How Do You Measure Costs Across the Supply Chain?

How Do You Measure Costs Across the Supply Chain? Gary Cokins, CPIM Director of Industry Relations ABC Technologies, Inc. & Tim Jordheim, Manager Operations Planning & Mgmt Systems, Cargill, Inc.

AGENDA • The case for better supply chain cost measurement • Powerful forces of change • New competitive realities • Cost measurement overview • Intra- and inter-firm costing requirements, issues • Role of activity-based cost management (ABC/M) • Inter-firm costing • The buyer-seller interface • Implementation examples

The Main Goal and Message This presentation covers a broad set of inter-related topics. The journey may be confusing. As a mental compass, the primary ideas are: -- The buyer-seller interface is a critical junction where an organization’s future profits (both sales and costs) are determined. -- The combined forces of “lean thinking” and the Internet may make long-held theories of competition obsolete. -- Being an efficient supplier no longer assures success. Success now depends on performance from all the partners in your value supply chain. -- Traditional accounting practices are inadequate to provide managers and teams with properly structured cost data to make effective decisions.

AGENDA • The case for better supply chain cost measurement • Powerful forces of change • New competitive realities • Cost measurement overview • Intra- and inter-firm costing requirements, issues • Role of activity-based costing • Inter-firm costing • The buyer-seller interface • Implementation examples

Consumers are Changing They are: Increasing in power (irreversibly) More Value-driven Relying more on brand names Smarter and more informed Discovering new channels Time- starved And Consumers have lasting memories!

From Mass Production to Mass Customization As customer service grows in importance, mass producers and niche companies will converge. Pre-20th Century Diversity, Variety Customizing specialist Product/ Service Specialization Uniform, Homogeneous Industrial Age Low High High Cost Boutiques, niches Specialization 21st-Century Information Age General Motors, AT&T Low Agile competitors and mass customization High High Cost Low Specialization Low Cost High Low

The Internet is Changing Everything As Power shifts to the consumer/buyer ….. …. Price pressure on suppliers will be relentless. “7/24” Will consumer preferences for mass customization and speedy delivery overwhelm the supplier’s economic interest in standard offerings? Probably.

Suppliers are now in Upheaval Products Change quickly Global Competitors Worldwide Over-capacity (from less uncertainty) Customers are rationalizing their Supply Base Shifting Roles A Digital Economy These forces will blow away any remnants of hierarchical “silo management” organization structures.

The Emergence of a New Order of Competition (1) Inter-organizational cost management is now important due to the emergence of the Lean and Agile Enterprise. Stockless Production The Lean and Agile Enterprise results from the long resisted acceptance that the single-piece continuous flow method is superior to batch-and-queue method long-associated with mass production. Just look at Dell Computers!

The Emergence of a New Order of Competition (2) The Lean and Agile Enterprise -- Allows faster reaction to defects or errors -- offers economies-of-scale at lower production volumes And now the same “single-piece flow” philosophy is now also being applied to new product development and launch.

The Emergence of a New Order of Competition (3) From: Mass Production Lean Producer competitors To: The premise is a producer is now unlikely to achieve sustainable product-related competitive advantages. That is, product-related competitive advantages are too fleeting. This is because Lean & Agile competitors can promptly produce “me-too” versions before customers can become educated about the initial market entrant’s product.

The Emergence of a New Order of Competition (4) From: Mass Production Lean Producer competitors To: OLD This means most lessons about competition amongst Mass Producers are now obsolete! NEW There is no way avoid competition. One must meet competitors head-on via confrontation … and confront continuously.

