Supply Chain Metrics That Matter

This article fits in a series of articles inspired by the book ‘Supply Chain Metrics

That Matter’. In her latest book Lora Cecere introduces ‘which are the metrics that

matter’, ‘how to ensure strength, balance and resilience’, what are the ‘evolutions

in different sectors’, … In this third article, Bram tries to explore alternatives for measuring the cash side

and the service-cost side of the supply chain triangle. He compares inventory

turns and CCC for the cash side. He compares EBIT and EBITDA for the service-cost

side. We also derive the best practice curve amongst 3 benchmark companies and

derive resulting targets for a combination of EBIT-inventory or EBIT-CCC. We hope

you enjoy the reading.

Linking the Supply Chain Triangle to Strategy

In our 3 previous articles,

• Balancing Cash Cost and Service. The Supply Chain Triangle

• Benchmarking and the Best Practice Frontier in the Supply Chain Triangle

• Financial Benchmarking for Inventory Turns and Working Capital

we have shown there is a lack of alignment for targets on the cash, the cost and the service side of what

we have called the Supply Chain Triangle. We have looked at the EBIT per inventory $ or per working

capital $ to define a best-practice frontier. That frontier can then be used for setting balanced targets on

EBIT% versus Inventory Turns or EBIT% versus CCC.

The resulting balanced targets typically pointed in 2 possible directions:

- Either a combined improvement on EBIT% and Inventory Turns (or CCC)

- Either an more focused improvement on EBIT% for the current Inventory Turns (or CCC)

As we will now argument, the choice between these 2 is the choice of strategy. To do so, we will map

the 3 strategic options proposed by Treacy & Wiersema to the Supply Chain Triangle.

The 3 strategic options proposed by Treacy & Wiersema

Treacy & Wiersema1 argument that in any sector, a company can be a market leader by excelling in 1 of

three dimensions only. Either the company is a product leader, is a leader by operational excellence, or

by customer intimacy. We will give our interpretation of these three extremes and then analyze the impact on the supply chain triangle.

An Opex (Operational Excellence) leader prevails by low-cost and hassle-free, no-nonsense, easy service.

He is focused on being the cheapest in combination with easy-to-deal-with. Commonly used examples

are the low-cost airlines like Southwest or Ryanair who have disrupted the airline sector by a relentless

focus on low cost and hassle-free service.

A Product Leader prevails by having the best product, again and again. He is focused on generating a

stream of innovative products or services that sell at a significant premium. The investments in product

1 Treacy, M., Wiersema, F., The Discipline of Market Leaders, Basic Books, 1995

development and marketing are significant. In fact, with each new product, the product leader is betting

his business. A success story will give an above normal return. Two failures in a row can destroy the

company. Apple would probably serve as an example. For years it stood out with a stream of new

products ranging from the i-pod, the i-phone and the i-pad to i-tunes and the i-cloud. But nothing lasts

forever. Fierce competition from Google and Samsung is putting the heat on Apple.

Some companies are not the cheapest, nor the first on the market. They prevail by having an intimate

knowledge of their customer. The key asset in customer intimacy is the knowledge of the customer and

the relation with that customer. Serving the full range of a customers’ needs will exceed the core

competences of the intimacy leader. It is key for him to expand his capabilities by forging key

partnerships. The integrated approach of the Intimacy leader is valued at a premium compared to an

Opex leader. The premium is driven by the ‘comfort’ to the customer of the ‘one-stop-shop’. It’s a

premium because of convenience.

Mapping Treacy & Wiersema to the Supply Chain Triangle

In Figure 1 we’ve started by mapping the 3 strategic options of Treacy & Wiersema to inventory axis of

the Supply Chain Triangle.

Figure 1 - Mapping Treacy & Wiersema to the Inventory Axis of the Supply Chain Triangle

The reason for an Opex leader to work with minimal inventory (or the highest turns) is the inventory

cost. Less SKU’s means easier operations, lower cost per unit, less risk and write-offs. Opex leaders typically have the smallest product portfolios, are ruthless on the value-add of an extra SKU. Simplicity

drives the efficiency on which the Opex leader prevails.

A Product leader has the highest inventory risk. Imagine the situation of Apple when launching the i-

pod, the i-phone or the i-pad. How to forecast sales of a new product in a new market? The uncertainty

is very high. If the forecast is too high and the product is a failure, you can be left with a lot of unsold

inventory. Given the fast pace of technological innovations unsold inventory is at a high risk of becoming

obsolete. If the forecast is too low, and the product is a hit, it can take weeks or months for the supply

chain to catch up. Delivery problems will affect sales and give time to the competition to respond.

Moreover innovative products typically sell at a high margin. All this favors having ‘too much’ stock over

‘not having enough’. In a series of innovative products, you know that some will fail. These will create

unsold inventories. This is the risk on which the product leader thrives.

To be on the edge, product leaders have to work with innovative components and suppliers. New components have a higher risk for quality issues, frequent revisions, … which adds to the overall

inventory the product leader is carrying.

