Opening a Can of Worms – Consequences of ROI driven supply chain decision making

One rule to unite them all

I was out cycling with my mates the other day, and one of the blokes (a banker) asked me to explain how our supply chain worked. He asked how would we know if we were doing a good job, and how would that be rewarded? Over the next 50km, his hard-nosed interrogation reminded me of the 5 whys of Lean, until eventually we arrived at a common root of understanding. The ultimate supply chain KPI must be return on investment (ROI). To be more precise, some practitioners refer to it as GMROI (Gross Margin Return on Investment), and this is what I imply when I use ROI in this article.

All supply chain decisions that could result in revenue or expenditure should be filtered through ROI. This aligns supply chain performance perfectly with the corporate financial goals and should guide rational supply chain decision making. By rational, I am suggesting we make and execute decisions that lead to increased overall ROI and stop doing things that decrease ROI below a certain threshold rate. After all, that’s how we assess all other types of capital expenditure proposals.

However, if you are lucky enough to have systems that support ROI analysis, you should be careful what you wish for, as you will unearth some unexpected situations, and put you in direct conflict with conventional wisdom. You will risk opening a can of worms.

Conventional wisdom

Most of us share a generic supply chain objective, which is to get the right stock, to the right place, at the right time. And almost certainly most of us trying to optimise the balance between maximising customer service/ revenue, minimising cash outflow, and maximising profit margins (minimising supply chain expenses).  Through S&OP, you are probably reporting your performance on a dashboard that includes some of the following vanity KPIs: Demand forecast accuracy or error; Vendor/ Manufacturing DIFOT and lead time, Out of stock items, stock turns, inventory $, excess and obsolete stock, COGS $, gross margin $, etc.

Benchmarking vanity metrics against best practice might make the supply chain look great. Of course, you should be working on improving forecast accuracy and supplier delivery performance and fine-tuning other planning parameters.  But at the end of the day, why are your stock turns still too low, or why is there so much excess and obsolete stock, why is it so hard to improve gross margins, why is there so much expedited freight expense? Is the conventional supply chain planning wisdom missing a piece of the puzzle?

Careful what you wish for

Let’s look at using ROI for supply chain decision making, assuming we have the systems in place to provide such rich information (and if you don’t, please start pressuring your system providers to develop the capability). We need to be ready to open a can of worms and deal with the consequences. We will be challenging decades of conventional wisdom, driven primarily by lack of computing power and over simplified planning assumptions and methods. We risk making recommendations to our colleagues and business partners that may sometimes be a complete anathema to what they have built their careers on.

While not an exhaustive list, the following decisions and conflicts are anticipated: 

1.      Purchase Orders

Each time your planning system runs it will recommend for each planned SKU a quantity to be purchased from each supplier. You may choose aggregate these according to some constraints around order frequency and MOQ. However, wouldn’t you like to know how to get the best ROI if you could change the lead time, MOQ or transportation mode? You might well be better off paying a higher unit cost, purchasing a lesser quantity and air freighting them in, rather than shipping entire containers every few months? Or change supplier? Could you convince the sales force or accountants that a lower gross margin (along with way less inventory) is better for the business? Is there some strategic reason you need to remain with your supplier?

2.      Stock Repositioning

Demand patterns change. Stock at a location yesterday may no longer be needed today or tomorrow (becoming “excess” at this location). If you could, select the option would give the greatest ROI: 

·      Reposition the stock to another store where it is needed

·      Purchase additional stock externally to send to the store where needed

·      Lose the potential sale?

How do you then motivate a store owner to give up their stock to another store? Or second store owner to forego an unprofitable sale? Instead of losing the sale, is there an alternative more profitable fulfillment channel?

3.      Constrained supply

For whatever reason, your store network replenishment requirements exceed what you have available to distribute. How do you decide who gets what and who misses out? ROI will tell you which locations should get their requirements fulfilled, in order that the organisation would make the greatest return on this limited stock. Could this cause some locations never getting their “fair share”? What does that say about the viability of the store location? Is there a strategic reason you need to maintain a presence in a certain geography?

4.      SKU/Range Rationalisation

Most businesses are afflicted by SKU and range proliferation. While product marketeers are eager to introduce "good, better, best" product offerings, new products, packaging options, promotions etc, they are less enthusiastic about determining an exit strategy for the older SKUs or brands they have just added to. An analysis to maximise ROI by product family range, by brand, by SKU, by store location will help to guide rationalisation about which products to keep, and which ones to quit. There would be difficult conversations around breaking long established relationships with less profitable suppliers, and product and business development managers will be in denial that the products and suppliers with which they have grown their careers are not contributing sufficiently to ROI.

5.      Display stock

Store product displays need to look pretty to attract customers. This interpreted as full shelves or stands. If the planogram quantities exceed those justified by the planning system, then a debate is likely as to who owns and approves the investment in the excess display stock. Is it a marketing consideration? Should the excess display stock value be included in the business case proposal?

There are many other examples (eg Opportunistic buys, Opportunistic substitution, Stocking vs Drop shipping) where ROI would give the rational decision response. I’ll leave those and others to the reader to think through.

Conclusion

Making supply chain decisions based on maximising ROI is a rational approach that will ensure the supply chain is fully aligned with the corporate financial goals. Some conventional wisdom will be challenged and there will be some difficult conversations. In the real world, sometime so-called strategic/ marketing considerations may override rational decisions, but at least the ROI analysis will separate one from the other to help temper expectations. Sometimes it's worth talking to bankers.