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Supply Chain Decisions - Make Sure You Understand the Dollars and Sense Part Two: The Impact on Real Costs

Written By: Jim Brown
Published On: July 22 2003

Analyzing the Real Costs

Most supply chain optimization models focus on optimizing supply chain. Frequently, though, the costs used in supply chain models are standard costs, averaged costs or "cost penalties". While these costs act as good guidelines for tactical decisions, they are not appropriate for strategic decisions because they often lead to incorrect conclusions. There is an inherent challenge in that high-level strategic decisions often have multiple, cascading cost impacts. The reaction of the costs to changes in the supply chain system is not predictable in a simple relationship that is based on current standard costs, because strategic changes often involve step changes in costs that alter the balance of fixed and variable costs.

For example, analyzing the impact of restructuring a group of manufacturing plants using simple fixed and variable costs would not be effective. It would not accurately predict the impact of adding volume or shifting the product mix, realities that companies live with when restructuring. It may be necessary to introduce an additional shift, which in turn may require significant changes in labor rates or a change in supervisory overhead. Product mix changes may alter the number of changeovers and cleanups, may change the effective operating speed of the production process, and may even impact the labor and energy costs for the plant.

Unfortunately, what appears to be a simple decision requires a true understanding of the real cost drivers to be incorporated in the decision criteria. By providing the ability to incorporate the true activity-cost drivers, the analysis ensures that the cost impact predicted from the operational changes is reliable and real.

This is Part Two of a two-part article. Part One proposed an approach to incorporating real costs into supply chain decisions.

Understanding the Dollars and Sense

Another challenge in making business decisions is understanding the impact of the changes in relation to the overall business and its strategic direction, as opposed to looking at the decisions on a localized basis within specific functions or departments. This is also a challenge in communicating the solution to get appropriate buy-in from disparate functions and stakeholders within the company. Frequently, the best solutions for the entire enterprise involve some negative aspects for individual functions. For instance, a lowest total cost solution may involve increases in transportation costs, which may negatively impact performance metrics instituted for the logistics function of the organization.

In order to understand the business level impact, the outcomes must be linked back to the P&L and Balance Sheet items in a way that financial analysts can validate and support them. But success in a business is not entirely measured on the financial statements. Other key performance metrics, such as lead times, order fill rates and customer response time, must also be available for each of the scenarios to identify the potential tradeoffs between financial performance and relevant customer service elements.

Is There Help Available?

What tools and techniques are available for business analysts and executives responsible for business decisions? Activity based costing tools from companies such as SAS, based on their acquisition of ABC Technologies, can be employed to develop actual costs and cost drivers.

For simple decisions without many options and with few interdependencies, the tool of choice is Microsoft Excel. A spreadsheet allows the decision to be modeled and the results calculated based on simple scenarios. But spreadsheets cannot handle the complexity and interdependencies of most supply chain decisions.

As the complexity and number of options increase, the need for modeling and optimization tools develops. Supply chain tools such as network optimization tools from i2 Technologies, Logic Tools, Insight, Manugistics, and others provide the modeling and optimization tools required to address decisions that are too complicated to be handled on a spreadsheet.

One promising vendor to watch is SCA Technologies. SCA Technologies offers tools and methodologies that support modeling and optimization in conjunction with activity-based costs, providing Supply Chain Cost Modeling and Optimization in one solution.

Conclusions and Recommendations

Understand the Options Companies can no longer afford to make decisions that are based on options that are convenient for them to evaluate or comfortable based on gut-feel of a few individuals. Not reliably understanding the complete financial and operational impact of the decision, as well as the sensitivity of the decision to changes in key competitive and market factors, is simply bad business practice.

Demand the Right Answer - Tools are available that can model the business impact of operational changes based on real costs and cost drivers. Do not accept decisions that lack the proper analytical support.

Develop a Systematic Decision Infrastructure - Companies should establish a standardized infrastructure to enable systematic and fact-based decision-making. Such an infrastructure should consist of a decision-making process, supporting toolsets that provide the analytical framework and standardized information that feeds the toolset to support a broad array of decisions. This will allow companies to effectively and reliably predict the impact of supply chain decisions on their company's financial performance, no matter which function or manager is making those decisions.

Start with a Pilot The initial investment for establishing this type of a systematic decision infrastructure does not have to be a board level decision. Choose a business challenge that has a significant impact on the supply chain that can be achieved in a short period of time. Prove the value with a pilot project, and then expand to solve other business problems.

Summary

Companies make strategic business decisions on a regular basis. In order to ensure that they are evaluating and selecting the correct options, they must fully understand the impact that the decisions will have on their business. The impact must be developed based on critical cost drivers, and then evaluated on the predicted impact on the companies' financials and key performance metrics. Before you make decisions, know the dollars and sense in a way that reflects the degree of accuracy and reliability demanded by today's marketplace.

About the Author

Jim Brown has over 15 years of experience in management consulting and application software focused on the manufacturing industries. Jim is a recognized expert in software solutions for manufacturing and has broad experience in applying enterprise applications such as Supply Chain Management, Product Lifecycle Management, CRM and ERP to improve business performance. Jim created his consulting firm, Tech-Clarity Associates, to help make the value of technology clear to business. Jim can be reached at jim.brown@tech-clarity.com.

 
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