lines) analysis. It is helpful to partner with finance managers in this process.

    This transaction analysis is not hard to do—in fact, a small team of one or two people can analyze a multibillion-dollar company in a month or two using standard desktop tools—but it is a very different approach. In essence, you must extract a three- or four-month sample of transactions and build an "income statement" for each transaction using available information and established guidelines. To gauge supply chain productivity, simply translate this information into a return on invested capital measure (earnings divided by supporting inventory) for each transaction. (A more detailed explanation of this method, with examples, can be found in Chapter 6 of my book, Islands of Profit in a Sea of Red Ink.)

    Once you have determined profitability and return on invested capital for each transaction, you can load this information into a database program and hunt down the good business, the bad business, and the marginal business. Because you are adding together individual transactions, it is very easy to combine and recombine your information on a product or customer basis. This process will let you explore exactly which products purchased by which customers are performing well, what changes are needed, and what gains will result.

    Note that this "bottom up" analysis is very different from traditional "top down" profit analysis, which generally focuses on the aggregate profitability of broad groups of products and customers. You will find that even in a "good" customer, there are plenty of underperforming products and that you can turn most of these around using relatively easy actions.

    It is very important to conduct this analysis at 70-percent accuracy, which is more than adequate for most decisions. Otherwise, you will be in danger of spending years debating cost distinctions that will not make a difference in actions that hit the bottom line. You can, of course, be more precise where it will make a big difference.

    2. Deploy a set of profit levers.
    Supply chain managers have a number of very powerful profit levers (focused actions that a manager can take to sharply improve profitability) that they can deploy to improve their companies' financial performance. Here are five that are especially productive: (1) account relationship standardization, (2) market mapping, (3) account relationship development, (4) service differentiation, and (5) product flow management. Note that several of these are traditionally the exclusive domain of sales and marketing, but supply chain management is vital to the success of every one of them. Let's look at each of them in more detail.

    Account relationship standardization. In most companies, customer relationships develop organically. Customers make suggestions to sales representatives and often want highly customized services. Over time, these small changes accumulate and become surprisingly costly. For example, I recently visited a large distribution center where over 30 percent of the cost stemmed from one-off requests from relatively small customers.

    Importantly, supply chain costs are only linear with respect to standardized processes, and they increase rapidly with complexity. Supply chain managers are expected to minimize the cost of escalating complexity, yet all too often, they are not involved in deciding what relationships the sales organization can offer to customers. As a result, many sales representatives agree to a wide variety of customer requests that offer little real value but cause fulfillment costs to escalate out of control. What can supply chain managers do to change this situation?

    The answer, not surprisingly, is to get in front of the problem by working with the sales and marketing team to define a standard set of relationships that will be offered. These relationships can vary in intensity from arm's length to highly integrated. In each relationship, both supplier and customer should receive measurable value, and each must have a clearly defined list of responsibilities. There also must be a clear set of account-qualification criteria for matching current and prospective accounts to the right relationships. By standardizing service offerings based on a small number of repeatable account relationships, the supply chain managers gain the crucial ability to design a streamlined, efficient operational process for each relationship.

    Market mapping. Once the supply chain, sales, and marketing teams specify the set of standard customer relationships, the next step is to match customers with the proper type of relationships. It is very important for the supply chain managers to be closely involved in this process. If, for example, a highly integrated relationship is sold to the wrong customer (e.g., a customer that is poor at execution or a poor operating fit), then costs will spin out of control.

    Here, the key to success is to qualify accounts using factors like potential margin, relationship versus transactional buyer behavior, operating fit, and willingness and ability to partner and manage change. Notice that most of these are operational measures. It is very important to determine what type of relationship a customer should ultimately wind up with, so the sales representatives can work with the supply chain managers to move each account to the relationship that maximizes financial performance.

    Account relationship development. As the Baxter case showed, supply chain managers are critically important in developing and managing the most important customer relationships, and for building trust and rapport from the very start. In fact, they have a particularly important role to play with high-potential but under-penetrated accounts.

    Sales representatives who have been stymied in their attempts to increase sales to a particular account may feel that they should not involve supply chain managers in a still-developing relationship. Yet the supplier's supply chain managers and their customer counterparts often can develop productive relationships even before the sales relationship matures. Both are naturally attuned to look for efficiencies, and this enables them to rapidly develop the productive initiatives and personal chemistry that lead to deep trust and rapidly rising sales.

    Thus, the essential objectives of account relationship development, in order of importance, are: (1) to secure the best accounts using integrated relationships, (2) to hunt down and secure the high-potential, under-penetrated customers, (3) to make marginal business more profitable, and (4) to price at compensatory levels the business that cannot be made more profitable. Each of these requires the full participation of supply chain managers.