Michael Porter The two traditional key strategies for competitive advantage have been (1) low cost provider or (2) high product differentiation. COST LEADER: “Don’t compete with me. If you do, I’ll drop my prices even lower and render you unprofitable.” High Productivity Frontier (Best Practices) Product/Service Differentiation (Quality, speed, variety) Today Low DIFFERENTIATOR: “This is my territory. I’m so good at what I do that attempting to compete with me is pointless.” High Low Relative Cost Position 14

Michael Porter Is there a 3rd Strategy Choice? Relative Cost Position Low High High Product/Service Differentiation Must also compete based on ??? (Quality, speed, variety) Today Low Source: Target Costing and Value Engineering, R.Cooper and R.Slagmulder, Productivity Press. 15

The 3rd Strategy Choice: Confrontation Management (1) When is it appropriate to adopt one of the three strategies? Cost / Price SURVIVAL Only the products, acceptable to customers, with values along all three of these dimension stand a chance of being successful. Functionality Quality “FPQ”

The 3rd Strategy Choice: Confrontation Management (2) Cost / Price A Customer’s acceptance tolerance has limits. Maximum allowable price Minimum feasible price Minimum allowable functionality Maximum feasible functionality Minimum allowable quality Maximum feasible quality Functionality Quality The survival triplet: a “survival zone” exists between the three gaps for each product/service. ( Customers react to price. Suppliers react to cost. The Supplier’s minimum acceptable profit transforms cost to price.)

The 3rd Strategy Choice: Confrontation Management (3) Price The “survival zone” is the volume-pane created by cutting across the three min-max points. Maximum allowable price Minimum feasible price Minimum allowable functionality Minimum allowable quality Minimum feasible functionality Minimum feasible quality Functionality Quality The survival zone is large and safe when the gap difference for two of the three dimensions is broad.

The 3rd Strategy Choice: Confrontation Management (4) When the gap difference becomes sufficiently broad, it is possible to split the survival zone into two discrete zones and firms must choose: -- Low Cost Leader? -- Product/Service Differentiator? Differentiators Price Low Cost Leader Functionality Quality As long as the functionality and quality gaps are large enough to justify the price gap, harsh competition is muted --- the participants have staked out their space.

The 3rd Strategy Choice: Confrontation Management (5) Price But when Lean Enterprises compete, survival zones become very thin and narrow. All firms offer products that have high functionality and high quality at a low price …..which requires products to be made at a low cost. Functionality Quality Therefore competing on product differentiation is no longer possible !

The 3rd Strategy Choice: Confrontation Management (6) Price THE CONFRONTATIONAL SURVIVAL ZONE That is, the “maximum feasibles” for functionality and quality increase, but the gap differences simultaneously narrows. It is a thin plane. Lean Enterprise competitors Functionality Quality

The 3rd Strategy Choice: Confrontation Management (7) Price Since all Lean Enterprises are evenly matched on all three dimensions, they are forced to compete head on --- and must adopt a confrontational strategy. Lean Enterprise competitors Functionality Quality Therefore cost management must be aggressive and pro-active!

The 3rd Strategy Choice: Confrontation Management (8) Survival then depends on information systems that create intense pressures to manage & reduce costs both: -- throughout the product life-cycle -- across the entire supply value chain

SCM is a value-add “Chain of Chains” Are an organization’s problems inter-firm or intra-firm? INTRA-FIRM (The ERP domain) SUPPLIERS BUYERS INTER-FIRM (from mother Earth’s minerals and resources to the store shelf)

Key Cost Related Issues INTRA-FIRM • Issues: • Increased overhead costs driven by increasing diversity • of products & services and types of channels & customers • Adding services to sell products and standard services • No visibility to inbound and outbound costs by partner • No common terminology amongst trading partners • Mistrust amongst trading partners

INTRA-FIRM COSTING THE TRENDS • Inbound – sourcing consolidation of suppliers (simplicity) • Outbound – mass customization (expanding complexity) • INTRA-FIRM NEEDS • Customer profitability analysis (includes multidimensionality) • Internal productivity improvement (cost containment or reduction) • Ability to Influence “demand” via pricing and service choices • ABC/M CAPABILITIES • Basic ABC assignment network net of Revenues (emphasis on freight, routes, carrier, order type) for “margin management” • Unbundling service costs for pricing and trade-off analysis

