6 Stages in Supply-chain Costing

6 Stages in Supply-chain Costing

Copyright 2002, Traffic World, Inc.

In today's business, cost reduction is a primary focus of top management. Growing the top line is tough unless your competitors are going out of business or you have a niche market tied to an essential need: survival. Many companies are sending their people to the University of Wisconsin Executive Education programs to get today's skills, both to address cost reduction and to learn how to gain and maintain market advantage in these tough times.

But what about costs? Costs mean many things to functional specialists. Costs also take on a different meaning when addressing cross-functional and interenterprise activities. Through their research, interactions with executive education program participants and recent consulting activities, UW educators have discovered that there is an evolutionary pattern in the way costs are perceived and managed by organizational leaders today. Six stages of cost orientation have been identified. These differing perspectives will help executives understand current organizational capabilities and set the vision and strategies for improved firm and multifirm performance.

Stage 1 - Functional Cost Minimization.

At this stage, many persons in their functional areas of responsibility manage and are recognized for minimizing the costs directly attributable to what management has assigned as their main area of focus. Examples: purchasing often minimizes prices paid for goods and services - no matter what the terms; transportation minimizes shipping costs; inventory analysts minimize inventory levels; warehousing minimizes its warehouse budget; production minimizes its added-value cost per unit; packaging looks for the cheapest packaging and unitizing costs. It is estimated that 50 percent or more of firms recognize their staff for achieving improvements in these key result functional areas. Increasingly, however, these firms are realizing that optimizing a part of the business system incurs penalties in other parts of the same system.

Stage 2 - Lowest Delivered Cost.

As firms begin to realize that functional cost minimization is not optimal for the firm, inbound and outbound shipments are scrutinized as to the impact and trade-offs of purchasing, asset management and transportation on acquisition and delivered price. Purchasing now solicits dual bids to identify how important transportation and alternative geographic sources of goods are to delivered prices. What role do the modes of transportation have on cost-at-origin prices and on packaging requirements and costs? What role does a supplier's warehousing - plant or remote - have on delivered prices? The same analysis is applied to interplant and customer shipments. Many firms do a great job managing inbound-from-supplier and/or outbound-to-customer flows, but forget to track and analyze interfacility transfer costs. About 25 percent of firms are at this stage. Here, cross-functional sets of teams collaborate to improve the firm's acquisition and delivered costs in meeting widely divergent customer needs.

Stage 3 - Total Costs of Ownership.

What big cash items in the firm's or enterprise's analyses are missing? Inventory carrying costs and the investment in assets to support the firm's decisions as to how much product should be flowing in, through and out of the enterprise are the big missing elements. Inbound, throughput and outbound teams in this stage analyze costs and asset investments as to the lowest total costs for delivering finished goods to their immediate customers.

Models are designed to address "customer-demand pull" costs that look at the tradeoffs across the enterprise in meeting demand. Using smaller inbound shipments delivered on the Japanese just-in-time basis to meet cell manufacturing schedules is one example of how a firm can analyze costs from Stage 2 and address the sticky question of how much inventory to hold. Additional metrics surface as the firm begins to develop a balanced scorecard of metrics that go beyond cost reduction and asset minimization.

Stage 4 - Enterprise Value-add Costs of Sales.

Guided by European and international economic models, the concept of "firm or enterprise value-add" costing is the next stage. What are the value-add costs that a firm contributes to the supply chain? These are costs that add customer value beyond the total costs of materials ownership. Now firms are beginning to address costs associated with marketing and sales, engineering and technical support, field service support, information technology costs, general and administrative costs.

Firms establish economic models in which product and customer profitability are analyzed. Gross markup analyses become a focus of the firm. The firm determines gross margin markups to analyze how to cover costs of purchases, the value-add costs, and profit margins before and after taxes and financing cost. Top management teams begin to understand the value-add concept in a strategic, systemic way to coordinate cross-functional team activities. There are few firms operating at this stage.

Stage 5 - Interenterprise Value-add Cost with Immediately Adjacent Trading Partners.

Up to this point, interenterprise cost tradeoffs have not been evaluated. Analyses have focused upon individual firm or enterprise financial analyses. Stage 5 addresses "immediate supplier, customer and intermediary" costs analyses. The focus of analysis now becomes multienterprise and includes the firm's customers, suppliers and also supporting intermediaries, such as logistics service providers and information technology providers.

The concept of Transactional Cost Analysis comes into play as firms begin to develop open-book analyses to determine who best can economically offer various functional services within the immediate supplier/firm/intermediaries/customer relationships. Activity-based costing capabilities provide for comparability across firms. Multifirm work flow design and value-engineering occurs.

Disintermediation and reintermediation are considered in resolving who can best perform tasks. For example, who and how should services related to demand forecasting and scheduling, inventory management and replenishment, transportation, warehousing, kitting and assembly, physical stock tracking and inventory visibility, engineering and technical support, product failure analysis, marketing and sales activities be performed?

Redundancies are eliminated, services improved and overall combined costs reduced through interenterprise collaboration. TCA facilitates interenterprise decision-making on the sharing of costs and benefits. A very small percentage of firms have attained these interenterprise levels of analysis and governance.

Stage 6 - Lowest End-user Delivered Supply-chain Cost

Stage 6 addresses issues and analyses that go beyond the focal firm or enterprise. Supply-chain trading partners address service and economic tradeoffs among all trading partners in the supply chain. The focus in Stage 6 is on the ultimate personal or business consumer or what is being called the end-user. This stage goes beyond immediate trading-partner tradeoff analyses and begins to address the newly developing area of supply-chain economics - not micro, firm or macro, total economy but interenterprise "supply-chain economics."

The literature in business and economics has developed from functional/firm economics based upon various microeconomic theories and then has been extended to macroeconomics dealing with the economics of entire countries and industries. This stage of analysis focuses on the end-user with the objective of developing business strategies across multiple enterprises in supply-chain networks that deliver products at the lowest end-user costs while efficiently allocating assets and profits across members of the supply chain. These interenterprise analyses include Tier 2, 3 and more suppliers, Tier 2, 3 and more customers, and multitier intermediaries that are linked in networks that attempt to efficiently and effectively allocate services and cash among the members.

Present accounting and economic principles are challenged to deal with this type of analysis. Several industries, such as automotive and industrial commodities and consumer package goods, are developing strategies to address these challenges. At present a very limited number of firms have attempted this most strategic perspective to develop the "value proposition or business case" for focusing upon these extended enterprise, supply-chain economic challenges to meet end-user demands.

At the UW, a team of academics and industrial practitioners are developing cross-functional economic models to develop "how to" methodologies to measure and recognize true extended supply economics for supply-chain trading partners. This capability will position one supply chain to more efficiently compete with other supply chains to ensure end-user retention and profitability.

-- Dr. Marien is professor and director of supply chain, transportation, purchasing and supply management programs for the Executive Education unit of the School of Business, University of Wisconsin-Madison. Dr. Keebler conducts workshops and consults in the areas of asset management, supply-chain management and performance measurement and serves on the faculty of the G.R. Herberger College of Business at St. Cloud State University, where he teaches marketing, logistics and supply-chain management. You may reach the authors at emarien@bus.wisc.edu and jskeebler@stcloudstate.edu.