Assignment due tomorrow

FORESIGHT Fall 20164

Forecasting PersPectives

INTRODUCTION: THE SUPPLY CHAIN TRIANGLE

Companies are struggling to balance service to customers, supply chain costs, and inventory, a balancing act I depict as the supply chain triangle of Fig- ure 1.

First, the company needs to deliver service to customers, the quality of which is af- fected by the lead time between order and receipt, the reliability of that lead time, the breadth of our product portfolio, and the flexibility of the ordering process.

Second, it tries to deliver that service at minimal cost. There’s the cost of purchas- ing, of manufacturing and distribution, and of after-sales services.

Third, since the financial crisis, companies are increasingly concerned with their in- ventory position, which forms the major element of their working capital.

DIFFERENT STRATEGIES LEAD TO DIFFERENT TARGETS

In their book The Discipline of Market Leaders (1997), Treacy and Wiersema ar- gue that a firm can only be successful if it pursues a particular long-term strategy.

They classify strategies as Operational Excellence, Product Leadership, or Cus- tomer Intimacy. Table 1 summarizes the features of each.

Figure 2 maps these strategies within the supply chain triangle.

• The Cost Dimension. The Opera- tional Excellence player should have the lowest cost, since that’s its pri- mary purpose. At the other extreme, a Product Leader will have the high- est cost because it requires signifi- cant investments in R&D as well as marketing to create awareness. I place Customer Intimacy in between the two.

The Impact of Strategy on Supply Chain and Forecasting BRAM DESMET

PREVIEW In this provocative article, Bram Desmet explores how a company’s market strategy affects its supply chain targets and forecasting methodology. The author introduces the con- cept of the supply chain triangle to illustrate the balancing act a company must perform to achieve the cost, service, and inventory mix that maximizes its return on capital employed. He then shows how the company’s strategic choice, be it operational excellence, product leader- ship, or customer intimacy, influences the position it seeks on the supply chain triangle and, in particular, its inventory targets.

Figure 1. The Supply Chain Triangle

Table 1. Strategy Paths in the Treacy-Wiersema Model

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■ Many companies struggle to balance service to customers, supply chain cost, and inventory. This is the essence of supply chain management. The supply chain triangle enables us to visualize the trade-offs among these targets.

■ The firm’s strategy, as defined by the Treacy- Wiersema model—operational excellence, prod- uct leadership, or customer intimacy—affects the way it strives to balance its supply chain targets. Each has a different effect on inventory, cost, and service.

■ A functionally oriented organization and misaligned departmental performance measure- ments can create conflict that impedes the firm’s ability to achieve these targets. Optimizing the triangle requires those responsible for each of the functional areas to work together, aligning their overall objectives and performance metrics.

■ Firms commonly set inventory targets based on benchmarking—for example, by studying inven- tory turns for companies in the same industry. However, one-dimensional benchmarks and the associated targets (an inventory target without targets for service or cost) are dangerous in prac- tice: benchmarking needs to consider the entire supply chain triangle of objectives, and the analy- sis of the benchmarking data needs to evaluate the company position, factor in the supply chain strategy, and set targets appropriately.

■ The strategy and the associated supply chain objectives create challenges in product forecast- ing: forecasting techniques as well as tactics for dealing with demand uncertainty will differ based on whether the company pursues operational excellence, product leadership, or customer inti- macy. Improved forecasting is always beneficial, as it will improve service while reducing both cost and inventory.

Key Points • The Inventory Dimension. I expect

the Operational Excellence player to require the lowest inventory. Simplic- ity drives efficiency. This firm will try to eliminate slow-moving products in its effort to maximize efficiency. I’ve again placed the Product Leader at the other extreme. Newer products tend to be more complex, necessitate delivery in niche markets, and require special- ized suppliers of components and raw materials. Moreover, not all the new products will achieve full market po- tential. All these factors contribute to high inventories with high risk. Again the Customer Intimacy player settles in between. To increase its market share among key customers, it typically must extend its product and service portfolio, requiring extra inventory as compared to the Operational Excellence player. On the other hand, Customer Intimacy players don’t have the gross margins of the Product Leaders, so they need to carefully control complexity.

• The Service Dimension. Here the Op- erational Excellence player is the most basic, although it will not necessarily deliver bad service. We rank the Prod- uct Leader highest in Service. It will be able to drive the highest gross margin. Working with the newest and the best goes beyond the functional to become emotional. Its marketing aims to create that “special feeling” of being part of that select club. The Customer Intimacy player will drive a higher margin from the intimacy proposition, but not to the level of the Product Leader.

So each strategy involves trade-offs among cost, cash (inventory), and ser- vice. But which trade-offs are acceptable and which are not? Which have acceptable financial results and which are problem- atic? What principles exist to determine whether a particular strategy will actually work and what the consequences may be?