For the Intimacy leader, being the 1-stop-shop for your customer typically comes with complexity. An

intimacy leader has a broad range of products and services. Not all of these products may individually

lead to a profit. The profit is judged on the level of the client, not on the level of the SKU.

We have plotted the Intimacy leader in between the Opex leader and the Product leader for inventory

turns. His higher complexity will lead to lower turns than the Opex leader. His premium will be lower

than that of the Product leader, pushing him to keep control.

Notice that none of the strategies is focused on ‘cash’. They all have to trade-off whether an extra

inventory cost is set off by higher margins. Carrying more inventory is allowed. As long as the margin

generated per inventory $ goes up, we assume financial markets will provide you with the necessary

cash. Also remember that in any industry you’ll find leading companies in each of the dimensions.

Figure 2 maps the 3 strategic options to the service dimension of the Supply Chain triangle.

Figure 2 - Mapping Treacy & Wiersema to the Service Axis of the Supply Chain Triangle

In our perception, a true product leader goes beyond service by creating emotional value. Customers

pay a double premium because of that emotion, to feel special, to be part of the clan that ‘owns

something special’. That’s why customers queue up at night in front of the store the day of a product

release.

Product leaders extend that emotion into the buying and after sales process. Apple stores breathe the

Apple spirit. They are not low cost shops. They are fashionable, playing the emotion, reinforcing the clan

feeling. In general, we expect product leaders to be highly service oriented. We ranked them highest.

We have ranked the ‘customer intimacy’ player above the ‘operational excellence’ player. It’s not that

Opex doesn’t care about service. Remember that ‘hassle-free service’ is one of the key aspects of the

Opex discipline. The level of service however is lower because of the cost focus. In customer intimacy

we are willing to go the extra mile for the customer, we extend the service and expect a premium in

return.

Finally, in Figure 3 we have also mapped the 3 strategic options to the cost side of the Supply Chain

Triangle.

Figure 3 - Mapping Treacy & Wiersema to the Cost Axis of the Supply Chain Triangle

The Opex leader should be the cost leader. Every fiber in his organization is focused on lowest cost. His

cost position is the reference on the cost axis. The extra mile of the ‘customer intimacy player’ comes at

an extra cost. That’s why we ranked them higher.

Finally, the Product Leader has the highest cost. Being the first on the market, again and again, requires

significant investments in R&D. You may have the best product, but if nobody knows it, it will not sell. As

a result, product leaders also invest a significant amount of money in marketing and sales. Playing the

emotion, is part of the product leaders game. Next to R&D and marketing, a product leader will also

have the highest supply chain cost. Forecasting the sales of a new product in a new market (e.g. the first

i-pad) comes with a high error. The corresponding supply chain will focus on flexibility, not efficiency.

The flexibility will come from multi-sourcing, ample capacity, fast transportation modes, … This flexibility

will come at a cost. However, if the product is a success, the premium paid the customer will lead to a

premium profitability for the product leader. It’s the highest risk game. The highest risk typically leads to

the highest potential payoff.

Figure 4 shows the resulting profiles for the product leader, the customer intimacy leader and the opex

leader. 3 different profiles, each of which can earn market leadership according to Treacy & Wiersema,

as long as executed in a disciplined way, hence the appropriate title of their book “The discipline of

market leaders”.

Figure 4 - Mapping Treacy & Wiersema to the Supply Chain Triangle - resulting profiles

Figure 5 is showing the same, but again maps it in 3D, as we did in our blog “Benchmarking and the Best

Practice Frontier in the Supply Chain Triangle”. Remember that the ‘surface’ was the ‘best-practice

surface’. Companies on the surface typically need to give in on 1 of the dimensions if they want to

improve on another. Companies below the surface can improve on the 3 dimension at the same time.

Figure 5 - Mapping Treacy & Wiersema to the Supply Chain Triangle - resulting profiles 3D

The mapping in Figure 5 sheds some extra light on the 3 options proposed by Treacy and Wiersema.

They are 3 strategic options on the ‘best practice surface’.

The ‘product leadership’ and the ‘cost leadership’ are probably the most easy to understand, as they

choose to excel in 1 dimension of the supply chain triangle.

Notice that we assume that cost and inventory go together. Next to cash consumed, inventory always

translates into the cost dimension. Inventory carries a cost for the room, the rent and the risk. Inventory

also hides inefficiencies. That’s another reason for an Opex leader to work with minimal inventories. Customer intimacy is probably the most difficult one. We add extra miles, which come at an extra cost.

We need to ensure they also come at an extra premium.

A strategic trade-off between EBIT and Inventory Turns

In our previous blogs “Benchmarking and the Best Practice Frontier in the Supply Chain Triangle” and

“Financial Benchmarking for Inventory Turns and Working Capital”, we were still left with a choice between two more aggressive targets for our benchmark Company 1, cfr. Figure 6, either

- Extend the turns from 3.75 to around 4.75 for an EBIT% of around 13%

- Either boost EBIT% to 20% if inventory turns stay around 3

Figure 6 – Aggressive Target Setting for Company 1 based on EBIT% vs Inventory Turns analysis

The choice between the two is a strategic choice. As we’ve shown in Figure 5, it is the choice between a

‘product leadership’ and a ‘customer intimacy’ position.