INTER-FIRM COSTING • THE TRENDS (contain or remove costs via:) • Collaboration (in contrast to mistrust) • Functional shiftability (exchanging whose organization is best to do specific work) • INTER-FIRM NEEDS • Identifying and focusing on opportunities (mainly cost reduction): • Removing redundancies • Eliminating unnecessary or non-conforming (poor quality) work • Managing/minimizing cost drivers • ABC/M CAPABILITIES • Assigning “Attributes” (e.g. VA vs NVA, strategy alignment, etc.) • Computing “unit cost of output of work” • Computing value chain-spanning Total Landed Cost • Utilizing SCOR compliant terminology (facilitate communications)

Overhead Costs are Displacing Direct Costs A key to understanding ABC/M is to understand how cost behavior truly varies in relation to other factors Changes in Cost Structure 100% The demand for overhead activities are not much linked to sales or production volume. They result from: Overhead Cost Components Direct Material • The diversity and complexity of products, services and customers • Quality levels • Rates of needed change Direct (recurring) Labor 1950s 1990s 0% Old-fashioned Integrated Hierarchical Stages in the Evolution of Businesses

#of #of #of #of #of #of #of #of #of #of Activities Are the Work You Manage Stating activities with an “action verb-object noun” grammar convention creates an atmosphere for change by providing a new way of looking at something people are already familiar with, rather than something that is foreign. To: ABC/M Data Base From: General Ledger Activity cost drivers Activity-Based View Chart-of-Accounts View Claims Processing Dept Claims Processing Department Key/scan claims Analyze claims Suspend claims Receive provider inquiries Resolve member problems Process batches Determine eligibility Make copies Write correspondence Attend training Total $ 31,500 121,000 32,500 101,500 83,400 45,000 119,000 145,500 77,100 158,000 $914,500 Favorable/ (unfavorable) Actual Plan $(21,400) (11,200) 2,000 (3,900) –– $(34,500) Salaries Equipment Travel expense Supplies Use and occupancy Total $621,400 161,200 58,000 43,900 30,000 $914,500 $600,000 150,000 60,000 40,000 30,000 $880,000 When managers get this kind of report, they are either happy or sad, but they are rarely any smarter!

An ABC/M system does not replace the accounting system. It restates the same data and adds operating relationships to more effectively support decision making. ABC/M Doesn’t Replace the Accounting System Data Data+ Information Ms. Strategy A B C / M General Ledger A blizzard of transactions (expense account balances) Mr. Operations types of decision makers Accumulator Optical Lens (Reassigns Costs)

RESOURCES • Resource Drivers: • hrs worked • machine time • sq. footage • motor hp • % usage, etc. Consumed By Basis few, simplistic drivers -- typically volume. RESOURCES ACTIVITY ACTIVITY ACTIVITY Allocated To • Cost Drivers: • # of claims • # of batches • changeovers • # of orders • processing time • load complexity, etc. Consumed By PRODUCTS ETC. CUSTOMERS PRODUCTS ABC/M is Cost Assignment Based on Consumption Activity Based Traditional But... Most of these costs DON’T vary as a function of volume. Highest volume products and service-lines often bear greatest proportion of allocated costs, incorrectly. Accurate end-to-end costs of business processes and activities can be traced basis consumption, giving a much truer picture of costs and profitability of products, service-lines, segments, channels, & customers.

Costs (2) “Costs Measure the Effects” (1) Demands On Work Cost Assignment Network - Segment the Diversities Salary, Fringe Benefits Direct Material Phone, Travel Supplies Depreciation Resources Rent, Interest, Tax Work Activities People Activities Support Activities Equipment Activities “cost-to-serve” paths Final Cost Objects Products & Services Business Sustaining Suppliers Customers

Bill of Activity Costs & Profit Margins For this product or service offering, the pricing does not recover the costs-to-make and costs-to-serve. Work Activities $ Loss each activity’s driver quantity x unit activity driver cost (eg. # of invoices) Price/Revenue Activity Costs

Profit Impact of Misallocated Costs Using Traditional Accounting Reassigning costs is a zero-sum game. Price x Volume = $ Revenues — $ ABC costs = $ ABC profit margin i i i products & services where = products & services i i But cost-plus pricing using “traditional” costs creates a total net profit condition of big winners and big losers.