In the following sections, I’ll analyze the impact of the different strategies on the Supply Chain Triangle. But first, let’s con- sider

• the kinds of decisions made in the ab- sence of some statement of strategy;

• how organizational structure and de- partmental metrics can inappropriately affect decisions and trade-offs.

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DECISION MAKING IN THE ABSENCE OF STRATEGY

Absent a defined strategy, supply chain objectives will not be balanced. Consider the Acme Supply Chain Company, a not too atypical example of strategy or lack of it:

The Apex Supply Chain Company believes in supply chain management. Recently, the VP of Procurement has signed major sourcing deals with companies in the Far East in a bid to lower cost. Its fabrication unit has noticed that purchasing lead times have become longer, so it decided that to maintain the same service level in assembly operations it must increase stocks of raw and purchased materials. And, because of the long lead times for ocean transport and reduced supply chain flexibility, sales and marketing have de- manded increased finished-goods inven- tory levels. “If we can’t be fast on our feet anymore, we’ll have to carry more inven- tory.”

Sales wants to increase market share and turnover, so pushes to introduce new prod- ucts. If done well, an expanded product portfolio will support top-line growth. At

the same time, however, it will increase the required amount of inventory. But then, that’s not the sales organization’s problem, is it? As inventories grow, the CFO launches a program to slash stock, and the VP of Manufacturing orders that safety stocks be lowered, with the natural and im- mediate effect of lowering inventory but also negatively impacting service. As customers are experiencing service issues, firefighting measures are put in place that increase operational costs.

Conclusion: in the absence of strategy, many initiatives are taken, some to re- duce cost, others to reduce inventory, still others to improve service and revenue. The problem is that they aren’t coordinat- ed, so conflicts arise. Because they lacked a common and aligned goal, none of the individual supply chain targets could be reached.

TRADITIONAL ORGANIZATION MODELS AND METRICS CREATE TENSIONS

A typical manufacturing organization is structured functionally, as depicted in Figure 3. The VP of Sales thinks about how to hit the top-line target or how to

improve market share. The VP of Purchasing is wor- ried about how to reduce spending by consolidating vol- umes and increas- ing leverage. The VP of Operations

Figure 2. Strategy Mapping within the Supply Chain Triangle

Figure 3. The Organizational Chart in a Manufacturing Company

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is concerned with maximizing efficiency, since efficiency is the main driver for the manufacturing cost. The CFO will be looking after financial targets such as earnings per share or inventory turns. And each of them will have performance measurements for their own department to measure how they are doing.

From the perspective of the supply chain triangle (Figure 4), Sales and Market- ing will primarily pull the service side of the triangle and Operations primarily the cost side. In some companies, that’s where it stops: a battle between Sales and Operations resulting in huge swings in in- ventory. The CFO may bring that to a halt and require less inventory. But that pro- cess has less to do with company strategy than it does with “protecting your own turf.” In fact, there is no guarantee that any department’s actions will be consis- tent with company goals and objectives.

Should we be concerned about this kind of decision making? Won’t there always be conflicting objectives for sales, op- erations, and finance? Isn’t that tension a source of creative energy?

Not necessarily. Some of these wounds are self-inflicted. There are performance mea- surements, but they are disconnected. An organization must define consistent metrics that support the service, cost, and inventory objectives. Balance in the supply chain can’t be achieved if people are rewarded for behaviors that do not conform to company objectives.

From an investor’s perspective, the top- line (gross revenues) is not of concern in itself. Rather, the concern is profitability. Where service is a driver only of the top- line, the combination of the service and cost efforts drives profitability (e.g. earn- ings before interest and taxes, or EBIT) and, in turn, return on capital employed (ROCE). The ROCE principle is illustrated in Figure 5.

So balancing the triangle is about maxi- mizing bang for the buck. It means that the entire organization—CFO, VP of Sales, VP of Marketing, VP of Supply Chain, VP of Procurement, etc.—has a common mission. They shouldn’t go it

alone. The Product Leader can afford a higher inventory, as long as the EBIT is higher. Or vice versa, it’s OK for the Oper- ational Excellence player to allow a lower EBIT as long as it requires less inventory.

BENCHMARKING

Supply chain targets often result from benchmarking. Figure 6 (see following page) illustrates an inventory benchmark that compares inventory turns across six technology companies. We see leaders and laggards. Managers of Company 1 will probably conclude they should set a higher target for turns.

But there is usually a comparability prob- lem, due to differences in markets, prod- ucts, processes, KPIs, and other factors (Kolassa, 2008). Accounting for different

Figure 4. The Functional Imbalance in the Supply Chain Triangle

Figure 5. ROCE as the Bang per Buck

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market niches leads to the more refined comparison of Figure 7. Company 1 really is competing with only two other companies, Company 2 and Company 3. Company 2 is certainly the leader in in- ventory turns, and this may prompt the

other companies to target higher inven- tory turns.