A product leader will experience superior profitability but with lower turns. Company 1 historically has

been a product leader. Staying true to the roots would plead for keeping the current level of complexity

and maximum focus on new high margin products.

The alternative is to go for a customer intimacy position. In this case we don’t go for the newest and the

highest spec, but go for a full coverage to a selected number of market segments, part of it with our own

products and developments, part of it with products we source from partners or 3d party manufacturing. Company 1 has been moving down this path since 2010. If it chooses to continue this

path, it should probably take it more to the extreme. Cut some of the apparently less performing, more

complex business to boost inventory turns. Boost EBIT% by reducing R&D spending in line with the new

‘customer intimacy’ position. Boost EBIT% by squeezing more margin out of the existing customer

relations.

Where the Orbit charts and analyzing the EBIT per inventory $ have helped to define the options. We

need a strategic framework to make the right decisions!

Complexity creep. The cost of complexity. Good and bad complexity.

We can also use the 3D supply chain triangle to talk about complexity. Figure 7 shows the so called

complexity creep. I notice that in companies, over time, complexity increases. We start adding products, we allow customer specific requirements in transports, in product development, … It is the natural push

of sales, marketing, product management, R&D, … to add ‘new stuff’ to the business. If the business is

under pressure, this will be accelerated. It is the ‘pulling on the service angle’ we introduced in our first

blog ‘Balancing Cash Cost and Service. The Supply Chain Triangle.’

A lot of this added complexity goes ‘unnoticed’ without passing any ‘formal approval’ or ‘decision

making’ process. If it does, it will still typically go unnoticed as it is a ‘piecemeal’ evolution. It’s not a big

bang, it’s a creep.

For a company working on the best practice frontier, the added complexity comes at an extra cost and with extra inventory. There is no way around. If the extra complexity is not set off by an extra margin, it

is classified as bad complexity, and it should be banished. If there is an extra margin, it could be

classified as ‘good’ complexity. There is a big caveat however …

Figure 7 - The danger of complexity creep

Don’t treat complexity in an incremental or an opportunistic way. There will be cases where a sales man

has a good story on how this extra complexity for this customer will pay off by this or that extra margin.

Treat complexity from a strategic perspective. Define the level of complexity you want to carry top-

down, not bottom-up.

If you’re an Opex player, you don’t want the extra complexity. Take the recommendation from Treacy &

Wiersema. You will only succeed by making a choice and by disciplined execution. It may be tempting to

add some more products, if it supports profitability, especially if your business is under pressure. It is the

wrong strategic choice. If as an Opex leader you’re under pressure … try harder! Stay true to yourself.

Find extra ways to lower costs. As Treacy and Wiersema convincingly explain, you can only be the best in

1 discipline. Avoid getting stuck in the middle. Once you’ve made a choice, it needs to be embedded in

every fibre of your organization. Once it’s embedded, you can never revert. It becomes your DNA.

If you’re under pressure as a Customer Intimacy or a Product leader, it may be tempting to cut costs, try

to rationalize product portfolios, customer service, … Don’t go blindly. Define the level of complexity you

need to thrive as a Customer Intimacy or a Product leader. Try harder in the chosen discipline. If you

have built your organization to be product leader, don’t try to turn it into a cost leader. You are likely to

fail as every fibre in your organization is focused on innovation, not cost. Ask yourself why you failed as a product leader in the first place. Don’t change the subject. What will it take to rebound as a product

leader? Convince shareholders why they should stay true and make that extra investment. It’s not the

easy way, but according the Treacy & Wiersema, it’s the only way.

So when looking at the Supply Chain Triangle we should remember that targets on EBIT and Inventory

should be aligned with each other + they should be aligned with your strategic positioning!

In conclusion, we should remember that making the choice on where to go with the EBIT versus Inventory strongly depends on your strategy. From Treacy & Wiersema we learn that being successful,

requires explicit choices. You need to take it all the way. Once you’ve made those choices, they’re hard

to revert later, as every fibre in your organization has to be realigned to your renewed positioning. We

like to push hard on inventories, but we should not do it lightly. Make sure it’s aligned with your EBIT.

Make sure it’s aligned with your strategy.

Dr. Bram Desmet is adjunct professor in Operations and Supply Chain at the Vlerick

Business School. He obtained his Phd at Gent University on the topic of “Safety stock

optimization in multi-echelon production-distribution networks”. He is working on a book

on “Supply chain strategy” and “Managing Working Capital. As the Managing Director of

Solventure and a Partner at MÖBIUS Consulting he helps global production and retail

organizations in the domains of Strategy, Supply Chain and Operations. He welcomes

your feedback at bram_desmet@solventure.eu