    Figure 2, the Service Differentiation Matrix, illustrates the process of matching the degree of supply chain integration to customer characteristics (here, account size and willingness and ability to partner).

    Service differentiation. Most sales and marketing managers make the seemingly obvious assumption that all customers should get the same great service. This is a very costly assumption.

    If a company promises rapid service to everyone, either it will fail to provide it, or inventory and delivery costs will become unacceptably high. Service intervals, such as order cycles, should therefore reflect the nature of the customer relationship. Steady customers should get rapid service, but occasional customers should be promised longer order cycles (although most of the time they would probably receive more rapid service). By lengthening the promised order cycle for occasional customers, the company gains the ability to bring in inventory from regional, pooled stock if needed, rather than have to keep extremely high levels of inventory in all of its field locations.

    If a sales representative argues that instituting longer service intervals will prevent the company from acquiring a potentially important account, the supply chain organization can offer rapid service for a period of time (perhaps two or three months), and only continue it if the customer signs a long-term contract or increases its purchases. This is another example of the importance of closely linking sales with supply chain management.

    Once you promise different service intervals, or order cycles, to different customers (depending on their relationship), that promise must always be kept. After all, the correct measure of customer service is not the length of the order cycle you promise, but rather how much of the time you fulfill that commitment. Supply chain managers are essential in setting realistic service intervals and relating them to the account development process. This is a key element in managing account relationships, growing revenues, and turning marginal business into profitable business.

    Product flow management. The Baxter case clearly demonstrated the power of product flow management. When the company gained control over the customer's order pattern, it could reduce the variance and significantly lower supply chain costs throughout the channel. This is another essential element that you can use to turn marginal business into profitable business.

    Most sales and marketing managers simply assume that their customers have a good reason to order the way they do, and most supply chain managers make the same assumption. In my experience, however, this assumption is usually incorrect. In fact, when customers' supply chain managers see their actual order pattern, they often are surprised, or even appalled. Order patterns with a lot of variance are costly for the customer as well as for the supplier. Supply chain managers have an important opportunity to coordinate with their customer counterparts to reduce this cost.

    3. Partnering with sales, marketing, and finance
    In the past, supply chain managers could largely meet their objectives by managing the functional areas under their direct control. Today, by contrast, they have to work much more closely with their counterpart managers in sales, marketing, and finance in order to realize the promise of the coming revolution in supply chain finance. This will require developing an effective new set of coordinative processes.

    Four of the processes that were discussed in a prior section are particularly important for supply chain effectiveness in the Age of Precision Markets: (1) profit mapping, (2) customer relationship definition, (3) market mapping, and (4) account management and service differentiation. Supply chain managers must get this short list of coordinative processes right if they are to be successful in the future.

    Director-level managers, or the department heads, are the key focal point for interdepartmental coordination. In the past, the primary job of a supply chain director was to oversee and coach the managers in his or her department. In the future, directors' jobs must change in a fundamental way. Taking advantage of the new opportunity for financial gain requires a lot of tight, day-to-day coordination among department heads throughout the company, along with coordination with counterparts in customers' companies.

    This means that supply chain directors must spend no more than half their time on internal department matters. The other, more important half of their job now is to partner with their counterparts in other functional areas (and with counterparts in customer companies) in order to create and manage the four core, coordinative processes outlined above.

    Huge, new opportunities

    As we have seen, the coming revolution in supply chain finance creates huge, new opportunities for supply chain managers, but it also requires that they develop a new set of capabilities, information, and management processes. Moreover, they must step up to a very different role—that of full business partners who make a big difference in their companies' strategic positioning, market development, and financial performance.

    Although this would require a major change in the way most supply chain managers think about their roles, the potential benefits are so great that such a shift makes undeniable sense. Think about it: In leading companies today, supply chain integration leads directly to sales increases of 35 percent or more, even in highly penetrated accounts. It seems clear that supply chain management is the fastest and surest way to increase revenues.

    At the same time, top companies that structure their sales processes to bring in revenues from business that fits their supply chains' capabilities see cost reductions of 30 to 40 percent or more. All revenues (and their sources) are not equally profitable, of course, and thoughtful sales discipline is the best way to create quantum increases in supply chain productivity and efficiency.

    Welcome, then, to the new world: supply chain management driving huge revenue gains, sales discipline creating massive new supply chain efficiencies, and in the process rapidly improving financial performance.

    This is the promise, and the challenge, of The Coming Revolution in Supply Chain Finance.

    Jonathan L.S. Byrnes is Senior Lecturer at the Massachusetts Institute of Technology and author of Islands of Profit in a Sea of Red Ink.

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