ORBIT CHARTS Even when the companies being bench- marked are comparable, benchmarking in one dimension such as inventory turns, while common, is misleading. The supply chain triangle calls for a balance of ser- vice, cost, and inventory. Benchmarking in three dimensions is indicated.

In Excel we can show only two dimen- sions. However, we can collapse the three dimensions into two by combining the service (leading to top-line) and cost into a profitability metric such as EBIT. (We could equally have used EBITDA, Gross Profit, or Net Profit.) In her book Supply Chain Metrics that Matter, Lora Cecere (2015) uses what she calls orbit charts to benchmark in two dimensions.

Orbit charts also assist in evaluating stra- tegic choices: “What should we improve to best achieve our strategic goals? Product cost? Inventory position? Service? If we are currently positioned as a “low-cost produce”’ but our strategy is “product leadership,” what do we need to do tacti- cally to shift our position?”

For the three companies retained in the benchmark, the orbit charts in Figure 8 show inventory turns on the horizontal axis and EBIT as a % of turnover on the vertical axis. Each dot represents a year. By connecting the years, we can follow the performance of a company. Remember from Figure 5 that EBIT over Inventory is a ROCE-like measurement.

Analysis of the benchmarking data in Figure 8 reveals that:

• The performance of Company 1, which obviously suffered from the financial crisis, has rebounded better than its two competitors.

• Company 2 improved its inventory per- formance from about 7 to 10 turns, but EBIT has averaged only 1.5%. Apparently Company 2 has not generated any profit during the past decade, jeopardizing its borrowing ability and possibly forcing it to cut inventory, risking service issues.

Figure 6. Inventory Turns Compared across Six Companies

Figure 7. Inventory Turns Compared across Three Companies in a Specific Niche

Figure 8. Inventory Turns versus EBIT% across Three Companies in a Specific Niche

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• Company 3 has generally better bal- anced performance but is not resilient: severely hit by the crisis, it has never fully recovered to pre-crisis levels of per- formance.

SETTING BALANCED TARGETS So how might each of the companies set appropriate, balanced targets for inven- tory turns and EBIT? And what would characterize performance leadership for each of the three general strategies (prod- uct leadership, customer intimacy, opera- tional excellence)?

First, it’s useful to understand the maximum, minimum, and median per- formance over time, using the best per- forming (highest combination of EBIT and inventory turns) company as the reference. For this analysis, we’ve added min, max, and median dashed lines to our orbit chart.

Take Company 3 as the reference, as it had delivered the highest combination of EBIT versus inventory turns during the last decade. The top-line displays the com- binations of EBIT and inventory turns that correspond to the maximum per- formance of Company 3 (which occurred in 2004). The bottom dashed line shows its minimum performance. The middle shows the median performance.

How does this help us to set targets? Focusing on Company 1 and its current performance, and assuming that the com- pany wishes to pursue aggressive targets related to maximum performance, the two best choices appear to be: • Engineer improvements that cause

performance to move straight up from current (2013) performance to the max line, improving EBIT without changing inventory levels;

• Engineer improvements that cause performance to shift up and to the right, reducing EBIT but increasing inventory turns.

These paths to improvement are depicted in Figure 10 (dark red lines). Moving straight up is the path a company pur- suing product leadership should take. Because of new-product complexity, it

will carry more inventory than other play- ers in the market but offset that cost by a higher EBIT achieved through a premium product.

Going up and to the right is the path of a company pursuing customer intimacy. The route requires elimination of some older, more complex products in favor of the broader but simpler product range that will benefit from improved customer relationships.

Some companies shift strategies from product leadership to customer intimacy after their market has been disrupted by a technology shift (think analog to digital). You must either buy into the new technology or build a product and service portfolio around the existing customer base.

Figure 9. Combinations of EBIT and Inventory Turns that Achieve Maximum Performance

Figure 10. Orbit Charts of the Three Strategies

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A company pursing operational excellence will move directly to the right. It works with razor-thin margins but compen- sates for this by employing less capital. Sometimes companies leave their cus- tomer intimacy strategy for operational excellence. If customers are no longer honoring the extra service via a premium price, it’s tempting to cut the service al- together and go for a cost proposition. Treacy and Wiersema recommend that if you go along this path, go all the way: be relentless on cost and cut any product that is not generating the required bang for the buck. In general, however, firms are neither that courageous nor truthful when taking such a leap. They don’t like to say to their customer “We will no longer deliver product X, Y, and Z.” So actually making this shift, while appealing, is in practice difficult to pull off.

