Recently I had some correspondence with another thought-leader in supply chain management on the matters of supply chain effectiveness versus supply chain efficiency.
Efficency v Effectiveness.png

 

It brought to mind the fact that, when we begin working with clients, they are nearly always focused on efficiencies, which they are typically defining in terms of some calculation of cost per unit.

 

For example, they may say, “This item costs us $16.24 per unit for inbound freight.”

 

They have a deeply-held belief that, if they could find a more efficient way of shipping these items, that they might be able to reduce their shipping costs by, say, one dollar per unit. They then extrapolate from that in their minds—or on a spreadsheet—and calculate: $1.00 per unit savings (through shipping efficiencies) times 30,000 units per year equals a saving of $30,000 per year. They also, generally, equate that savings in their calculated costs to additional profit on their bottom-line.

 

Your experience probably proves this

Unfortunately, such calculations related to efficiencies and cost-per-unit almost never produce the calculated bottom-line outcomes. I would wager that your experience proves this (were I a wagering man).

 

I think you have already had this experience—not once—but over and over again.

 

You and your team have repeatedly come up with ways to improve efficiencies—to reduce cost-per-unit according to your calculations—only to find that, in the final analysis, the true effect on the bottom-line was zero, near zero, or even negative.

 

Nevertheless, like a good soldier, you persist in trying to find efficiencies—making cost-cutting your chief aim—in the vain hope that someday you will discover the “efficiency” that really works at improving the bottom-line.

 

Why doesn’t this work?

There are lots of reasons attempts to improve efficiencies doesn’t work at bringing real, effective and durable improvements to the bottom-line. You can read about them in books like The Measurement Nightmare where author Debra Smith writes:

 

The ability to implement an organization's strategy is dependent on aligning internal resources so that they act in concert to improve and execute the strategy. Resource contention between competing initiatives, programs, and investment decisions must be resolved and their interdependencies understood and prioritized. Improvements in one area cannot be gained at the expense of another area of the business, if both are necessary for the business to succeed. Unfortunately, that is precisely what happens when individual improvement programs are put in place at local levels. To achieve our inventory reduction goals, we cause stockouts and delays in manufacturing. To cut our costs, we harm our quality or ability to deliver on time. To ensure that one product or project is brought in on time, we expedite over other products or projects, causing them to be late or delayed. Accounting systems and financial and incentive measurements focused on local improvement or cost collection or allocation continue to be one of the biggest stumbling blocks to companies wishing to improve their financial performance with the above-mentioned improvement processes. This is because they fail to recognize the interdependencies of the local actions and programs on the performance of the business as whole. [1]

 

Or, you can read about the problems with calculated unit costs and efficiencies in Relevance Lost where the writer says:

 

The management accounting system also fails to provide accurate product costs. Costs are distributed to products by simplistic and arbitrary measures, usually direct-labor based, that do not represent the demands made by each product on the firm's resources. Although simplistic product costing methods are adequate for financial reporting requirements--the methods yield values for inventory and for cost of goods sold that satisfy external reporting and auditing requirements--the methods systematically bias and distort costs of individual products. The standard product cost systems typical of most organizations usually lead to enormous cross subsidies across products. When such distorted information represents the only available data on "product costs," the danger exists for misguided decisions on product pricing, product sourcing, product mix, and responses to rival products. Many firms seem to be falling victim to the danger. [2]

 

You could also read about why these efficiency and cost calculations continually mislead executives and managers like you in Lies, Damned Lies and Cost Accounting where the author opines:

 

When trying to cost a product, service, or activity in an analysis period, since each approach available to use assigns costs differently, you can create different values for the cost. The cost of a pen you manufacture, for example, may be calculated to be $ 1.12 with standard costing, $ 1.27 with activity-based costing, and $ 1.35 with overhead costs spread equally. This can be disturbing but understandable because each approach emphasizes different things. However, even if you talk to three people about using one approach such as activity-based costing, you will likely receive three different costs as well. What is even more puzzling is that if you use a fairly standard procedure, the approach will pass an audit performed by your CPA (certified public accounting) firm. Had you used another standard approach and calculated a different number, it, too, would pass the audit. So, what is the right answer? [3]

 

The real bottom-line profits come from “the system” and effectiveness

Going back to our example above: if your efficiency that you believe drives a one-dollar-per-unit reduction in shipping costs causes “the system”—read: the supply chain—to adjust, adapt or change in such a way that FLOW is in any way reduced or disrupted, or other costs or expenses must be increased, then any one of several thousand factors could mean the calculated positive effect on the bottom-line is negated.

 

Real and effective bottom-line profits in your supply chain come from the ability of “the system” (the entire supply chain) being able to sustain FLOW that supports THROUGHPUT [4].

There are only two system-wide metrics of your supply chain’s effectiveness at producing profits for its participants. They are:

  1. Return On Assets (ROA)
  2. On-Time Performance (customer service levels)

 

We help our clients achieve high-levels of performance of these crucial metrics (key performance indicators) by helping them assess a simple formula:

 

Effectiveness (system efficiency) = Sum(Throughput) / Sum(Operating Expenses)

 

The great thing about this system efficiency calculation is that it can be measured within your company, in collaboration with any supply chain trading partners, or across the whole supply chain where collaborative participants are willing to share a minimal set of data.

 

The bottom-line is…

The bottom-line here is that typical efficiency metrics do not always contribute to the bottom-line according to our calculations. In fact, they almost never do.

We need to be focuses on THROUGHPUT and FLOW to maximize the profit and cash-flow benefits to our company and to our supply chains.

 

Let us know how efficient or effective you and your supply chain have been in producing lasting and effective improvements to your bottom-line. Please leave your comments below, or feel free to contact us directly, if you prefer.

 

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[1] Smith, Debra. The Measurement Nightmare - How the Theory of Constraints Can Resolve Conflicting Strategies, Policies, and Measures. Boca Raton, FL: St. Lucie Press, 2000.

[2] Johnson, H. Thomas, and Robert S. Kaplan. Relevance Lost - The Rise and Fall of Management Accounting. Boston, MA: Harvard Business School Press, 1991.

[3] Lee, Sr., Reginald Tomas. Lies, Damned Lies, and Cost Accounting: How Capacity Management Enables Improved Cost and Cash Flow Management. Business Expert Press. Kindle Edition.

[4] Here we define Throughput as revenues less (only) truly variable costs—that is, only those costs that vary directly with every change in quantity of units produced, transported and/or sold.

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