Profitability profiles are like electrocardiograms of a company’s health. After sales are attached to the ABC/M costs, this graph reveals that $8 million was made on the most profitable 75% of products—and then $6 million was conceded back! Profitability Profile Using ABC/M Cumulative Profit (Millions) $8 $6 Net Revenues Minus ABC Costs $4 Unrealized profit revealed by ABC $2 $1.8 profit $0 Specific Products, Services, and/or Customers (ranked most profitable to least profitable)

By Product By Customer The Traditional Profit and Loss Statement can be replaced by an ABC/M P & L with its “layered” Gross Profit Margins Sales mix = Unit cost X Customer Volume Traditional P & L Activity-Based Costing (ABC/M) P & L Total Segmented Total Segmented Sales Sales - Direct Product Materials - Direct Material - Direct Labor - Overhead By Product = Gross Margin 1 - Product Work Activities = Gross Margin 2 ** - Customer Work Activities * = Gross Profit - Sales & Distribution - General - Administration Period Costs = Gross Margin 3 - Business Sustaining Activities = Operating profit before tax (OPBT) = Operating profit before tax (OPBT) * = segmented margin by product & customer

ABC/M Profit Contribution Margin Layering SALARY & FRINGE BENEFITS DIRECT MATERIAL CAPITAL (equipment-related) NON-WAGE RELATED (e.g., operating supplies) RESOURCES RELATIONSHIP MANAGEMENT PURCHASES, RECEIPTS • BRAND/PRODUCT- • RELATEDWORK, • BRAND/PRODUCT- • RELATED ADVERTISING • & MERCHANDISING, • FACILITIES COST MACHINES MAKE PRODUCT, MOVE PRODUCT, SET-UPS TRADE SHOWS, IMAGE ADVERTISING SALES CALLS, ORDER HANDLING, FREIGHT WORK ACTIVITIES (examples) # Sales calls # orders # shipments # POs # Receipts FINAL COST OBJECTS Facility costs # Machine hours # Material moves # Set-ups # Advertisements SUPPLIER SUSTAINING SENIOR MGT OSHA IRS DOT Etc. Gvt Regulators ARBITRARY (for full absorption) # Pounds # Gallons # Meters BRAND SUSTAINING UNIT & BATCH LEVEL UNUSED CAPACITY R&D Product-specific # Shows # Advertisements BUSINESS SUSTAINING RELATED PRODUCT/SERVICE LINE SUSTAINING SUPPLIERS CUSTOMER SUSTAINING SUPPLIER- RELATED UNIT & BATCH LEVEL UNIT & BATCH LEVEL ARBITRARY (for full absorption) PRODUCTS/SKUs PRODUCT & SERVICE LINE- RELATED CUSTOMERS CUSTOMER- RELATED

ABC/M Customer Profit & Loss Statement CUSTOMER: XYZ CORPORATION (CUSTOMER #1270) Sales $$$ Margin $ Margin (Sales - Costs) % of Sales Product-Related Supplier-Related costs (TCO) $ xxx $ xxx 98% Direct Material xxx xxx 50% Brand Sustaining xxx xxx 48% Product Sustaining xxx xxx 46% Unit, Batch* xxx xxx 30% Distribution-Related Outbound Freight Type* xxx xxx 28% Order Type* xxx xxx 26% Channel Type* xxx xxx 24% Customer-Related Customer-Sustaining xxx xxx 22% Unit-Batch* xxx xxx 10% Business Sustaining xxx xxx 8% Operating Profitxxx8% * Activity Cost Driver Assignments use measurable quantity volume of Activity Output (Other ActvityAssignments traced based on informed (subjective) %s)