As shown in Figure 10, companies already near the best-practice frontier have to make choices—either try to increase EBIT by increasing complexity or re- duce complexity at the expense of EBIT. Shifting your position via new targets may mean shifting your strategy. In con- trast, laggards typically can improve on

both dimensions (inventory and EBIT) at the same time, by applying best practices such as improved forecasting, SiOP, and multi-echelon inventory optimization, to name a few.

FORECASTING CHALLENGES

Improvements in forecasting perfor- mance can shift the best-practice frontier. Improved forecasting allows the orga- nization to increase service, even while reducing inventory and cost, resulting in simultaneous improvement on inventory turns and EBIT. Adoption of better fore- casting practices will allow the laggards to catch up with the leaders, and the leaders to gain further competitive advantage.

But how to extract forecast improvement depends on the strategy chosen. As illus- trated in Figure 11, a change in strategy implies a change in the forecasting ap- proach.

Simplicity drives efficiency: that’s the motto of the Operational Excellence Player. A company whose strategy is op- erational excellence will be willing to cut slower-moving products and stabilize demand in order to maximize efficiency. A stable product portfolio is normally the easiest to forecast statistically. So statis- tical forecasting will be helpful for the product leader.

The product leader will try to build niches from its newest products. Consider the technology company active in high-end projection. It is currently releasing a first laser projector for digital cinema appli- cations. Assume a cost per unit of $250,000. If there are about 100,000 cinema rooms worldwide and if 20% of these are expected to switch to la- ser projection in the next five years, we’d project sales of about 4,000 per year. If we are the market leader with a 50% market share, that gives sales of 2,000 per year. But what if we overforecast sales by 25%, or 500 projectors per year? Multiplied by the $250,000 cost per projector, this means a shortfall in revenue of $125

Figure 11. Impact on Strategy on Forecasting

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million! Imagine if the unsold projectors end up in inventory!

From this example, it should be clear that the main challenge for the forecaster will be how to deal with the market un- certainty surrounding the entry of new products. Qualitative techniques such as the Delphi method could be helpful for a product leader.

The challenge for the customer intimacy player is how to deal with product portfo- lio complexity. You can expect customer- specific products with spiky demands. Forecasting these will probably require collaboration and projections based on sell-out or consumption, instead of sell-in or orders. For a customer intimacy player, collaborative planning and forecasting will be especially helpful.

Finally, a change in strategy will also re- quire a change in forecasting approach. Remember our product leader whose analogue niche got disrupted by digital technology? Instead of buying in to the digital technology he decided to switch to a customer intimacy strategy, driving more value from existing customers by offering a less complex but wider range of products. To ensure the company doesn’t fall back from a leader to a laggard, it will need to install collaborative forecasting with key customers to be able to control the increased complexity in his product portfolio.

Then we have the customer intimacy play- er who was switching to an operational excellence strategy because his customers were no longer honoring the extra service via a premium price. He should lower the cost of forecasting by getting rid of the collaborative forecasting process, which is time consuming, and installing an au- tomated statistical forecasting process.

CONCLUSIONS

The lack of a clear strategy and the func- tional focus in traditional organizations makes us feel like jugglers in a circus. We have initiatives on service, on cost, and on inventory, but we are uncertain where these are going and so we face a juggling act to keep them in balance. We need

alignment between the three: we can’t decide on an inventory target without specifying service and cost targets as well.

Moreover, the combined target for the three depends on the company strategy. Companies with different strategies will have different sets of targets.

Two-dimensional benchmarking via or- bit charts helps to reveal the difference between the leaders and the laggards in each of the possible strategies: product leadership, customer intimacy, and opera- tional excellence. Your targets will depend on your strategy. A change in strategy will change your targets.

Forecasting is a key enabler of strategies and supply chain performance. Improved forecasting will simultaneously improve service, cost, and inventory. It allows laggards to catch up with the leaders. It allows leaders to shift the best-practice frontier and gain a competitive edge as they adopt innovative forecasting practic- es. Different strategies require different approaches to forecasting, so a change in strategy requires a change in forecasting approach. It is clear we should acquire forecasting tools sufficient to fit the dif- ferent challenges imposed by corporate strategy.

REFERENCES Cecere, L. M. (2015). Supply Chain Metrics that Matter, Hoboken, N.J.:Wiley.

Kolassa, S. (2008). Can We Obtain Valid Benchmarks from Published Surveys of Forecast Accuracy?, Fore- sight, Issue 11 (Fall 2008), 6-14.

Treacy, M. & Wiersema, F. (1997). The Discipline of Mar- ket Leaders, New York: Basic Books.

Bram Desmet is the Managing Director of Solventure, a Europe-based company that de- signs and implements sales, inventory, and oper- ations-planning processes. Bram earned his PhD at Ghent University in Belgium and serves as an Adjunct Professor in Operations and Supply Chain at the Vlerick Business School. He is now working on a book about the Supply Chain Triangle.

[email protected].

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