The cost of flexibility

This week I had a conversation with a Supply Chain Leadership partner of Gartner on how to account for the cost of flexibility. If a supply chain needs to be more responsive, for instance by having excess capacity, how do we factor that in, and how do we explain that if organizations are heavily cost focused?

There are a couple of dimensions to the question. A first question is the impact of responsiveness on cost and capital employed, and how do we reveal that. A second is how to deal with the extra cost and capital employed if there is a lot of pressure on both cost and capital employed. A third question was which companies had found the trick on how to master this.

To answer the first, let’s retake some fundamentals on supply chain management. For this we happily quote Chopra and Meindl, who say that there are two types of supply chains, a cost-effective supply chain, and a responsive supply chain, and the supply chain should match the business complexity, which can be low, or which can be high.

There is what they call a ‘zone of strategic fit’. A high-volume/low-variety business fits well with a cost-effective supply chain. As business complexity increases, we need a more responsive supply chain.

It is popular thinking that we can be ‘lean’ and ‘agile’ at the same time, we can be ‘leagile’. Though that is a nice ambition, Chopra and Meindl also nicely explain that a lower business complexity and responsiveness will always correspond with a lower cost position and vice versa. There is a kind of limit of ‘how agile’ you can be for a ‘given cost position’. They call it the cost-responsiveness efficiency frontier. If you are laggard and are below the frontier, you can improve on both dimensions at the same time, but once you are close to the frontier or on the frontier, extra agility typically comes at an extra cost.

The model of Chopra and Meindl is a simpler version of what we have elaborated in more detail in our book “Supply Chain Strategy and Financial Metrics” or what is summarized in our article on the strategy-driven supply chain. We link the ‘business complexity’ of Chopra and Meindl to ‘strategic choices’: an operational excellence player will have less complexity than a customer intimacy player or a product leader. A customer intimacy player will have a broader product portfolio and a product leader will have more complex products with more complex BOMs and supplier networks. Instead of looking only at the cost, as Chopra and Meindl, we also look at the impact on the capital employed. Introducing a long tail in the product portfolio will erode the efficiency in manufacturing and increase cost (in comparison to the operational excellence player). Next to the cost effect, introducing a long tail will reduce the inventory turns so increase working capital. Storing a long tail will increase physical storage space in shops or distribution centers so also increase the fixed assets (and reduce the fixed asset turns). So a customer intimacy player will not only have a higher cost, it will also have a higher working capital and higher fixed assets (compared to the operational excellence player).

So first of all, we need to make people understand that extra complexity comes at an extra cost, and not just an extra cost, also an extra investment, in either working capital, either fixed assets, or both. If I’m a product leader, with a highly unpredictable demand, I’ll need to have a responsive supply chain, operating that supply chain at peaks will be less efficient (compared to an operational excellence player) and will require excess capacity and strategic inventories (compared to an operational excellence player).

Companies running different types of supply chains under 1 roof, for instance a branded and a private label supply chain, have successfully used activity based costing to more accurately allocate costs to the branded versus the private label products. Not a lot of companies have also allocated the costs of (free) capacity or (extra) inventories to the corresponding business segments. If you do that, you could calculate a segmented ROCE. The alternative is that you translate the (extra) inventory into a cost, by using the WACC or the inventory carrying cost, and translate the (free) capacity into a cost, by using the WACC. We refer to our article on using Return On Capital Employed (ROCE) or Economic Value Add (EVA) for more details on the two alternatives. Essentially, these are the ways to show the impact of responsiveness on cost and capital employed, as an answer to question 1.

The second question was how to deal with the extra cost, if there is a lot of pressure on both cost and capital employed.

In the discussions I have with senior supply chain people, I see that supply chains in general, are designed on cost, not on flexibility or agility. It is hard to explain ‘excess capacity’ and ‘extra inventory’ to anticipate a ‘peak demand’ that might never materialize. So we typically don’t foresee the ‘excess capacity’ and the ‘extra inventory’ and then hit the wall when the ‘not anticipated peak demand’ does occur. At that moment, when sales is at risk, we resort to panic and lots of noise, we will disappoint customers and make crazy costs trying to minimize the damage. That’s not professional. So how can we get out of this?

In a recent discussion with an operations manager of a product leader company, we talked about discussing different options on ‘supply chain adaptability’ with finance and the business leaders. Because of a recent success in a newly launched product, the operations manager had to significantly scale up (double) the production volume in a short timeframe (3 months). Adding extra resources takes time, and as these resources need to be trained, it reduces the efficiency of the direct labour in that scale-up period. The operations manager was also frustrated by the fact there was a huge pressure on working capital from finance, which was making his job even more difficult.

I challenged the operations manager on both aspects. First, if you are a product leader, and the forecast is 100, you know that for some product segments, it is never going to be 100 but either 10 or 1000. If you know that upfront, you need to have the discussion with the business upfront. A useful concept can be the ‘supply chain adaptability’ metric of SCOR. Try to create options for the business where you say ‘this will be the level of cost and investment in working capital and fixed assets’, if we want to be able to double the volume in 3 months versus 6 months versus 12 months, which one do you prefer? You should not accept that finance puts stringent inventory targets in a market segment that is exploding. That is like trying to accelerate with the hand break on. It will get smelly, with a lot of smoke, and not very good for the car nor the engine. I understand that finance is concerned about free cash flow (cfr our earlier posts on the links between ROCE, value and free cash flow) but it’s simply poor practice to choke a growing business by restricting the working capital. So here again, as operations or supply chain, make sure you sit down together with finance and the business and create insights and options on ‘what is the uncertainty per business line’, ‘what is the opportunity per business line’.

If the uncertainty is low, we should be able to set stricter targets on inventory and asset utilization. If the uncertainty is high and the opportunity is big, we may want to invest in strategic stocks and excess capacity. It is up to you as a supply chain or operations lead to reveal and force this type of deliberate choices. Let’s be pro-active instead of reactive.

So coming back to our second question on how to deal with the extra cost and capital employed, if there is a lot of pressure on both cost and capital employed? You need to return the pressure by creating options and forcing finance and the business to make a choice, in a pro-active, rather than a reactive mode.

Are there any companies that are ‘good at this’? Maybe I run into the wrong companies or maybe I am too strict, but my feeling is that most companies are struggling with this type of debate internally. When talking to the leadership partner at Gartner there was 1 company that came to mind, being 3M. I couldn’t remember the exact rule but I think it was every plant has at least 3 technologies and every technology can be run in at least 3 plants. 3M was aware that from a cost and an asset utilization perspective, this was not optimal. I don’t know if they could ‘measure’ the extra cost and the extra investment. My feeling is they did not necessarily care. It seemed more a basic design principle, a strategic choice, to invest in this flexibility. Over the years 3M had learned that events occur in the market that allow to earn sufficient returns. An example was when the EU decided to switch to new car plates. That triggered a surge in demand for reflective coatings. Whereas competitors were unable to follow, 3M was the one that could deliver, and has delivered at premium prices. At the same time, if a technology becomes obsolete, instead of having expensive restructurings, they can keep their existing plants open while replacing one of the technologies with a newer one. So far 3M for me has been the odd example of a company that proactively thinks about flexibility and considers it as a strategic choice.

But let us know your thoughts and experiences. How do you deal with this debate in your company? Have you found a way to account for the cost of flexibility and channel the pressure on costs and working capital into a discussion on value?

If you are triggered and want to know more, follow our work in our strategy-driven supply chain group.