Shaping Future Supply Chains for Success
INTRODUCTION
Supply chains should be a solution to our common needs. So, why do they frequently present more of a risk while adding necessary challenges that drain resources and reduce profits?
One significant reason for this is that we frequently assign too much emphasis on Efficiency while forsaking Effectiveness.
This is a mistake because effectiveness is vital – yet many companies keep pressing the ‘efficiency’ button, expecting it to deliver more than it is capable of.
Recent disruptions to the supply chain have been a wake-up call for many and have re- tuned our attention towards availability, instead of price – shifting the focus back to effectiveness.
DEFINITION OF THROUGHPUT ECONOMICS
Despite the sleepless nights and worries that these disruptions have brought, the reprioritisation of effectiveness and availability is a tremendous opportunity for all stakeholders in the supply chain.
To stay on this course, it is essential to use measurements and metrics that reward this perspective.
Thankfully, these metrics already exist. Eli Goldratt defined three metrics that are appropriate for measuring the effectiveness of a company: Throughput, Inventory, and Operating Expense.
Throughput is defined as the flow of money over a certain period. This is a measure of goods that are reaching the customer and be redeemed for cash – which then flows up the chain.
Inventory is the cost of stock – it is a measurement of capital that is tied up inside the company. It’s important to see inventory as the liability it is – stock is not the same as money, rather it is the opposite.
Operating Expense is the expenditure relating to generating Throughput. This includes all expenditure for stock handling, overheads, etc., measured over a certain period.
Refocusing on supply chains
Companies around the world have become accustomed to the habit of buying the most inventory for the cheapest price-per-unit.
It’s based on the flawed assumption that cheaper goods will increase throughput and reduce investment in inventory.
While this will occasionally be true, it will only be a successful strategy for fast movers that enable companies to recoup their investment more quickly.
What is more likely, is that the fast- movers will sell out before demand has been satisfied.
When stock-outs occur, the throughput for those SKUs immediately sinks to zero. Conversely, excess quantities of ‘dead’ inventory will ultimately need to be written off or dumped on the market for a discount – either way, you lose.
The reduction in profits caused by this methodology usually manifests itself much later.
The people who make these mistakes do not see the consequences for themselves. As a result, no lessons are learned, and the behaviour continues.
LEAD TIMES IN RETAIL
A change in priority is needed. Companies need to shift their attention away from reducing operating expenses and concentrate on reducing inventory instead.
The operation is significantly de-risked when inventory is reduced while increasing Throughput.
Throughput should be the number one priority, but this is closely followed by reductions in inventory and with it the capital that is tied up in unsold stock.
The reduction of operating expenses is still a good tactic, but only once these top two priorities are already being attended to.
When companies are freed from their enslavement to cost-cutting, they no longer feel the pressure to buy stock from the cheapest, and often most distant suppliers.
By shifting priorities away from cheap stock, retailers are no longer exposed to the risks of long lead times and the uncertainty that comes with them.
Shorter supply lines mean that more accurate decisions can be made, and orders can be placed in smaller batches. As a result, less capital is locked away in inventory, and the inventory risk is reduced.
A simple step that kick-starts this re-prioritization is to reduce the replenishment interval for inventory. This can rapidly eliminate stockouts and reduce the impact of any that do occur in this shorter period. If demand is disappointing, then the pool of dead inventory is much smaller, as is the requirement for discounting or dumping the stock.
Current and future profits will increase significantly when you find ways to implement shorter replenishment intervals.
ACCOUNTING FOR TIME
Time only flows in one direction – when it’s gone, it’s gone. The time that is wasted can never be gained back. Both Throughput and Operating Expenses are ‘flows’ of capital, and it only makes sense to reference these key metrics to a determined span of time.
Like a pipe, or a river, we can measure the speed of the flow in a meaningful way, whereas it is meaningless to try and measure the absolute quantity of a river, or water in a pipe – it doesn’t end. This helps to leave behind the idea that stockpiling is necessary; why would you need 4 months’ worth of stock if the replenishment period is 2 weeks?
A new focus on time is sensible for any company, even if it has healthy cashflows. This is more important than price, and it helps ensure availability when you know how quickly items need to be replenished. Buyers are increasingly concerned about availability more than any other factor, including price.
To assist with keeping a closer eye on the time, new metrics can help by measuring success in terms of flow, for example:
SHORTENING THE CASH-TO-CASH CYCLE
Let’s consider the Cash-to-Cash cycle for an average European retailer, sourcing stock from suppliers in the Far East.
‘Day 0’ is the day that the retailer places an order, and also when the supplier subsequently places their order for materials and staff. Sixty days later, half the balance is due, so that the supplier can pay for their costs and start production.
After 180 days, the goods arrive, and the second half of the payment is remitted. In this example, it is assumed that the retailer sells out of the stock after 330 days - on average - after having sold out in some locations in the first week, and with the remaining stock being slowly liquidated via outlet stores over the following few years.
In this typical scenario, the retailer has on-hand inventory for an average of 150 days. Of course, half of the stock was paid for on day 60 (120 days in advance) and the rest on day 180 (0 days in advance), so you have paid in advance for an average of 60 days.
When buying the items at the store, most customers will make payments with a credit card or with cash before leaving the store. However, some sales will occur later in the outlet store, meaning that some inventory is in Accounts receivable, for an average of 30 days. With 180 days of Inventory on the books as either Inventory or Receivables, added to the 60 days of advance payments to the suppliers, this means that the retailer’s cash is tied up for an average of 240 days. The goal, therefore, is to reduce this period without running out of stock entirely.
This is an example of a much shorter Cash-to-Cash timeline, based on the same one-year period:
SHORTENING THE CASH-TO-CASH CYCLE
This can be achieved when a local supplier is used to replenish items on a shorter timescale and supply them with daily sales updates. This information and the close proximity enable the supplier to reduce their response time to 15 days.
Using a Dynamic Buffer Management System, the retailer can automatically replenish their stock so that inventories are fully sold after 30 days instead of the original 150 days. By accepting payment with the sale, the retailer cuts their A/R to 0. The supplier will happily receive payment in 40 days, and the Cash-to-Cash cycle drops to negative 10 days.
This is the path to a healthier, bigger business. With this model, you can collect the cash before paying for what is sold, so the more you sell, the more cash is available so you can expand your business faster.
With this business model, the retailer is using Little’s Law to produce cash by reducing W (days of financial inventory). Assuming a retailer purchases stock that costs $300 million over a year, then this equates to $1 million/day, based on 6 days/week opening. Multiply this by the -10 days of financial inventory, and the retailer has $10 million cash in the bank.
To compare this with the older method (in which the retailer had a liability of 240 days of financial inventory), this would mean that they have $240 million locked away in inventory, and not in the bank.
The difference between the two systems is that the shorter replenishment interval adds $340 million in extra cash.
A retailer of this size would likely sell something in the region of $500 million per year – the suggested improvements would generate over 8 months’ worth of sales in cash. This frees up a great deal of capital for rapid expansion, demonstrating the value of investing in your supply chain strategy.
Original author: Henry Camp Edited by: Retail Twin Labs