In the end, we were all going to live “happily ever after.” At least, that’s what was promised.
I was at three clients’ sites over the course of the last two weeks. During those visits I heard comments like, “I believe that something has fundamentally changed in the market.” Or, a casual comment of, “We cannot run our supply chains like we used to.” I smiled.
Each of these companies performed better than their peer group on Return on Assets (ROA), but worse than their peer group on operating margin. When you run the graphs, there is marked difference for these companies that begins to appear in 2009. (For clarity, Return on Assets (ROA) is defined by net income/total assets, and Operating Margin is calculated by dividing net income/revenue.)
However, none of the three companies knew this before the benchmarking activity. In fact, I am surprised how few companies are knowledgeable on their own performance on supply chain ratios. It constantly amazes me.
Being a long-time student of supply chain, I, like many, have been under the false assumption that companies that outperform their peer group in ROA would also be able to outperform their peer group on operating margin. Traditional supply chains in process-based industries operate on this assumption. Based on the analysis, I no longer think that this is true. I think that three things have changed:
Marketing Teams Are Introducing Demand Volatility to Try to Capture Market Share. Growth is slowing. It is harder to come by. To maximize volume opportunities, marketing teams are deploying one-to-one marketing tactics that are increasing demand volatility. This includes the automation of path-to-purchase for consumer products, active shaping of demand through price, channel incentives and promotions, eCouponing and mobile commerce for retail, and product proliferation for all. This puts pressure on the supply chain team to deliver a new type of supply chain. It needs to be one that is agile and flexible.
To minimize costs, supply chain teams of manufacturing leaders have designed the value network to absorb this volatility. This supply chain is designed to NOT have the lowest ROA. Instead, it is designed for resiliency. However, for most, there is still not a clear understanding of the problem. For many, this understanding is the worst in the area of supply chain finance. The tendency is to build a supply chain for the lowest manufacturing cost-per-case which they believe is the lowest ROA. With the rising costs of commodities and transportation, reducing ROA can often increase operating margin. (Something that no one wants.)
- Most Supply Chains Were Built with the Assumption That Manufacturing Was a Greater Contributor to Operating Margin Than Distribution. When I go in to help a company, I first benchmark their supply chain ratios. To do this, I compare each company against their peer group to see if they have made progress on the ratios of growth, profitability, complexity and cycles. (You can also request this data from the SCI Community. We do free analysis in the community on publicly available financial data.)
As I work with these companies, I am noting a trend. Companies that have the best ROA do not have the best operating margin. By focusing so strongly on manufacturing, they have thrown the supply chain out of balance. One of the issues is the rising costs of commodities including the cost of oil. As shown in Figure 1, the cost of Texas crude has increased nearly four times in the last decade; yet, too few companies are actively modeling the trade-offs of make, source and deliver TOGETHER. Instead, the functional teams will often do an ad hoc or partial analysis. I am surprised how many companies are operating their supply chains like the good old days when oil was $30/barrel.
Network Complexity Is Increasing. Because many companies want to maintain high ROA values, they will outsource new products. This adds to total costs. Surprisingly, for most companies, there is little cross-functional oversight into the design of the supply chain for a new product launch.
In short, the times … they have changed. When I was interviewing Keith Harrison, prior manager of the Procter & Gamble supply chain global team, he commented that the cost of distribution outstripped the cost of manufacturing in 2002 for P&G. It is for this reason that the P&G teams actively began the processes of direct plant shipments, selective placement of items in distribution centers and the active modeling of their supply chains. I am amazed when I talk to supply chain leaders that have not taken this important, and fundamental step to actively model the trade-offs of source, make and deliver at least quarterly. (My preference is monthly as part of the S&OP process.)
In the modeling, my recommendation is to look at the cost metrics in aggregate. Study the trends of your company on operating margin, gross margin and ROA together. Do what-if analysis to understand the drivers and then contrast them to peer groups to mark the progress that you have made on the effective frontier (trade-offs between growth, profitability, complexity and cycles). And, don’t be surprised if you also find that the lowest ROA does not lead to the lowest operating margin for you either. For me, it is the end of a fairy tale.