ABC/M Customer Profitability Matrix Customers with high sales volume are not necessarily highly profitable. Customer profitability levels depend on whether the net revenues recover the customer-specific costs-to-serve. Types of Customers Very Profitable High (Creamy) • Passive • Product/service • is crucial • Good trading • partner match • Savvy • Pays top-shelf price • Costly to serve Product Mix * Margin • Aggressive • Leverage their buying • power • Buying low-margins • Cheap • Price-sensitive • Low service & • quality • requirements Low (Low Fat) * Unique to each customer (their basket of purchases) very demanding Nominally demanding Very unprofitable Cost-to-Serve

Migrating Customers to Higher Profitability Knowing where channels or customers are located requires knowing their true costs via ABC. Types of Customers Very Profitable High (Creamy) Profitable Big Profit $ (but not necessarily margin%) Product Mix Margin Small profit $ (but not necessarily margin%) Unprofitable Low (Low Fat) Very unprofitable High Low Cost-to-Serve With the facts, customers than be migrated toward higher profitability by: (1) managing the service costs, (2) reducing their services, (3) renegotiating prices and or shifting their purchase mix to richer products. 42

Influencing Customer Behavior Increasingly, organizations will drive “desired” customer demand by offering lower prices for less services (or vice-versa). Knowing the incremental cost trade-off is critical to assure that profits increase. Money Cost Change in service level (loss) Price profitable Time Example Incenting a customer via lower price to receive weekly rather than daily shipments will require keen understanding as to which and how much activity costs change.

Activity-based costing (ABC) reassigns expenses to work activities and subsequently to the things that cause those activities to be performed. Understand Markets & Customers Develop Vision & Strategy Resources ,i.e., expenses Procure Materials COST OBJECTS Make Product-Activity\ I Functional Products, Customers, Segments, Channels, Suppliers, etc. Organization Make Product - Activity II Sell Products Activity Modeling Deliver Products Marketing Logistics Prism Service Products Mfg. Supporting Depts. Manage Information Operations Manage Financial & Physical Resources Manage External Relationships Continuous Improvement Loop Manage Improvement & Change Manage Human Resources Problem-solving methods and best practices Generate reports and identify improvement opportunities Process improvements and informed decision making Activity-based management (ABM) focuses on the management of activities as the route to improving the value to the customer and the profit achieved by providing this value. Summary: From Functions to Processes/Activities

“Manage the outputs, not the functions!” -- Michael Hammer. Process-based thinking has replaced hierarchical command-and control. The Extended Enterprise Source: The Supply Chain Council - International Plan Source Make Deliver Source Make Deliver Source Deliver Make Deliver Source Supplier’sSupplier Customer’sCustomer Your Company Supplier Customer (INTRA-FIRM) Internal or External Internal or External Shipping Sales Design Engineers Receiving Buyers Process Engineers Shipping Sales Design Engineers Receiving Buyers Process Engineers “A supplier’s invoice does not represent the total cost of doing business with them.” – Enterprise “Different customers and their orders place varying demands on the activities within our processes.” – Enterprise

Pre-ABC/M Era: TCO and DPP Supply Chain costing includes prior subset costing methods, but ABC/M captures all the costs. Sources Converters Retailers Goods Conduit Suppliers Distributors Consumers Funds Conduit (Supply Chain Costing) Perspective of the Firm Customer (Downstream) Marketplace Landed Cost Vendor (Upstream) Total Cost of Ownership (TCO) DPP, ABC DPP, ABC

Current ABC/M Era: Initiatives Just-in-Time (JIT), stockless production Quick Response (QR) Efficient Consumer Response (ECR) Efficient Foodservice Response (EFR) Efficient Healthcare Consumer Response (EHCR) Collaborative Planning, Forecasting & Replenishment (CPFR) Lean & Agile Management The message: Add value and speed at every step

Inter-organizational Cost Systems Western buyer-seller relations have been historically adversarial It is no longer sufficient to be the most efficient firm. It is now also necessary to be part of the most efficient supply chain.

But Where are the costs and profits across the supply chain? If an upstream supplier is gouging with obscene profits, if their margin was passed through as a lower price to the consumer, wouldn’t the chain itself benefit from volume and market share?

How Do You Measure Costs Across the Supply Chain?